Introduction to Corporate Finance

ONLINE CHAPTERS

The relationship between VCs and investors is fraught with agency problems. Investors must commit

large amounts of money for long-term, illiquid, non-transparent investments in private partnerships, over

which they can exercise no direct control without forfeiting their limited liability. Venture capitalists

have many opportunities to expropriate the limited partners’ wealth. They can set up new funds, which

exclude the old limited partners, to finance the most promising companies, and they can make side

deals with the best companies in their fund. Reputational concerns largely control these problems, but

contractual covenants also play a role in curtailing agency problems. These include limiting the VC’s

ability to establish new funds, without granting existing investors equal access, mandating that existing

investors be included in any equity sale contracts the VC negotiates, and restricting the VC’s freedom to

invest in foreign and in publicly traded securities, or in leveraged buyouts. These covenants restrict the

VC’s ability to expropriate the limited partners’ wealth through side deals, as well as ensure that the VC

will not make investments outside the fund manager’s area of expertise.

Another area fraught with agency problems is the area of performance reporting. Even though most

funds are required to report their quarterly performance, until returns are realised by the divestment of

their investments, the valuations of the investee companies are very subjective and open to manipulation.

This is because these valuations are generally conducted by the general partners of the funds (and it is

usually in their best interests to report good performance). Pricing is examined further in section 20-3d.

Many senior partners at top venture capital companies are well known for their skills in finding,

nurturing and bringing to market high-tech companies. Examples include John Doerr of Kleiner Perkins

Caufield Byers, William Hambricht of Hambricht and Quist, and Sam Rosen of Rosen Partners. These

industry leaders have become extraordinarily wealthy, but even ‘ordinary’ venture capitalists did quite

well during the 1995–2000 boom. The industry’s financial rewards attract numerous would-be VCs,

but jobs in the industry are notoriously difficult to obtain, particularly for newly minted business

school graduates. Partners and associates in venture capital companies often are engineers or other

technically trained professionals who themselves worked in high-tech companies before becoming

full-time VCs. This experience gives them in-depth knowledge of both the technological and business

aspects of the industries in which they invest. It is this expertise, along with capital and contacts,

that entrepreneurs look for when they approach a VC for funding. For example, John Doerr of Kleiner

Perkins Caufield Byers has bachelor’s and master’s degrees in electrical engineering, plus an MBA

from Harvard Business School. He worked for Intel Corporation for five years before becoming a

venture capitalist.

20-3b HOW VENTURE CAPITALISTS AND PRIVATE EQUITY

MANAGERS STRUCTURE THEIR INVESTMENTS

Although one should be wary of describing anything as unique as a venture capital investment contract

as standard, most agreements between VCs and entrepreneurs share certain characteristics. First and

foremost, venture capital contracts allocate risk, return and ownership rights between the entrepreneur

(and other existing owners of a portfolio company) and the fund. The distribution of rights and

responsibilities depends on: (1) the experience and reputation of the entrepreneur; (2) the attractiveness

of the portfolio company as an investment opportunity; (3) the stage of the company’s development;

(4) the negotiating skills of the contracting parties; and (5) the overall state of the market. If, at a time

of fierce competition among VCs, a respected and experienced entrepreneur approaches a fund with an

opportunity to invest in an established company with a promising technology, then the entrepreneur will

secure financing on relatively attractive terms. At the other extreme, if an inexperienced entrepreneur

investee companies

Companies in which the fund

invests. These are also called

portfolio companies

Manju Puri, Duke

University

‘Venture capital does

have a positive role for

innovative companies

in helping to push their

product out quickly.’

See the entire interview on

the CourseMate website.

COURSEMATE
SMART VIDEO

Source: Cengage Learning

LO20.3