Venture capital and private equity contracting an international perspective douglas JC sofia AJ

Venture Capital and Private Equity Contracting
Venture Capital and Private
Equity Contracting
An International Perspective
Second Edition
Douglas J. Cumming
Professor and Ontario Research Chair, York University,
Schulich School of Business Toronto, ON, Canada
Sofia A. Johan
Adjunct Professor, York University, Schulich School of Business
Toronto, ON, Canada
and
Extramural Research Fellow, Tilburg Law and Economic Centre (TILEC)
The Netherlands
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Table of Contents
Front-matter, Pages i,iii
PDF (156 K)

Copyright, Page iv
PDF (172 K)
Dedication, Page v
PDF (12 K)
Preface, Pages xix-xxiv
PDF (45 K)
Part One: Introduction
1 - Introduction and Overview, Pages 3-37
PDF (2398 K)
2 - Overview of Agency Theory, Empirical Methods, and Institutional Contexts, Pages 39-60
PDF (815 K)
3 - Overview of Institutional Contexts and Empirical Methods, Pages 61-76
PDF (124 K)
Part Two: Fund Structure and Governance
4 - Fundraising and Regulation, Pages 79-143
PDF (1547 K)
5 - Limited Partnership Agreements, Pages 145-173
PDF (246 K)
6 - Compensation Contracts, Pages 175-205
PDF (254 K)
7 - Style Drift, Pages 207-238
PDF (220 K)
8 - Institutional Investment in Listed Private Equity, Pages 239-266
PDF (153 K)
9 - The Role of Government and Alternative Policy Options, Pages 267-302
PDF (998 K)
Part Three: Financial Contracting between Funds and Entrepreneurs
10 - The Investment Process, Pages 305-317
PDF (216 K)
11 - Security Design, Pages 319-368

PDF (501 K)
12 - Preplanned Exits and Contract Design, Pages 369-403
PDF (340 K)
13 - Legal Conditions and Venture Capital Governance, Pages 405-442
PDF (227 K)
Part Four: Investor Effort
14 - Investor Value Added, Pages 445-450
PDF (60 K)
15 - Contracts and Effort, Pages 451-490
PDF (241 K)
16 - Local Bias, Pages 491-521
PDF (181 K)
17 - Portfolio Size, Pages 523-562
PDF (356 K)
18 - Fund Size, Pages 563-587
PDF (159 K)
Part Five: Divestment
19 - The Divestment Process, Pages 591-601
PDF (84 K)
20 - Investment Duration, Pages 603-631
PDF (738 K)
21 - Contracts and Exits, Pages 633-675
PDF (216 K)
22 - Returns, Valuation, and Disclosure, Pages 677-722
PDF (271 K)
Part Six: Conclusion and Appendices
23 - Summary and Concluding Remarks, Pages 725-727
PDF (38 K)
Bibliography, Pages 729-756
PDF (598 K)

Preface
This book is intended for advanced undergraduate and graduate students in business,
economics, law, and management. This book is also directed at practitioners with
an interest in the venture capital and private equity industry. We consider a number
of different countries in this book. The terms venture capital and private equity
may differ in different countries, therefore in this book we generally refer to venture
capital as risk capital for sma ll private entrepreneurial firm s and private equity as
encompassing a broader arr ay of investors, entrepreneurial firms and transactions,
including later stage investments, turnaround investments, and buyout transactions.
Financial contracting is the common theme that links the topics covered in this
book. This book explains the ways in which these contracts differ across different
types of venture capital and private equity funds, different types of institutional
investors, different entrepreneurial firms, and differ across countries and over time.
This book will show when and how financial contracts are material to the allocation
of risks, incentives, and rewards for investors and investees alike. This book will
further show when and how financial contracts have a significant relationship with
actual investment outcomes and success.
Why should we care about financial contracting? Venture capital and private equity
funds are financial intermediaries between sources of capital and entrepreneurial
firms. Sources of capital typically include large institutional investors including
pension funds, banks, insurance companies, and endowments. These and other sources
of capital do not have the time or expertise to invest directly in entrepreneurial firms,
particularly high-growth firms in high-tech industries. As such, specialized venture
capital and private equity funds facilitate the investment process, at a price of course.
These funds are for all intents and purposes organizations that are established, capital-
ized, and operated under specific contractual terms and obligations agreed between
the investors and the venture capital and private equity funds. Another different type
of financial contract governs the relationship between venture capital and private
equity funds and their investee entrepreneurial firms, how such firms are capitalized
and how they are in turn operated. It is obvious therefore that financial contracting

is not something that venture capital and private equity funds do, it is also in essence
what they are.
Broadly framed questions addressed in this book include, but are not limited to,
the following:
●
What covenants and compensation terms are used in limited partnership contracts?
●
In what ways are limited partnership contracts related to market conditions and fund manager
characteristics, and how do these contracts differ across countries?
●
What are the cash flow and control rights that are typically assigned in venture capital
and private equity contracts with investee firms, and when do fund managers demand
more contractual rights?
●
Do different contractual rights assigned to different parties influence the effort provided
by the investor(s)?
●
In what ways are different financial contracts related to the success of venture capital and
private equity investments?
By considering venture capital and private equity contracting in an international
setting, this book offers an understanding of why venture capital and private equity
markets differ with respect to
●
Fund governance
●
Investee firm governance
●
Investee firm performance
In this book, we provide examples of actual contracts that have been used in
practice, including a limited partnership agreement, a term sheet, a shareholder

agreement, and a subscription agreement. In addition, we provide datasets of venture
capital and private equity that include details on a large number of actual contracts.
It is important and relevant to review data to show real investment contracts from
actual transactions, and explain how financial contracts are central to actual invest-
ment decisions and investment outcomes. Without analyzing data, we would at best
be limited to our best guesses, which is not the intention here. The data considered in
this book are international in scope, with a focus on Canada, Europe, and the United
States. It is important to consider data from a multitude of countries to understand
how and why venture capital and private equity markets differ around the world. As
well, idiosyncratic features of certain countries may distort our understanding of how
venture capital and private equity contracts work in practice.
In short, by considering international datasets, and not data from just one country
such as the United States, we are able to gain a significant amount of insight into
how venture capital and private equity funds operate in relation to their legal and
institutional environment. Each chapter in this book, where possible and appropriate,
will refer to and analyze data. Note however that venture capital and private equity
funds are not compelled to publicly report data, nor are they willing to do so. As
such, there is always more data that can be collected. It is the authors’ hope that this
book will not only provide an understanding of how venture capital and private
equity funds operate through financial contracts, but also that it will inspire further
empirical work in the field so that we may better understand the nature and evolution
of venture capital and private equity markets in years to come.
A Brief Note on Organization and Data
Part I of this book comprises three chapters. Chapter 1 briefly refers to aggregate
industry statistics on venture capital and private equity markets around the world to
xx Preface
compare the size of the markets in different countries. Chapter 2 describes agency
problems in venture capital and private equity inve stment. Chapter 2 is the only
chapter that does not consider data. The intention in Chapter 2 is to provide a
framework for understanding agency problems. Chapter 3 provides an overview of

the empirical methods considered in this book. The description of the statistical
and econometric techniques used is intended to be user friendly so that all readers
can follow along each of the chapters regardless of background. As well, Chapter 3
provides an overview of the institutional and legal settings in the countries consid-
ered in the different chapters. A central theme in this book is that differences in
venture capital and private equity markets, including but not limited to contracting
practices, are attributable to international differences in legal and institutional
settings.
Part II of this book (Chapters 4À9) considers venture capital and private equity
fundraising and the structure of limited partnerships (Chapters 4À7), as well as
listed private equity (Chapter 8), and public policy toward fundraising and fund
structure (Chapter 9 ). In order to understand the contractual structure of limited
partnerships, we do not exclusively focus on contracts themselves, but rather
provide a context in which to understand the contracts by providing evidence on
motivations underlying institutional investm ent in venture capital and private
equity. We provide some country-specific data (Chapters 4 and 7) from the
United States and The Netherlands, as well as data from a multitude of countries
(Chapters 4À6, 8, and 9 ). W e start with t he perspective of institutional investors
in Chapter 4 to understand the motivations underlying the source of capital—
institutional investors. Outsi de the U ni ted States, institutional investors have
comparatively less experience with venture c apital and private equity investment .
Chapter 4 examines recent data from institutional investors from The Netherlands
to study a market somewhat less developed than that in the United States, but
nevertheless with significant commitments to venture capital and private equity
funds, commitments to funds both domestic a nd international, as w ell as commit-
ments in niche areas such as the socially responsible investment class. Also, regu-
latory changes to make The Netherlands particularly interesting to study from the
perspective of institutional investors. In t he United States, many institutional
investors have longstanding relationships with venture capital and private equity
fund managers that span multiple decades. In Chapter 7, we examine data from

the United States pertinent to the issue of “style drift,” which refers to situations
in which f und managers deviate from stated objectives in limited partnership
contract s. Chapte rs 5 and 6 pr ovi de a broader perspecti ve with data from venture
capital and private equity funds from a multitude of countries (Belgium, Brazil,
Canada,CaymanIslands,Finland,Germany, Italy, Luxembourg, Malaysia,
Netherland Antill es, The Netherlands, New Zealand, Philippines, South Africa,
Switzerland, the U nited K ingdom, and the United States). This international com-
parative evidence highlights the role of legal and institutional differences around
the world and the impact on fund governance. Likewise, the data introduced in
Chapter 8 on listed private equity and Chapter 9 on the role of government and
public policy are from a variety of countries.
xxiPreface
While Part II focuses on fund structure and governance, the subsequent sections
of this book highlight a role of financial contracts with entrepreneurs (Part III),
governance provided to investees (Part IV), and the divestment process (Part V).
Part III (Chapters 10À13) covers material pertaining to financial contracting
with entrepreneurs. Chapter 10 first summarizes evidence on investment activities
in a number of studies from the United States. Chapter 11 considers evidence from
financial contracting from United States and Canadian venture capitalists, with a focus
on security design. Chapter 12 considers evidence on financial contracting from
Europe, and Chapter 13 provides evidence from an even broader set of countries
around the world. It is worthwhile to compare evidence on financial contracts from
the United States, Canada, and Europe to understand how laws and regulations,
among other things, influence the design of financial contracts and venture capital
governance more generally.
Part IV (Chapters 14À18) relates financial contracts and other investment
mechanisms to the governance provided to the investee firm. Chapter 14 provides a
survey of all of the factors that might influence inve stee governance. Chapter 15
considers the relation between contracts and actual investor effort in terms of
advice and monitoring, as well as disagreement between investors and investees.

Chapters 16À18 consider noncontractual factors that influence investor effort, par-
ticularly the role of geographic proximity (Chapter 16), portfolio size (Chapter 17),
and fund size (Chapter 18).
Part V (Chapters 19À22) studies the exit outcomes of venture capital and private
equity-backed companies. Because investees typically do not have cash flows to pay
interest on debt or dividends on equity, venture capital and private equity investors
invest with a view toward capital gain in an exit event. Chapter 19 provides an
overview of the exit decision and summarizes evidence on exits from Australasia,
Canada, Europe, and the United States. Chapters 20 and 21 show exits are signifi-
cantly related to the governance of the fund (as considered in Chapters 4À9) and
contracts between investors and investees (as considered in Chapters 10À14) and the
effort provided (Chapters 15À18). Exit outcomes are considered with reference to
extensive data from Canada (Chapter 20) and Europe (Chapter 21). Thereafter,
Chapter 22 provides evidence on the financial returns to venture capital investment
from 39 countries aroun d the world from North and South America, Europe,
Africa, and Australasia. The data indicate financial structures and governance are
significantly relat ed to returns. As well, Chapter 22 discusses evidence on reporting
biases of the performance of unexited institutional investors for companies that
have not yet had an exit event.
Selected chapters in this book are based on previously published material, as
summarized below:
Chapter 4:
Cumming, D., and S.A. Johan, 2007. “Regulatory Harmonization and the Development
of Private Equity Markets” Journal of Banking and Finance, 31, 3218À3250.
Cumming, D., and S.A. Johan, 2007. “Socially Responsible Institutional Investment in
Private Equity” Journal of Business Ethics 75, 395À416.
xxii Preface
Chapter 5:
Cumming, D., and S.A. Johan, 2006. “Is it the Law or the Lawyers? Investment
Covenants around the World” European Financial Management 12, 553À574.

Chapter 6:
Cumming, D., and S.A. Johan, 2009. “Legality and Venture Capital Fund Manager
Compensation” Venture Capital: An International Journal of Entrepreneurial Finance
11, 23À54.
Chapter 7:
Cumming, D.J., G. Fleming and A. Schwienbacher, 2009. “Style Drift in Private Equity”
Journal of Business Finance and Accounting 36(5À6), 645À678.
Chapter 8:
Cumming, D.J., G. Fleming and S.A. Johan, 2011. “Institutional Investment in Listed
Private Equity” European Financial Management 17(3), 594À618.
Chapter 9:
Cumming, D., 2007. “Government Policy Towards Entrepreneurial Finance in Canada:
Proposals to Move from Labour Sponsored Venture Capital Corporations to More
Effective Public Policy” CD Howe Institute Commentary No 247.
Chapter 11:
Cumming, D., 2005. “Agency Costs, Institutions, Learning and Taxation in Venture
Capital Contracting” Journal of Business Venturing 20, 573À622.
Chapter 12:
Cumming, D., and S.A. Johan, 2008. “Preplanned Exit Strategies in Venture Capital”
European Economic Review 52, 1209À1241.
Chapter 13:
Cumming, D.J., D. Schmidt and U. Walz, 2010. “Legality and Venture Capital
Governance Around the World” Journal of Business Venturing 25, 54À72.
Chapter 15:
Cumming, D., and S.A. Johan, 2007. “Advice and Monitoring in Venture Capital
Finance” Financial Markets and Portfolio Management 21, 3À43.
Chapter 16:
Cumming, D.J., and N. Dai, 2010. “Local Bias in Venture Capital” Journal of Empirical
Finance 17, 362À380.
Chapter 17:

Cumming, D., 2006. “The Determinants of Venture Capital Portfolio Size: Empirical
Evidence” Journal of Business 79, 1083À1126.
Chapter 18:
Cumming, D.J., and N. Dai, 2011. “Limited Attention, Fund Size and the Valuation of
Venture Capital Backed Companies” Journal of Empirical Finance 18(1), 2À15.
Chapter 20:
Cumming, D.J., and S.A. Johan, 2010. “Venture Capital Investment Duration” Journal of
Small Business Management 48, 228À257.
xxiiiPreface
Chapter 21:
Cumming, D., 2008. “Contracts and Exits in Venture Capital Finance” Review of
Financial Studies 21, 1947À1982.
Chapter 22:
Cumming, D.J., and U. Walz, 2010. “Private Equity Returns and Disclosure Around the
World” Journal of International Business Studies 41(4), 727À754.
We are indebted to Na Dai, Grant Fleming, Armin Schwienbacher, Daniel
Schmidt, and Uwe Walz for the generosity in allowing us to use some of the material
upon which Chapters 7, 8, 13, 16, 18, and 22 are based, as that work was developed
jointly with these excellent coauthors.
Each chapt er of the book has been adapted in a way that be gins with a list of
learning ob jectives. As w ell, each chapter ends with a list of k ey terms a nd a num ber of
discussion questions. PowerPoint lecture s lides for each chap ter and online Appendices
1À4 are available online at
/>and http: //booksite.elsevier.com/9780124095373/.
xxiv Preface
1 Introduction and Overview
These days it is difficult to not have heard of the terms “venture capital” and “pri-
vate equity”. The venture capital and private equity markets are frequently dis-
cussed in popular media and typically referred to as “scorching” in the popul ar
press, at least in boom times. The market has direct relevance for entrepreneurs

who want to raise money, investors who want to make money from financing entre-
preneurs, and individuals who want to work for a fund or set up their own fund.
Also, venture capital and private equity is of significant interest to the public sec-
tor, as government bodies around the world strive to find ways to promote entre-
preneurship and entrepreneurial finance. It is widely believed that venture capital
and private equity funds facilitate more innovative activities and thereby improve
the well being of nations. It is thought of as a critical aspect of national growth in
the twenty-first century.
In the next 23 chapters, which are divided into 4 parts, we will provide an analy-
sis of the issues that venture capital and private equity market participants face dur-
ing the fund-raising process (Part II) , investment process (Part III), and divestment
process (Part IV). A common theme across all issues involves agency costs, and
hence agency theory is reviewed after this introductory chapter in Chapter 2 (Part I).
All the issues addressed in this book are analyzed from an empirical law and finance
perspective, with a focus on financial contracting. Finan cial contracts are central to
the establ ishment of the relationship betwee n venture capital and private equity
funds and their investors. Financial contracts also govern the relationship between
venture capital and private equity funds and their investee entrepreneurial firms, as
well as determine the efficacy of the divestment process. In most chapters we refer
to datasets to grasp the real-world aspects of the venture capital and private equity
process. Further, it is important to consider international evidence to grasp the
impact of laws and institutions on the respective venture capital and private equity
markets. The empirical methods and legal and institutional settings in this book are
overviewed in Chapter 3.
1.1 What is Venture Capital and Private Equity?
At the outset, it is important to discuss what is meant by the terms venture capital
and private equity. Venture capital and private equity funds are financial
intermediaries between sources of funds (typically institutional investors) and high-
growth and high-tech entrepreneurial firms. Funds are typically established as
Venture Capital and Private Equity Contracting. DOI: />© 2014 Elsevier Inc. All rights reserved.

limited partnerships, but as discussed herein, there are other types of funds. A lim-
ited partnership is in essence a contract between institutional investors who become
limited partners (pension funds, banks, life insurance com panies, and endowments
who have rights as partners but trade “management” rights over the fund for lim-
ited liability) and the fund manager who is designated the general partner (the part-
ner that takes on the responsi bility of the day-to-day operations and management of
the fund and assumes total liability in return for negligible buyin). Chapter 5 exam-
ines in detail the structure of limited partnerships and limited partnership contracts.
The basic intermediation structure of venture capital and private equity funds is
graphically summarized in
Figure 1.1.
Venture capital funds are typically set up with at least US$50 million in capital
committed from institutional investors and often exceed US$100 million. So me of
the larger private equity funds raised more than US$10 billion in 2006.
1
Fund man-
agers typically receive compensation in the form of a management fee (often
1À2% of committed capital, depending on the fund size) and a performance fee or
carried interest (20% of capital gains). Chapter 6 discusses factors related to fund
manager compensation. Venture capital funds invest in start-up entrepreneurial
firms that typically require at least US$1 million and up to US$20 million in capi-
tal. Private equity funds inve st in more established firms, as discussed further
below.
Venture capital is often referred to as the “money of invention” (see, e.g., Black
and Gilson, 1998; Gompers and Lerner, 1999, 2001; Kortum and Lerner, 2000) and
venture capital fund managers as those that provide value-added resources to
entrepreneurial firms. Venture capital fund managers play a significant role in
enhancing the value of their entrepreneurial investments as they provide financial,
administrative, marketing, and strategic advice to entrepreneurial firms, as well as
facilitate a network of support for an entrepreneurial firm with access to accoun-

tants, lawyers, investment bankers, and organizations specific to the industry in
which the entrepreneurial firm operates (Gompers and Lerner, 1999; Leleux and
Surlemount, 2003; Manigart et al., 2002a,b; Sahlman, 1990; Sapienza et al., 1996;
Institutional investors
Entrepreneurial firm
Returns Capital
Equity, debt,
warrants, etc.
Capital
Venture capital fund
Figure 1.1 Venture capital financial intermediation.
1
See />4 Venture Capital and Private Equity Contracting
Wright and Lockett, 2003). Academic studies have shown us that venture capital-
backed entrepreneurial firms are on average significantly more successful than non-
venture capital-backed entrepreneurial firms in terms of innovativeness (Kortum
and Lerner, 2000), profitability, and share price performance upon going public
(Gompers and Lerner, 1999, 2001).
Venture capital and private equity investments carried out by a fund typically
last over a period of 2À7 years. A venture capital limited partnership envisages
this extended investment horizon and hence is structured over a 10-year horizon
(with an option to continue for an additional 3 years) so that the fund manager can
select investments over the first few years and then bring those investmen ts to fru-
ition over the remaining life of the fund. Investments are made with a view toward
capital gains upon an exit event (a sale transaction), as entrepreneurial firms typi-
cally are not able to pay interest on debt or dividends on equity. The terms of the
investment often give the venture capital fund significant cash flow rights in the
form of equity and priority in the event of liquidation. As well, the venture capital
fund typically receives significant veto and control rights over decisions made by
the management of the entrepreneurial firm.

The terms venture capital and private equity differ primarily with respect to the
stage of development of the entrepreneurial firm in which they invest. Venture cap-
ital refers to investments in earlier-stage firms (seed or start-up firms), whereas pri-
vate equity is a broader term that also encompasses later-stage investments as well
as buyouts and turnaround investments. In this book, unless explicitly stated other-
wise, for ease of exposition we use the term “private equity” to encompas s all pri-
vate investment stages including venture capital. The various financing stages are
defined as follows.
●
Seed
2 Financing provided to entrepreneurs to research, assess, and develop an initial con-
cept before a business has reached the start-up phase.
●
Start-up
2 Financing provided to firms for product development and initial marketing. Firms
may be in the process of being set up or may have been in business for a short time
but have not sold their product commercially.
●
Other early stage
2 Financing to firms that have completed the product development stage and require
further funds to initiate commercial manufacturing and sales. They will not yet be
generating a profit.
●
Expansion
2 Financing provided for the growth and expansion of a firm which is breaking even
or trading profitably. Capital may be used to finance increased production capacity,
market or product development, and/or to provide additional working capital.
●
Bridge financing
2 Financing made available to a firm in the period of transition from being privately

owned to being publicly quoted.
●
Secondary purchase/replacement capital
2 Purchase of existing shares in a firm from another private equity investment organi-
zation or from another shareholder or shareholders.
5Introduction and Overview
●
Rescue/turnaround
2 Financing made available to an existing firm which has experienced trading difficul-
ties (firm is not earning its cost of capital (WACC)), with a view to reestablishing
prosperity.
●
Refinancing bank debt
2 To reduce a firm’s level of gearing.
●
Management buyout
2 Financing provided to enable current operating management and investors to acquire
an existing product line or business.
●
Management buyin
2 Financing provided to enable a manager or group of managers from outside the firm
to buyin to the firm with the support of private equity investors.
●
Venture purchase of quoted shares
2 Purchase of quoted shares with the purpose of delisting the firm.
●
Other purchase of quoted shares
2 Purchase of shares on a public stock market.
In practice, sometimes broader categories are used. For example,
●

Start-up: sometimes used in practice to refer to start-up and other early stage
●
Expansion: sometimes used in practice to refer to expansion, bridge financing, and res-
cue/turnaround.
●
Replacement capital: sometimes used in practice to refer to secondary purchase/
replacement capital and refinancing bank debt.
●
Buyouts: sometimes used in practice to refer to management buyout, management buyin,
and venture purchase of quoted shares.
Precise definitions of terms vary somewhat depending on the norms in a particu-
lar country and the specific individuals surveyed. As the chapters in this book
make use of data from different countries, we will define and explain the use of
terms like these, as well as others, in their specific contexts in each chapter.
Definitions of stages of development in venture capital and private equity are
perhaps usefully viewed in the context of a diagram. A common picture used in
practice is shown in
Figure 1.2. In this figure, venture capital finance is placed in a
broader context of other sources of finance. Prior to seeking and obtaining venture
capital finance, entrepreneurs who are just starting their venture often obtain capital
from friends, family, and “fools” (known as the 3 Fs or FFF) . The term “fools”
refers to the high risk associated with investment in nascent stage firms and the
“valley of death” depicted in
Figure 1.2 where firms require significant capital
inflows but show little or no revenues until subsequent years. Professional individ-
ual investors known as “angel” investors are a common source of capital for entre-
preneurs pri or to obtaining more formal institutionalized venture capital finance
(Wong, 2002). Many angel investors are successful entrepreneurs who have,
through their experience, specialized abilities to recognize talent in other entrepre-
neurs and their new ventures. A classic example is Andy Bechtolsheim who

cofounded Sun Microsystems. He gave US$100,000 to the founders of Google,
who could not even cash the check as they had not yet established Google as a
6 Venture Capital and Private Equity Contracting
legal entity. A limitation in the study of the market for angel investment, however,
is the lack of systematic data.
2
This book will not be considering angel investment.
In
Figure 1.2, the term “mezzanine” refers to investment in late-stage firms that
are close to an initial public offering (“IPO”). An IPO is the first time a firm sells
its shares for sale in the public market (i.e., lists or floats on a stock exchange). A
seasoned equity offering involves additional capital-raising efforts by firms already
trading on a stock excha nge. The latter part of this book (Chapters 19À23) will
consider issues involved with the exit of venture capital investments through IPOs,
mergers and acquisitions, and othe r exit vehicles.
1.2 How Does Venture Capital and Private Equity Differ
from Alternative Sources of Capital?
A salient point about raising capital for entrepreneurial firms is that there are many
different sources of capital. This book considers venture capital and private equity
only. But it is worth mentioning at the outset some general characteristics about
this type of financing relative to other sources of financing.
Table 1.1 provides a
Profit
Time
Valley of
death
Break
even
Angels, FFF
Seed capital

(Could include VC)
1st
2nd
3rd
Mezzanine
IPO
Public
market
SEO
Early stage Later stage
VCs, acquisitions/mergers
Strategic alliances,etc.
Figure 1.2 Stages of entrepreneurial firm development.
2
Recent efforts spurred by the Kaufmann Foundation have begun to fill this gap, but there is significant
work to be done in gathering systematic data. Most notably, see Shane (2005).
7Introduction and Overview
Table 1.1 Greatly Oversimplified Typical Characteristics of Funds Providers
Source Investment
Motivation
Focus of
Attention
Cash
Typically
Available
Source of
Funds
Biggest
Drawbacks
Biggest

Advantages
Security
Required
Subject to
Market
Conditions?
Internal
operations
Reinvestment Execution Unlimited Earnings Slow Nondilutive None Some
Founders Ambition Varies $100,000 Savings Personal risk Nondilutive None Little
Friends and
family
Relationships Support $250,000 Savings Relationships Easy sell None Some
Private “angel”
investors
The
entrepreneur
Varies $500,000À
$1.5M
Previous
successes
Varying
commitment
Brings credibility None Considerable
Venture capital
funds
Business plan,
team, market,
trajectory
Contracts,

liquidity
event,
valuation
$1MÀ
$20M
Limited
partners,
institutions
Time
consuming,
expensive
Brings help,
credibility
Contractual
terms and
conditions
Greatly
Private equity
funds
Mezzanine,
buyout,
turnaround
Contracts,
liquidity
event,
valuation
$20MÀ
$500M
Limited
partners,

institutions
Time
consuming,
expensive
Brings help,
credibility
Contractual
terms and
conditions
Greatly
Commercial
banks (and
venture
banks)
Risk versus
return
Two
repayment
sources
80% of
A/R,
50% of
inv.
Deposits Regulatory
agencies
Advice, clean,
straight-forward,
businesslike
A/R,
inventory,

IP
Little
Bridge funds Risk versus
return
Low risk $500,000À
$5M
Limited
partners,
institutions
Warrants Speed (5 days to
get a loan)
All assets
including
IP
Greatly
Leasing
companies
Risk versus
return
Liquidation
values
80% of
value
Company
treasury
Costly Cheaper than
equity
Varies Little
Factors (buy
your A/R)

Risk versus
return
Collections 80% of
A/R
Company
treasury
B5% over
prime
Cheaper than
equity
Varies Little
Asset lenders Risk versus
return
Balance sheet 80% of
A/R,
60% of
inv.
Company
treasury
Expensive Cheaper than
equity
Personal
guarantee
Little
Partner
companies
What you can
do for them
Synergies Varies Company
treasury

May preclude
other
opportunities
2-Way economics,
low pricing
pressure
Little Some
Government
agencies
Mandates Regulations,
warrants
Varies Taxes Paperwork,
oversight
Inexpensive, no
recourse
Little or none Little
Investment
bankers at
IPO
Fees Stock market Unlimited Public Costs,
underpricing,
public
disclosure
Advice, public
exposure
Escrow,
lock-in
Extreme
helpful, albeit oversimplified, overview of typical characteristics of alter native fund
providers for entrepreneurial firms.

3
It shows where venture capital and private
equity fit in within the financing spectrum.
The range of sources of capital enumerated in
Table 1.1 is broader than that
shown in
Figure 1.2. Figure 1.2 presented financing sources for start-up firms on a
high-growth trajectory. But the variety of sources of capital available to firms is
much broader than that indicated in
Figure 1.2.
Firms may finance their operations internally from reinvestment of their profits.
Alternatively, for firms that do not have internal finance or sufficient internal
finance, they must seek external capital. A well-established literature in finance has
established a “pecking order” of firms’ preferences for raising capital. Theoretical
and empirical work has show n that firms prefer to finance their growth internally
by reinvesting their profits because it is less costly than seeking external finance
(Myers and Majluf, 1984; see also Myers, 2000). External capital comes at a cost.
The cost of debt finance is the interest payments and the risk of being forced into
bankruptcy in the event of nonpayment. The cost of equity finance is the dilution
in ownership share associated with the equity sold. Where investors do not provide
significant value added to the entrepreneurial firm, equity tends to be a more costly
form of finance than debt.
4
In an empirical study of nonpublicly traded entrepre-
neurial firms raising external capital, Cosh et al. (2009) find evidence that is highly
consistent with this pecking order .
Different sources of external capital for entrepreneurs include banks, venture
capital and private equity funds, leasing firms, factoring firms (that buy your
accounts receivable or A/R), trade customers and suppliers, partners and working
shareholders, angel investors, government agencies, and public stock market s. Cosh

et al. (2009) find that firms’ ability to access capital from different sources depends
primarily on the degree of information asymmetry faced by the investors and their
ability to do due diligence to mitigate such information asymmetry. Information
asymmetry refers to the fact that the entrepreneur knows more about the project
than the external investor. Information asymmetry is a risk and cost to the external
investor, and it explains why a firms’ own profits is a cheaper source of external
capital than external debt or equity finance. With internal finance there is no price
to pay in terms of compensating a bank or equity investor for carrying out a due
diligence review to assess the quality of the firm before investment and for taking
on a risk if the investment is carried out. Internal finance also has the advantage
that it is nondilutive in that the entrepreneur does not have to give up equity owner-
ship to an external investor.
Apart from the founding entrepreneur’s (or entrepreneurs’) savings, family,
friends, and fools (the 3 Fs mentioned earlier) are a common source of capital for
the earliest stage entrepreneurial firms. An entrepreneur without a track record typi-
cally has an easier time raising this type of capital because these investors will
3
Table 1.1 is a slightly modified version of a chart that was circulated an angel investment forum in
Edmonton Alberta Canada in 2003.
4
This issue is discussed more extensively in Chapter 11.
10 Venture Capital and Private Equity Contracting
have known the entrepreneur for a long time and possibly for the entrepreneur’s
entire life. In other words, information asymmetries faced by the 3 Fs are lower
than that faced by other sources of external capital. As mentioned, angel investors
do finance early-stage entrepreneurial firms but in general do not have a prior rela-
tionship with the entrepreneur. Angel investors typically look for entrepreneurs
with their own “skin the game” (personal wealth invested), as well as that of the
3 Fs, as a way to ensure that the entrepreneur is committed to the venture and to
make sure that those who know the entrepreneu r believe in his or her abilities.

Venture capital funds tend to finance entrepreneurial firms with significant
information asymmetries in terms of not having a lengthy operating history and in
high-tech industries with hard-to-value intangible assets. Venture capital funds typi-
cally require an equity stake in the firms in which they invest.
5
Venture capital
fund managers are specialized investors with the ability to carry out extensive due
diligence of suitable projects in which to invest. One explanation for the very exis-
tence of venture capital funds is in fact the pronounced information problems asso-
ciated with financing high-tech start-up entrepreneurial firms (Amit et al., 1998).
As ventu re capital funds are intermediaries between institutional investors and
entrepreneurial firms (
Figure 1.1) and there are minimum fund sizes that make the
costs of establishing this type of financial intermediary viable, venture capital funds
rarely consider projects that require less than US$1 million and almost never con-
sider projects that require less than US$500,000.
There are a variety of sources of external debt capital. Perhaps the most well-
known source is the typical commercial banks. Most commercial bank loans require
significant collateral and prefer to finance low-risk projects, and bank managers
invest with a view solely to ensure the loan is repaid on time and with interest.
Riskier projects such as that considered by venture capital funds typicall y will not
receive bank finance. Some banks, however, do have a strategy of making loans
to venture capital-backed entrepreneurial firms. Silicon Valley Bank, which is part
of SVB Financial Group, is one well-known example of this type of bank. Other
specialized merchant banks undertake riskier projects with terms that compensate
for the risk taken.
Bridge funds provide quick short-term sources of capital to firms with signifi-
cant collateral. Leasing companies, factors (firms that buy your A/R), and asset len-
ders provide terms that are typically less favorable than a typical commercial bank
loan but often used by entrepreneurial firms that need to ensure cash flow to con-

tinue to pay salaries and other ongoing expenses.
Entrepreneurial firms may receive capital from partner firms (such as major sup-
pliers or customers). Costs and benefits depend on relative bargaining power of the
two organizations and the potential for strategic alliances.
Few studies have compared the relative importance of different sources
of entrepreneurial capital. Perhaps the most informative data are provided by
5
The form of equity taken is discussed in Chapter 11. Occasionally, funds will also invest with debt
securities as shown in Part III.
11Introduction and Overview
Cosh et al. (2009), which are based on a sample of 2520 private firms in the
United Kingdom for capital-raising decisions in 1996À1997. There were 37.8%
(952 of 2520) firms in their data that did seek external finance in the 1996À1997
period. The average amount of external finance sought was d467,667, and the
median amount sought was d100,000. The average amount obtained was almost
81% of that which was sought, and the median perc entage obtained was 100%.
Overall, therefore, the data do not suggest a shortage of external capital for firms
that make more than a trivial effort in applying for capital.
Table 1.2 reports the
number of firms in their data that did seek external finance by the type of source of
finance, as well as the percentage of all their external capital obtained from the
source. Among the firms that did seek external finance, 775 approached banks, 474
approached leasing firms, 151 appro ached factoring/invoice discounting firms,
138 approached partners/working shareholders, 87 approached venture capital
funds, 83 approached private individuals, 53 approached trade customers/suppliers,
and 67 approached other sources. It is of interest that outright rejection rates were
highest among ventu re capital funds (46% rejection) and much higher than that for
banks (17% outright rejection). The lowest rejection rate was among leasing firms
(5%). Banks comprised the median and mean highest percentage of outside finance
in terms of which type of source was approached and which type of source

provided the finance. In fact, banks comprised the only type of source for which
the median percentage of a firm’s total external capital was greater than 0%
(for banks, the median percentage is 34%; see
Table 1.2).
The Cosh et al. (2009) data indicate that there is not a substantial capital gap
for the majority of firms seeking entrepreneurial finance; rather, firms seeking
capital are able to secure their requisite financing from at least one of the many
different available sources. There are, however, differences in firms’ ability to
obtain finance in the form that they would like. Even after controlling for selec-
tion effects, Cosh et al. find that banks are more likely to provide the desired
amount of capital to larger firms with more assets. Leasing firms, factor discount-
ing/invoicing firms, trade customers/suppliers, and partners/working shar eholders
are more likel y to provide the desi red capital to firms with higher profit margins.
Profit margins are not statistically relevant to venture capital funds and private
individual investors; smaller firms are more likely to obtain finance from private
individuals, whereas young innovative firms seek external capital from venture
capital funds.
Apart from private sources of capital, a variety of different types of government
support programs exist to enable access to entrepreneurial finance. The nature and
scope of programs varies greatly across different countries. Some of the programs
related to venture capital are detailed in Chapter 9.
Finally, entrepreneurial firms may access external capital by listing their firm on
a stock exchange in an IPO. This is one of a variety of different ways in which ven-
ture capital and private equity funds exit their investments. Part V of this book con-
siders why venture capital and private equity funds exit by IPO versus other forms
of exit. Also, Part V provides evidence on factors that influence the performance
of IPOs.
12 Venture Capital and Private Equity Contracting
Table 1.2 Relative Importance of Specific Sources of External Capital in the UK
Banks Venture

Capital
Funds
Hire
Purchase or
Leasing
Firms
Factoring/
Invoice
Discounting
Firms
Trade
Customers/
Suppliers
Partners/
Working
Shareholders
Other
Private
Individuals
Other
Number of firms that did approach
this source for external capital
775 87 474 151 53 138 83 67
Number of firms that did not
approach this source, but did seek
external finance elsewhere
177 865 478 801 899 814 869 885
Number of firms that did approach
this source but no finance offered
133 40 23 29 5 12 20 14

Number of firms that approached this
source but less than full amount
offered
133 8 20 38 10 19 15 15
Number that did approach this source
and full amount offered
509 39 431 84 38 107 48 38
Mean percentage of total external
capital obtained from this source
42.749 2.851 23.792 5.892 1.624 5.313 3.910 3.598
Median percentage of total external
capital obtained from this source
33.580 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Standard deviation of percentage
obtained from this source
39.451 13.948 33.630 18.261 9.069 17.602 16.605 16.224
Minimum amount obtained from this
source
0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Maximum amount obtained from this
source
100.000 100.000 100.000 100.000 100.000 100.000 100.000 100.000
Source: Cosh et al. (2009).
1.3 How Large Is the Market for Venture Capital and
Private Equity?
The market for venture capital and private equity varies significantly in different
countries around the world. Data on the amount of venture capital and private
equity per GDP for 28 countries is presented in
Figure 1.3. Similar data over a lon-
ger time horizon is presented in

Figure 1 .4 and Table 1.3. Figure 1.4 and Table 1.3
also include information pertaining to the value of exit transactions (sales of invest-
ments) and fundraising from institutional and other investors. More recent data up
to 2011 are discussed immediately thereafter.
The venture capital industry in the United States is the largest in the world in
terms of total capital under management. As of 2003, there was over US$100 bil-
lion in capital under management by more than 1000 funds. Funds in the United
States are predominantly set up as limited partnerships and are typically very spe-
cialized in terms of stage of development and industry focus. There is significant
geographic concentration of investment activity. Route 128 in Boston has a high
concentration of biotechnology investments, whereas Silicon Valley in California
has a high concentration of electronics and computer-related investments.
6
In Canada, there were around 130 funds in 2003, with US$20 billion in capital
under management and approximately 50% of this capital managed by tax-
subsidized labor-sponsored venture capital corporations (LSVCCs).
7
LSVCCs are
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Iceland
United States
Canada

The Netherlands
United Kingdom
Sweden
Belgium
Norway
Finland
European Union
Ireland
Germany
France
Spain
Switzerland
Portugal
Italy
Denmark
Greece
Austria
Poland
Czech Republic
Hungary
Slovak Republic
Korea (1995–2000)
Australia (1995–2000)
New Zealand (1995–2000)
Japan (1995–2000)
Early stage
Expansion
Buyout and others
Total
Figure 1.3 Venture capital investment by stages as a percentage of GDP, 1998À2001.

Source: OECD.
6
, , , mo-
neytree.com/
.
7
, .
14 Venture Capital and Private Equity Contracting
Early stage
Exp
ansion stage
Total private equity
All dispositions
Fundraising
Amounts averaged 1990–2003
relative to GDP expressed in %
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Austria
Belg
ium
Denmark
Finland

Franc
e
Germany
Ireland
Italy
Netherlands
Portugal
Spain
Sw
eden
UK
US
Canada
Figure 1.4 Size of venture capital and private equity markets across countries.
Source: Armour and Cumming (2006).
Table 1.3 Size of Venture Capital and Private Equity Markets Across Countries
Country Early
Stage
Expansion
Stage
Total Private
Equity
Fundraising All
Dispositions
Austria 6.06E-03 1.38E-02 2.44E-02 3.72E-02 9.41E-03
Belgium 2.85E-02 5.33E-02 1.03E-01 1.18E-01 4.61E-02
Canada 8.68E-02 9.34E-02 2.01E-01 2.13E-01 4.38E-02
Denmark 1.94E-02 2.79E-02 6.43E-02 9.99E-02 1.16E-02
Finland 3.54E-02 4.40E-02 1.23E-01 1.84E-01 4.26E-02
France 1.92E-02 5.15E-02 1.61E-01 1.91E-01 8.74E-02

Germany 1.92E-02 3.89E-02 8.65E-02 8.60E-02 3.52E-02
Ireland 2.37E-02 5.78E-02 1.05E-01 1.54E-01 6.01E-02
Italy 1.16E-02 4.10E-02 1.19E-01 1.12E-01 1.98E-02
Netherlands 3.17E-02 9.93E-02 2.22E-01 2.26E-01 1.03E-01
Portugal 1.32E-02 4.75E-02 8.16E-02 7.87E-02 4.27E-02
Spain 9.82E-03 5.18E-02 8.42E-02 9.01E-02 2.99E-02
Sweden 3.52E-02 6.98E-02 2.96E-01 4.12E-01 6.13E-02
UK 2.96E-02 1.31E-01 5.45E-01 7.70E-01 2.50E-01
US 7.75E-02 1.57E-01 2.96E-01 3.29E-01 1.72E-01
The size of the early stage, expansion stage, total private equity (including early, expansion, late, buyout, and
turnaround stages), fundraising and dispositions (exits) expressed as a fraction of GDP are presented. Values are
averaged for the 1990À2003 period.
Source: Armour and Cumming (2006).
15Introduction and Overview