Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

Giacinta Cestone

Series number :

Serial Number: 
349/2013

Date posted :

February 01 2013

Last revised :

February 18 2013
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Keywords

  • control rights • 
  • cash-flow rights • 
  • security design • 
  • venture capital

This paper develops a theory of the joint allocation of control and cash-flow rights in venture capital deals. When the need for VC advice and support calls for a highpowered outside claim, the entrepreneur should optimally retain control in order to avoid undue interference. Hence, I predict that riskier claims should be associated with fewer control rights.

This challenges the idea that control should always be attached to more equity-like claims, and is in line with contractual terms used in venture capital, in corporate venturing and in partnerships between biotech start-ups and large corporations. The paper also rationalizes evidence that venture capital contracts include contingencies triggering both a reduction in VC control and the automatic conversion of VC’s preferred stock into common.

Published in

Published in: 
Publication Title: 
CEPR Discussion Paper No. 3462

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