DP3462 Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

Author(s): Giacinta Cestone
Publication Date: July 2002
Keyword(s): control rights, corporate governance, security design, venture capital
JEL(s): G30
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3462

This Paper develops a theory of the joint allocation of control and cash-flow rights in venture capital deals. I argue that when the need for investor support calls for very high-powered outside claims, entrepreneurs should optimally retain control in order to avoid undue interference. Hence, I predict that risky claims should be negatively correlated to control rights, both along the life of a start-up and across deals. 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 the evidence, documented in Gompers (1999) and Kaplan and Stromberg (2000), that venture capital contracts include contingencies triggering both a reduction in VC control and the conversion of VC's preferred stock into common stock.