MBA elective: Venture capital &

private equity
Week 1: Venture capital

Agency issues and their

resolution

Course leader:
Prof. Robert Cressy

1
 Objectives of the lecture
 To understand how venture capital differs from
conventional equity finance
 To understand the two agency relationships in
the provision of venture capital
 To understand some of the conflicts these
generate
 To understand the contractual and other
structures used to resolve these issues

2
 To examine some of the empirical
research on the role of covenants in the
investor-VC relationship

3
 Outline of the lecture
1/ Venture capital and corporate finance theory
2/ The Agency problem: theory
3/ Dual agency problems in venture capital
4/ Solving the VC-company agency problem: the
venture capital contract
5/ Solving the Investor-VC agency problem: The
LP agreement
6/ Research on owner-manager replacement
7/ Summary and conclusions

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1/ Venture capital and corporate
finance theory
 How do they differ? (Figure 1)
1. Information availability
2. Monitoring of management
3. Access to capital
4. Tradeability of shares
5. Market for corporate control
6. Asset specificity
7. Project valuation
8. Investment decisions

5
Fig. 1: Venture capital vs. corporate finance
theory

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 VC vs. Corporate Finance
cont’d
 Venture capital finance
 Recipient: Entrepreneurial firms
 Young
 Small
 Often high tech
 Fast growth
 Information
 Asymmetric
 Entrepreneur knows more
 Scarce
 No public reporting of activities
 Uncertainty about
 Management
 Product

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 Purpose
 Early stage investments
 Growth
 Type
 Equity
 Often as preference shares
 Convertible to equity
 Staging
 Funds provided in tranches
 Contingent on performance
 Ameliorates information problem
 Syndication
 Funds typically provided by a group of VCs
 Rather than as a lone investment
 The agency problem: Theory
 A principal-agent (PA) relationship is one in
which a principal hires an agent to perform a
task on his behalf
 Examples
 I hire a lawyer to pursue a court case
 Principal is Robert Cressy
 Agent is the lawyer
 Task is to win the case
 A pension fund hires a venture capitalist to invest a
proportion of their funds
 Principal is the Pension fund
 Agent is the Venture capitalist
 Task is to invest the fund’s money

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 First-best contract
 If the agent’s effort could be observed a contract
could be written between the two making
payment (w=‘wage’) contingent on effort (e):
 w=f(e)
 This is called a First-best contract
 both parties are as well off under this as under any
other arrangement
 However effort cannot in general be observed

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 Another form of PA problem is where the agent
obtains funds from the principal
 for investment for a specific purpose and
 with specific characteristics e.g. risk-return
combination
 A First best situation is where
 the agent’s actions can be observed and
 a contract is written on this
 .

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 Example:
First-best contract
 Suppose I as a VC can observe (and
understand!) a biotech company’s GenTech’s
research activities
 The contract I write with GenTec can specify that
the money I offer is to be used to fund R&D into
a very specific disease, e.g muscular dystrophy
 If I see the firm is not using it for that purpose, I
can sue them for breach of contract

13
 Realising this, they are likely
 to stick to the original agreement or
 alternatively not to take the finance

 In both cases the outcome is economically

satisfactory I.e. there is no market failure

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 A Second best situation with Moral hazard
occurs when
 actions are unobservable and effort is
suboptimal
or
 the funds are misused in some way

15
 Example:
Moral hazard and strategy
 The VC of a biotec company decides that the
founders should change their product strategy
 Originally they had been developing 6 drugs
 VC requires them to focus efforts on one only
 Founders agree to this but
 Know this is a highly risky strategy
 Hence they secretly continue work on the other 5

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 This is moral hazard in practice:
 Conflict of interest between principal (VC) and
agent (company)
 Results in unobserved action that is not in the
principal’s interest
 Or at least is believed by the principal not to be so

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 Recourse
 Contractual recourse (legal action against
the agent) in the presence of moral hazard
is difficult
 unless the contract can be specific about what
the agent should do/not do
 Actions can be ‘costlessly’ observed

 In many real world situations then, some

‘cheating’ will occur

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 VCs, realising it is difficult to deal with this,
may provide too little equity to such
businesses
 Too many businesses may be self-funded as
a result
 More businesses may fail as a result of
undercapitalisation
 See Figure following

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 Class exercise 1:
Failure curve and capitalisation
 The chart that follows can be thought of as
showing the failure curves for two
businesses:
 One with adequate capitalisation (the ‘right’
volume of initial funds)
 The other with inadequate capitalisation (the
‘wrong’ volume).

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 Failure and capitalisation
Figure 1: Young firm failure and Capitalisation

0.5

0.45

0.4

0.35

0.3

Unde rc a pit a lise d busine ss

0.25
P rope rly c a pit a lise d busine ss

0.2

0.15

0.1

0.05

Ti m e t r a d i n g ( a r b i t r a r y u n i t s )

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 Questions for discussion
 Firstly, what happens to the failure rate
over time?
 Is it constant?
 Does it have the same pattern for well-
capitalised and badly-capitalised firms?
 Secondly, is there any period of time
during which failure rates are zero?
 If so, why?
 If so, what might be the reason for this?

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 Thirdly, what happens to failure in the long
run?
 Fourthly, does this pattern of failure have
any implications for public policy?
 E.g. do firms with low capitalisation need a
public subsidy?
 If so, what would justify such a policy?

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 Implications for startups
 Inadequate capitalisation may cause
 Loss of first mover advantage
 Competitors get there first
 You are preoccupied with survival
 Or may not even be able to start the business
 If venture capital is not provided for viable
projects then the rate of innovation may suffer

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 Incentives to risk-taking:
GP compensation as an option
 Compensation of venture capitalists (GPs) takes
a very specific form in a Limited Partnership
agreement (Figure 4)
 As we have seen from the numerical example,
there is a fixed and variable component to GP
compensation:
 A fixed management fee, M, proportional to the initial
value of the fund, F: M=kF, k>0
 A variable fee H proportional to the profits (capital
gains) of the fund, H=a[S-F], a>0, when S>F

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 Figure 4:
45o
GP compensation as a Call option

G=kF+max{0,a[S-F]}
kF+a[S1-F]
LPs’ loss if investee
companies are
GP compensation

worthless

kF

GPs’ guaranteed fee

income
S Portfolio
0 F S1 value at IPO

Increase in prob
S>F with increase
in volatility
 Black-Scholes formula
 The Black-Scholes (BS) formula for the market
value of a Call option, c, is:
 c=f(X,S,T,r,)
 where
 X=initial value of the fund
 S=value of VC’s portfolio of investments at IPO
 T= time to return of investors’ money
 r=safe rate of interest
 =volatility of the VC’s portfolio value (S)
 It is well-known that the value of an option
increases with the volatility of the share’s cash
flow, 

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 This means that the VC has an incentive to
make the investments of the fund more risky
than investors would like
 This appropriates money from the investors
 The VC’s return is proportional to the capital gains of the
fund
 An increase in the probability that the value of the
investments exceeds F increases the VC return (Fig. 4)
 It is another kind of moral hazard

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 General contractual solution
 The principal wishes to find
 a way to motivate the agent to
 put in effort or
 to invest the principal’s money correctly

 whilst only being able to observe the outcome

of his activities
 E.g. a patent is generated (or not)

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 Methods of doing for VCs include
 Covenants in the LP agreement
 Methods of doing this for entrepreneurs include
 Gearing their asset holdings to performance
(ratchets)
 Aligning their success with that of the firm
 Management share options
 Replacement of underperforming management
 See the research paper by Cressy and Hall(2005)

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 3/ Agency problems in VC
 There are in fact two agency relationships
in venture capital:
 The relationship of investors to venture
capitalists (‘firms’)
 Governed by the limited partnership agreement
 The relationships of venture capitalists to the
companies they invest in (‘investee
companies’)
 Governed by venture capital contracts

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3.1/ Solving the Investor-VC agency
problem: Limited partnership
 Investment behaviour of venture capitalists is
 regulated by covenants
 written into a contract called
 a Limited Partnership (LP) agreement
 LP agreements are the most common vehicle
for VC investment in the United States
 Less so in Canada, Europe and Asia

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 Partners in a limited partnership are of two
types:
 General partners (Venture Capitalists or VCs)
 These have unlimited liability
 They manage the fund on a day to day basis
 Investing money
 Monitoring investee firms’ performance
 Harvesting (selling) investments
 Etc etc.

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 Limited partners
 These are the investors (money-providers) and have
limited liability
 They are liable only to the extent of their investments
 They delegate to the VCs responsibility for
 investment selection and
 monitoring of investments

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 LP cont’d
 Characteristics of the LP fund
 Duration
 Typically 10-12 years (US, UK)
 Contract terms
 fixed throughout
 renegotiation uncommon
 Compare executive contracts - frequently renegotiated
 Management
 Long term
 Objectives set by investors annually
 Short-term
 Day-to-day management in the hands of the VC

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 Flows of funds and services
 What is the flow of services and funds between
investors, venture capitalists and the company?
 We can see this from Figure 3:
 Involvement begins with the establishment of a VC fund
 Legal agreement (‘the deal’) between
 venture capitalists
 the investors
 Investors make money available over a (generally) fixed period
 Subject to a range of conditions
 For investments in unquoted companies

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General Partner
 Generate deal flow
 Screen opportunities
 Negotiate deals
 Monitor and advise
 Harvest investments

Effort Annual Carried

and management interest of
1% of fee 20-30 %
capital 2-3% of gain

Investment Portfolio
Venture capital and company
Capital effort Value creation
Financial
Fund Claims

99% of Capital
investment
capital appreciation
70-80% of

Limited Partners gain

 Pension Plans
 Life Insurance companies
 Endowments
 Corporations
 Individuals

Figure 3: Organisational Structure

Source: Entrepreneurial Finance, Smith et all
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 Timeline cont’d
 During investment VC will have varying
degrees of involvement with investee firms:
 Monitoring
 Advice and assistance (membership of BOD)
 Harvesting of the investment
 Involvement in IPO/trade sale
 VC involvement ends with the closure of the
fund

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 The VC makes very little investment in the
fund (1% max)
 However, she derives income from two
sources
 A fixed annual management fee during the life
of the fund (2-3% of fund value)
 A fixed proportion (20-30%) of the capital
gains of the fund (carried interest)

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 Class exercise 2:
VC compensation
 Suppose Lydia VC has raised a $1 billion
fund for early stage investment
 She will
 invest this money (for simplicity, immediately)
in fast growth businesses
 Then, with her partners, manage the
businesses to IPO over the next 10 years
 She has 4 other partners also who act as
investment managers

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 They are paid salaries from the VC’s
annual Management Fee
 Suppose that after 7 years she sells (again
for simplicity, in one go) her investments
for $7billion, via a set of IPOs
 However, payments to underwriters at IPO
eat up $1bn of this gain
 Assume that
 all payments to the partnership are divided equally
amongst the 5 partners
 even though the investments are cashed in after 7
years the partnership continues for the full 10 years.
 Carry or Carried interest is paid at 20% of the capital
gain
 Management fee is 2% of the initial value of the fund
 Question:
 What is the average partner compensation (total
payments per partner over the 10 year fund)?
 Exercise 3:
IRR to the fund
 Calculate the internal rate of return to the
fund

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 3.2/ Solving the Investor-VC
agency problem: details
 Motives for use of Limited Partnerships
 Dealing with agency problems associated with
employing a VC to invest money
 Covenants are used to govern the relationship between the
VC and investor
 Tax efficiency considerations
 Taxation of capital gains:
 Transfers of cash or shares between GPs and LPs in a
limited partnership are exempt from capital gains tax
 See the SJ Berwin document on the Inland Revenue treatment
of capital gains on the BVCJ website
 This may be a very important motive for using the LP as
capital gains can be large

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 As a result
 Most VC funds are organised as LPs in the
US and the UK
 These are two stock market-based economies
 Venture capital is well-developed

 But less so in Europe

 These are traditionally bank-based economies
 Venture capital is less well-developed

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 Covenants
 We can distinguish covenants relating to 3
areas of activity:
1. Overall fund management
2. Activities of general partners
3. Types of investment

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 Covenants cont’d
1. Covenants relating to overall fund
management
Agency problems exist in the relationship
of the General partners to the Investors:
 The General partners share of the fund’s
profits is (as we have seen) a Call option:
 GPs receive their share of profits after the LPs
have received their return

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 Hence GPs will wish to find ways to ensure that
the profits (share price) exceed this minimum level
(strike price)
 They will gain by increasing the risk of the portfolio (in
VCs interest since this increases the value of the Call)
 This is done at the expense of diversification (in the
interests of the investors or limited partners)

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 Covenants cont’d
 GPs can increase risk by:
 Excessive investments in one firm
 Increasing the leverage of the fund (borrowing)
 Co-investments with the venture organisation’s earlier
and/or later funds to
1. salvage investments they made in earlier vintage
funds by
2. follow-on investments in later vintage funds
 Reinvestment of profits of the fund
 This will not return profits to investors at the agreed
times

49
 Covenants cont’d
2. Covenants regarding the activities of the general
partners (VCs)
 Contract limits the following:
 Investment of GPs’ personal funds in firms
 Motive of action: increase returns to GPs
 Covenant: outlaws personal investment by VCs
 Effect: avoids unwarranted special treatment by GPs
 undue attention lavished on certain firms
 unjustified follow-on funding /failure to terminate

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 Sale of partnership interests by GPs
 Motive of action: reduced effort
 Covenant: outlaws sale of partnership interests
 Effect: prevents possible reduction in monitoring of
investments as a result of new partners being
inducted

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 Covenants cont’d
 Fundraising by GPs
 Motive of action: to increase GPs’ return
 component that is proportional to volume of funds raised
 Covenant: bans such fundraising
 Effect: prevents reduced attention to existing investments
 Outside activities by GPs
 Addition of new GPs
 Motive of action: to reduce the burden of work on existing
GPs
 Covenants: ban certain (professional!) outside activities and
addition of new partners
 Covenant effect: prevents possible reduction in quality of
oversight of existing investments

52
 Covenants cont’d
 3. Covenants restricting types of
investment
 Classes of investment
 Publicvs. private company securities
 Other venture funds vs. current fund
 Motive for GPs action:
 higher commission to GPs
 acquisition of experience by GPs in different fields
of investment

53
 Covenants cont’d
 Effects of GPs’ behaviour
 Investments made in which GPs have little(less)
expertise
 Hence their chances of success may be low(er)
 Covenant: bans these types of investment
 Effect:
 prevents diversion of funds to unauthorised uses
 reduces potential losses to investors from VC
‘experimentation’

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 3.3/ Recent history of the GP
compensation schedule
 In the technology boom of the late 90s, the
demand for venture capitalists’ skills was
high
 This resulted in GPs negotiating
considerably above-normal:
 management fees (up to 3%)
 share of carried interest (up to 30%)

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 After the bubble burst, litigation was
threatened by both parties:
 GPs suing LPs because they will not release
funds for investment
 legally
they are required to do so, unless
incompetence is provable
 LPs suing GPs for incompetence in their
investment activities to avoid paying out more
money

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 One thing is clear: the GPs were extremely
shrewd to negotiate large increases in the
management fee:
 This is independent of their performance!

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 3.4/ Solving the VC-company
agency problem: the VC contract
1. Non-disclosure
 Dealt with in the contract by representations
and warranties covering
 Ownership of assets (Who?)
 Litigation outstanding (Is there any?)
 Accuracy of financial data (Do they conceal
anything about the firm’s finances?)

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2. Misuse of funds
 Divided into two categories
 Affirmative covenants
 Prescribing
actions that need to be taken by the
entrepreneur
 Appointment of the Board of Directors
 Setting annual budgets
 Production of regular financial statements

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 Negative covenants
 Proscribing certain activities of the entrepreneur
 Changing the nature of the business
 This might otherwise make investments more risky for investors
 Issuing securities
 These might otherwise dilute investors claims etc.
 The same pie is divided into more slices
 Altering employee compensation
 This might otherwise weaken performance incentives to VCs and
 alter the risk-sharing features of the agreement
 Setting up in competition against the venture
 This might otherwise reduce the returns available to investors

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3. Contingencies
 Upside gains
 IPO
 Registration rights
 Guarantee that shares of the investor are tradeable on
the market at time of IPO
 Two varieties
 ‘Demand’ registration: obligation to sell shares
 ‘Piggyback’ registration: option to sell shares

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 Future funding opportunities
 Participation rights
 Rights to buy shares
 if the business expands
 Needs more funds (e.g. ‘seasoned equity’ offering)
 Examples
 Right of ‘prior negotiation’: entrepreneur must offer
opportunity to invest to existing investors when raising
more capital
 ‘Pre-emptive’ rights: investor can maintain existing
fractional shareholding by further participation

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 Downside losses
 Liquidation of the investment
 In event of breakdown of relationship
 Increases salvage value to investors
 Devaluation of the investors’ shares
 Might result from issuing of more shares in later rounds of
financing
 Under a ratchet provision, existing investors may acquire extra
shares at zero or much lower cost (than in the original contract)
 This is done in such a way as to keep the average price of
shares constant

63
 Detail:
Operation of a ratchet
 Suppose an investor
 puts in £400
 to purchase 100 shares in Wondertech startup
 in an initial round of financing
 In the first round of financing these shares are
therefore valued at £4.
 Now Wondertech decides to expand and
requires a second round of funding.

64
 Ratchet cont’d
 However, it finds that the shares it wants
to issue can only be sold at £3.
 This would reduce the value of the original
investors’ holdings to £300.
 The ratchet provision will keep his
investment value constant

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 Answer
 This device answers the question:
 What number of free shares should be offered
to the old investors to keep the value of their
shareholdings constant?
 Answer: 1 new share for 3 old shares held.
 The old investor will then have 133 shares valued
at £3 each yielding a portfolio value of £400

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 3.5/ Solving the VC-owner agency
problem:
Replacement of owner-manager
 We have seen that ratchets provide one means
of
 incentivising the entrepreneur
 protecting the VC against moral hazard and just bad
luck
 But what if the owner-manager is just
incompetent, inappropriate or unmanageable
rather than deceptive?
 Replacement may provide the solution to this
problem for the VC

67
 3.5.1/ Large company
replacement
 In large companies replacement of CEOs
has an impact on performance of the
company
 However it varies with the type of
replacement:
 CEOs that were formerly Insiders vs. those
that were formerly Outsiders to the firm

68
 Research shows that Outsiders
 outperform insiders in the first half of their
tenures
 underperform in the second half!

 Possible explanation?
 Outsiders are at greater risk of being left out
in the cold if they fail to meet their initial
targets

69
 3.5.2/ CEO replacement in
small companies
 Little is known about the replacement frequency
of owner managers in small companies
 In general one would expect it to be lower
 Less public scrutiny of performance
 Family business structure dominates
 Few M&A events to discipline poor performers
 What of VC-backed companies?

70
 Some evidence on replacement of owner-
managers by VC investors in Hannan, Burton
and Barron(1996)
 They examine a sample of young, high-tech
Silicon Valley firms
 Find the probability that the founder will be
replaced
 In the first 20 months of a firm’s life is 10%
 In the first 40 months 40%
 In the first 80 months 80%

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 So in the
 Early stages the probability is below 1% per month
 Later stages is above 1% per month
 The vast majority of owner-managers are
replaced eventually
 Why?
 Poor management skills?
 Inappropriate management skills?
 Falling out with the VC?
 Free riding/moral hazard?

72
 Research findings:
Cressy-Hall (2005)
 Apart from the Hannan et al study no
empirical work had to our knowledge been
done in this area
 Furthermore, no formal theory of the
factors influencing
 replacement
 the effects of replacement on firm value
appeared to exist

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 VC will update his estimate of the
manager’s ability as observations
accumulate
 In any period he can either
 Continue with the existing manager and learn
more about him
 Replace the existing manager by a
professional with known ability

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 VC will choose a cutoff S* on the
incumbent’s track record that maximises
his (VCs) expected profits

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 Optimal cutoff
 Model shows the existence of an optimal
cutoff value on managerial track record
S*(t)
 If his current performance falls below the
cutoff the manager is replaced
 In Fig. 1
a manager with a poor track record (L) has a high
hurdle on current performance S*(L)
 A manager with a good track record (H) has a low
hurdle on current performance

76
 2-period model:
The graphics of S*(2)
VC’s period 2 expected return
from the current manager given
good track record (S1=H)

R(H)=replacement set given

good track record (S1=H)

VC’s period 2 expected return

from the current manager given
poor track record (S1=L)

VC’s period 2 expected return

R(L)=replacement set given
from the replacement manager
poor track record (S1=L)

Good track record rewarded by S 2* ( H ) S 2* ( L) S2

low hurdle rate
Poor track record penalised
77by
high hurdle rate
 Predictions
Variable Probability of replacement

Manager track record (S(i)) -

Demand for firm’s product (γ) -

Discount factor (δ) -

Monitoring cost (c) +

Return to substitute manager (П) +

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 Summarising predictions
 Thus the probability of replacement goes down
(-)
 the better the manager’s track record
 The greater the demand for the firm’s product
 The higher the value placed on future earnings
(discount factor)
 The probability of replacement goes up (+)
 The higher the monitoring cost of the manager
 The better the quality of the replacement manager
 The data
 Sample
 Companies:
 Venture One companies with 1st financing round in 1999-
2001
 Geographical coverage
 N. America, Europe, Israel
 Sectors: High tech
 Electrical
 Semiconductors
 Telecoms
 Biotech/Pharma
 etc

80
 Descriptive statistics
 Replacement
 24% of managers were replaced in any given round
on average
 80% were replaced in rounds Seed to 2
 Statistics are consistent with Hannan et al (1996)
 Management track record (MGTINDEX)
 Typical manager scored 4/16=25% on our scale
 VC financing proportion (VCPORTION)
 Surprisingly VCs provided only 60% of the finance
required for a given round
 40% provided by other sources

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 Logit regressions for
Prob(REPLACE)
 We fit the following logistic regression to
the data:

Pr(MGTREPLACE it  1)  1  1 zit   1 xt   1it

 where
 z is a firm level vector of explanatory variables
for round i at time t
 x is a market level vector of the same

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 Discussion
 Controlling for a large number of company,
industry and macro effects we find that:
 Higher costs of monitoring are associated as
predicted with greater chances of managerial
replacement
 One critical stage of development, the Beta stage as
predicted is a critical point in the replacement decision
 A change in the kind of manager is required when moving to
market
 For a given track record, more risk is involved in retention

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 A measure of the manager’s and company’s
productivity, patent usefulness, reduces the
chances of replacement as predicted

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 PreMV regressions
 Regression equation estimated was
PMVit   2   2 zit   2 xt   2 it
where
 PMV=company’s preMoney valuation at time t
 z-vector includes a dummy variable indicating
whether the owner-manager was replaced

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 Summary of results
 Firms with useful patents receive higher
valuations than other firms
 Financing rounds associated with
replacement have
 Lower valuations relative to other firms
 Higher subsequent valuations…
 Replacement, as predicted, enhances the
value of the firm

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