Ownership and Control in Entrepreneurial Firms: An Examination of Convertible
Securities in Venture Capital Investments
*
Paul A. Gompers
September 1997
In this paper I analyze the allocation of ownership and control rights in entrepreneurial firms,
examining the role of convertible securities in venture capital investments. Large private benefits and
the importance of the firm's financing choice as an incentive contract make it optimal to separate the
allocation of control rights from the allocation of cash flows. If entrepreneurial ability is private
information and equity financing is utilized, adverse selection may occur with high ability
entrepreneurs leaving the venture capital market. Under reasonable assumptions, convertible
securities can separate out bad entrepreneurs and limit incentives to take risks. Empirical evidence
from a sample of fifty venture capital contracts is consistent with the paper's predictions. The
convertible stake converts to common equity when the investment has been revealed to be successful,
either at the time of an initial public offering or when certain performance targets are achieved.
Similarly, contracts explicitly assign important control rights to the venture investors through the use
of well-specified covenants independent from the allocation of cash flows. The use of covenants
increases as potential agency costs rise, i.e., in early stage firms and firms in industries characterized
by high R&D expenditures and high market-to-book ratios.
*
Harvard University and National Bureau of Economic Research. I wish to thank Oliver Hart, Steve
Kaplan, Josh Lerner, Andrew Metrick, Randall Morck, Jim Poterba, Raghu Rajan, Abraham Ravid,
Richard Ruback, Bill Sahlman, Bill Schwert, Andrei Shleifer, Jeremy Stein, Luigi Zingales, and
participants at the Entrepreneurship, SMEs, and the Macroeconomy conference in Jonkoping, Sweden
for helpful comments and suggestions. I also wish to thank Scott Sperling and Michael Eisenson of
Harvard Management Company for providing access to convertible financing documents. Any errors
or omissions are my own. This research was funded by the Division of Research at the Graduate
School of Business Administration, Harvard University.
1. Introduction
Contracting between capital suppliers and entrepreneurs is fraught with many potential
conflicts. Moral hazard and adverse selection result from the asymmetric information that is associated
with startup companies. In addition, uncertainty makes fully state contingent contracting impossible.
Observability and verifiability may both be quite limited. Venture capital firms, which specialize in
financing young, high potential firms, have developed unique contractual mechanisms to finance startup
companies. This paper explores the use of convertible securities in venture capital settings and seeks to
explain their use in light of the complex environment associated with startup companies. My approach
is similar to Smith and Warner’s (1979) analysis of bond covenants.
I explore the economic
importance of various aspects of control rights and ownership as well as the specific conversion terms
employed in a sample of fifty convertible venture financings. The results have important implications
for understanding the allocation of ownership and control as well as the theory of the firm.
Evidence from this sample of agreements is consistent with the view that the use of a
convertible security, as opposed to straight equity or straight debt financing, serves to motivate the
founder to exert the proper effort and avoid improper risk taking. A detailed analysis of the terms of
the documents shows that the contracts also explicitly allocate control rights to venture investors to
minimize potential losses due to agency conflicts. The use of covenants that explicitly allocate control
rights to the venture capitalist increase with the potential for agency costs and conflicts of interest.
This separation of ownership and control has important implications for the efficiency of
entrepreneurial firms.
While most theories of financial contracts derive the optimality of straight debt or equity,
convertible debt and redeemable convertible preferred equity are the financial instruments that venture
1
capitalists employ most often. Most existing theories of convertible securities are not appropriate for
the venture capital environment and evidence on the terms of contracts employed in the industry.
Recently, a number of papers have explored the use of convertible financing in venture capital
transactions. Marx (1994) focuses on the venture capitalist's incentive to intervene and increase value
in an entrepreneurial firm. Berglöf (1994) examines the use of convertible debt to promote efficient
takeovers of entrepreneurial companies. Hellman (1994) provides an excellent principal-agent analysis
of venture capital transactions, but focuses on leverage ratios rather than on the use of convertible
securities. An issue that this paper seeks to answer is whether any of these theories has potential to
explain the use of convertible financing.
Venture capital provides a unique perspective in which to examine the nature of financial
contracting and corporate control. Venture capitalists raise money from individuals and institutions to
invest in early stage entrepreneurial projects. These projects are characterized by their extreme
uncertainty, asymmetric information, and potentially high rewards. Venture-backed success stories
include Microsoft, Cisco Systems, Genentech, and Federal Express. Venture Economics (1988),
however, noted that 6.8% of venture-backed projects accounted for 50% of the return on venture
investments. 34.5% of all projects experienced either a partial or total loss of invested capital. The
variance in potential outcomes is quite high.
The contractual relationship between venture capitalists and entrepreneurs needs to align
1
The payoff to convertible debt and redeemable convertible preferred equity are essentially equivalent
and I will refer to them both as convertible venture financings.
2
entrepreneurs' incentives with venture capitalists' goals. The venture capital industry has developed
control mechanisms to deal with incentive problems in an uncertain environment.
The use of
convertible financing needs to be understood in the context of the broad array of control mechanisms
that are employed by venture capitalists. Sahlman (1990) gives an excellent summary of the common
governance structures that typify the venture capital industry. Gompers (1995) explores the periodic
reviews by venture capitalists and shows that staged capital infusion is important in minimizing agency
costs.
Lerner (1994) examines how syndication of investment by venture capitalists generates
additional information.
The ability to terminate entrepreneurs or dilute their equity holdings is also
utilized by venture capitalists.
While many theories of financial instruments have been developed around optimal control
allocation, the use of cash flow allocation to determine control right allocation may not be optimal in a
venture capital setting. Other contractual measures can address the issue of control rights. Contracts
often give the venture capitalist the right to control the board of directors, approve major expenditures,
and limit new security issuances. I examine these explicit control rights and explore how they alleviate
various conflicts between venture capitalists and entrepreneurs. Sahlman (1990) hypothesizes that the
most important role of convertible securities is to properly align the incentives of entrepreneurs and
venture capitalists and to provide information about the entrepreneur.
" A key feature of the contracts and operating procedures is that risk is shifted from the
venture capitalists to the entrepreneur. The entrepreneur's response to these
(contractual) terms enables the venture capitalist to make informed evaluations and
judgments. ... the convertible preferred security shifts some of the costs of poor
performance to the entrepreneurial team."
While Sahlman does not expand on the source of incentive problems or the mechanism by which
3
convertible preferred equity corrects them, this paper addresses those issues. The implication of
Sahlman's statement is that the allocation of value via the stakes granted to the founders and venture
capitalists acts as an incentive scheme that ensures proper actions by both the venture capitalist and the
entrepreneur.
The paper is organized as follows. The nature of ownership and control between entrepreneurs
and venture capitalists is explored in Section 2. Section 3 discusses the major terms and conditions of
convertible preferred venture investments. An analysis of the terms of a sample of fifty convertible
preferred equity venture investments is analyzed is Section 4. Section 5 concludes.
2. Ownership, financial instruments, and entrepreneurial firms
Grossman and Hart (1986) define ownership as the ability to exclude others from accessing an
asset. Their notion of ownership is critical to understanding security design. While the Grossman and
Hart definition of ownership is well understood and many models build upon its ideas to derive control
theories for various securities, most papers assume that control is allocated via mechanisms like
majority equity ownership. The person who owns the asset has greater than 50% of the equity in the
firm. While this may be a very useful concept in certain settings, allocating ownership proportional to
residual value, as is done in the case of common equity, may not always be optimal.
Entrepreneurial startups are subject to tremendous agency conflicts. A firm’s founder may
place significant weight on increasing his private benefits at the expense of outside shareholders. The
entrepreneur’s human capital is also critical to the success of the firm. If the equity stake given to the
entrepreneur is used as an incentive system, he will need a large fraction of the firm to induce the
proper effort level. The value of the entrepreneur’s input may be valuable enough such that he retains a
4
majority equity stake in the company. Similarly, reducing his equity stake below 50% may not be
prudent if this increases the entrepreneur’s desire to consume private benefits of control. The large
equity ownership is necessary to align incentives when the entrepreneur’s input is critical.
If the entrepreneur owns greater than 50% of the equity, however, it might be impossible for
investors to control other conflicts that might arise. If investors understand potential areas that could
lead to future agency conflicts, they could explicitly assign control rights over those activities to
themselves. This separation of equity ownership and control rights might increase efficiency and the
likelihood of success.
Covenants and restrictions can be understood in this framework. They assign control rights to
investors over actions that are particularly damaging to them. We expect that the degree of covenant
coverage should be related to potential conflicts. Smith and Warner’s (1979) analysis of bond
covenants discusses the explicit role that covenants play in reducing agency costs. Smith and Warner
argue that writing contracts is costly. Parties negotiating certain restrictions will only include them
when benefits from restricting activities outweigh costs of contracting and monitoring compliance. The
greater the potential for agency conflicts, the more likely restrictions will be imposed.
Similarly, Gompers and Lerner (1996) find that potential agency costs explain some of the
covenant inclusion in venture capital limited partnership agreements. The greater the likelihood for
conflicts between venture capitalists and their investors leads to tighter covenants in the venture capital
limited partnership. In a similar manner, if the use of covenants in venture capital convertible financing
agreements is related to the cost of potential conflicts, then the number of covenants should be related
to proxies for agency costs.
5
Various proxies for agency costs can be examined. Gompers (1995) finds a group of industry
accounting variables that appear to be related to agency costs in entrepreneurial firms and are related to
the intensity of monitoring. These proxies may also be related to the tightness of covenant usage.
First, conflicts are more likely to arise in early stage companies. The level of asymmetric information is
likely to be considerably higher. Similarly, firms that have high R&D intensities are more likely to
generate higher levels of asymmetric information leading to potential conflicts of interest between the
entrepreneur and the venture capitalist. Finally, market-to-book ratios measure the fraction of the
firm’s value that is represented by the exercise of future growth opportunities. As the fraction of value
that is growth options increases, so does the potential for the entrepreneur to make decisions that do
not maximize shareholder value. Each of these variables should be related to the probability of
covenant inclusion.
Similarly, we can look at the effect of the supply of venture capital funds as a determinant of
contractual restrictiveness. Gompers and Lerner (1996) find that the relative supply and demand
conditions in the venture capital fundraising market affect contractual restrictiveness in the agreements
between limited partners (investors) and the venture capitalist. Gompers and Lerner argue that
bargaining power should be a major determinant of covenant inclusion. Similarly, Gompers and Lerner
(1997a) find that the money flowing into the venture capital sector affects the price level of private
equity investments.
If the supply of venture capital somehow affects bargaining power of the entrepreneur versus
the venture capitalist, the probability of covenant inclusion may be affected. Increases in the supply of
venture capital can reduce the venture capitalist’s negotiating power as competition for investment
6
gives entrepreneurs the ability to resist accepting financing with tight covenants.
The use of convertible securities as opposed to straight equity financing can also be understood
in this context. Green (1984) presents a model of convertible debt that captures the spirit of this
relationship. In his model, a firm wants to issue debt to finance two investment projects, each having
different levels of risk. The firm cannot guarantee ex ante allocation of funds between the two projects.
As Jensen and Meckling (1976) point out, a manager whose firm has been financed by debt has an
incentive to increase allocation to riskier projects. By using convertible debt, the manager limits his
incentive to take risk because the warrant portion of the debt increases in value as risk increases.
Green, however, never considers the use of equity financing. He conjectures that moral hazard
or taxes would preclude equity, although he does not explicitly model them. Gompers (1993) builds a
simple model of venture capital financing that combines both moral hazard and adverse selection. The
model shows that under mild assumptions, convertible preferred equity dominates straight debt and
straight equity as a financing choice for venture capitalists. The convertible preferred security can act
as both an incentive compensation system for the entrepreneur (because he shares substantially in the
upside of the firm but does not benefit from increasing risk) and as a screening mechanism (because the
downside discipline of the preferred (debt) portion makes the deal unattractive to low quality
entrepreneurs). This model is referred to as the incentive/screening model of convertible venture
financing.
The incentive/screening model predicts that the convertible security would not be converted to
common stock until the investors receive positive information that the firm is very likely to be
successful. This information might be an event like an initial public offering (IPO) or when the firm
7
surpasses some performance targets. At that time, the discipline of the preferred (debt) portion of the
financing is relatively less important and can be eliminated. Similarly, it is likely that performance
targets that impose mandatory conversion would be more likely for earlier stage and riskier companies.
These are the companies that are in greater need of performance hurdles.
Several recent papers examine the use of convertible securities in venture capital investments.
Marx (1994) examines the incentives of a wealth constrained entrepreneur when returns to a project
are uncertain but verifiable. The entrepreneur raises money from a risk averse venture capitalist. The
choice of financing instrument determines the allocation of cash flows and the incentive for the venture
capitalist to intervene in the company. Intervention by the venture capitalist requires incurring some
fixed cost. This intervention is relatively more valuable when returns to the project are low. Debt
contracts lead to too much intervention and equity contracts lead to too little. The choice of
convertible preferred equity provides the proper intervention incentives and the optimal insurance for
the venture capitalist.
Berglöf (1994) examines how the entrepreneur and venture capitalist allocate cash flows and
control rights to yield an optimal exit decision. Both the entrepreneur and the venture capitalist are
assumed to want to liquidate their stake in the firm at some future date. The use of convertible debt or
convertible preferred equity provides both the proper incentive to sell the firm and enables both parties
to extract the maximum surplus from the buyer.
Both the Berglöf and Marx papers depend upon the control aspects of the convertible preferred
financing to align incentives or promote the proper decision. Because the contracts actually contain
many explicit, state-contingent control rights that are allocated to investors, it is unlikely that the
8
primary purpose of the convertible payoff structure is to further allocate control rights.
3. Terms and conditions of convertible venture financing
3.1. Conversion characteristics
In this section I discuss the major elements of the convertible preferred equity agreements
between venture capitalists and entrepreneurs. This discussion is meant to provide background for the
empirical tests in the next section. This discussion is meant to provide background for the empirical
tests in the next section. The model term sheet in Appendix A provides insights into the structure of
typical contracts. Conversion terms will be examined first, then various covenants and restrictions will
be outlined.
First, the contract states the conversion price, usually set to the purchase price of the
convertible preferred. This ensures one for one conversion. The contracts also contain antidilution
protection to ensure that the entrepreneur does not try to take advantage of them by performing stock
splits or issuing special dividends. The contracts usually contain explicit formulas for calculating any
adjustment to the number of commons shares into which the preferred shares convert which may be
affected by selling equity below the venture capitalists’ purchase price.
As the contract in Appendix A shows, the contracts also list explicit events which trigger
automatic conversion of the preferred equity. Initial public offerings above a certain, pre-specified size
almost universally trigger conversion to common. Black and Gilson (1997) argue that this conversion
to common equity and the concomitant elimination of restrictive covenants represents a call option on
control. They argue that this automatic conversion at IPO is an integral part of the venture capital
process and one reason a robust public offering market is so important to the venture sector. In
9
addition, few investment banks would be willing to underwrite a common equity offering if venture
investors maintained a higher priority claim than they were underwriting.
In addition to automatic conversion at IPO, many contracts contain provisions for conversion
upon reaching other milestones. Many of these milestones are accounting based. Income targets tend
to be the most common, but sales or other targets are sometimes utilized. These targets serve as
barometers of success. Upon surpassing these predetermined hurdles, the entrepreneur shows that the
firm has been objectively successful.
3.2. Covenants and restrictions
In addition to conversion provisions, the preferred equity agreements also contain numerous
covenants and restrictions that serve to limit detrimental behavior by the entrepreneur. For example,
the contract in Appendix A explicitly states the number of board seats that Series B investors can elect.
Along with the rights in the Series A contract, the venture investors would probably control the board.
This is true in many venture investments. Even if the venture investors do not own greater than fifty
percent of the equity, the contracts may allocate control of the board to venture capitalists. The board
control serves as an important check on management that may try to extract rents from minority
shareholders. Similarly, in any future initial public offering, the outsider dominated board would lend
credibility to the firm.
Explicit control mechanisms give the venture investors control over specific aspects of the firm.
Certain actions are expressly forbidden or require the approval of a supermajority of investors. These
contractual features essentially separate out the allocation of control from the allocation of residual
value.
10
The preferred stake of the venture capitalist always has higher priority than common stock as
long as it is not converted. Many contracts give additional consideration to the preferred stock.
Sometimes the contracts pay out the entire face value of the preferred claim and then lump the claim of
preferred shareholders with the common. Some contracts give venture capitalists a multiple of the face
value before the common shareholders (usually the firm’s founders) receive anything. For the purpose
of payout, sale of the firm in an acquisition is usually treated as a liquidation. This “super-priority”
prevents the entrepreneur from making early liquidations decisions. If the venture capitalist invested in
common stock that had the same priority as the entrepreneur, the founder may want to liquidate early
and receive his percentage cut of the investment. For example, if venture capitalists invested two
million dollars in the common stock of a startup in which the founder retained 75% of the firm, the
founder could liquidate the company on day two and walk away with $1.5 million. Clearly, the greater
the possibility of gaming, the greater is the need for super-priority.
Many contracts also contain mandatory redemption rights. These are rights of the venture
investors that allow them to put the stock back to the company. Essentially, the venture capitalists can
force the firm to repay the face value of the investment at any time. This mechanism can often be used
to force liquidation or merger of the firm. The mandatory redemption provisions help the venture
investors determine the outcome from investment.
Sale of assets is often restricted as well. Any disposal of assets above a certain dollar value or
percentage of the firm’s book value may be limited without the approval of venture investors. This
prevents the entrepreneur from increasing the risk profile of the company. It also prevents the
entrepreneur from making “sweet heart” deals with friends. The prohibition on asset sales prevents the
11
firm from changing its intended focus.
The venture investors are also often concerned about changes in control. The contracts may
state that the founders cannot sell any of their common stock without approval of the venture investors
or offering the securities to the venture investors. Similarly, restrictions may prevent a merger or sale
of the company without approval of the investors because it ultimately means a change in who controls
the firm. Transfer of control restrictions are important because venture capitalists invest in people. If
the management team decides to remove its human capital from the deal, venture capitalists would
want to approve the terms of the transfer. Many transfers in control may hurt the position of the
venture investor if they are done on terms that are unfavorable to earlier investors.
The purchase of major assets above a certain size threshold may also require approval of
venture investors. This restriction may be written in absolute dollar terms or may be written as a
percentage of book value. The wording is usually broad enough to cover purchases of assets or
merger of the firm. Restrictions on purchases may help prevent radical changes in strategy or wasteful
expenditure by the entrepreneur. Many such strategy changes could have detrimental effects on the
value of the venture investors stake.
Finally, the contracts usually contain some provision for restricting the issuance of new
securities. Almost all documents contain a provision that restricts the issuance of senior securities
without the approval of previous investors. Many documents alter the restriction to include securities
on the preferred equity level or any security issuance. Usually, a majority of preferred shares must vote
in favor of such an issue. Restricting security issuance prevents the transfer of value from current
shareholders to new security holders.
12
4. Empirical evidence
In this section I examine evidence concerning convertible debt and convertible preferred equity
in venture capital investments. The empirical tests will focus on three areas; 1) characteristics of the
venture capital industry and the use of convertibles, 2) conversion features of the convertible securities,
and 3) factors affecting covenants and restrictions in venture capital convertible preferred equity
investments.
4.1. Characteristics of the venture capital industry and the use of convertibles
The screening/incentive model developed in Gompers (1993) relies upon asymmetric
information between the investor and the entrepreneur. The entrepreneur's ability is unknown to the
venture capitalist who designs a contract to screen out potentially bad entrepreneurs and limit risk
taking behavior. Venture capital-backed firms are clearly active in industries where asymmetric
information is significant.
Because the entrepreneur often comes to the firm with a technical
background in the area of the firm's business, he is likely to be at a substantial informational advantage
relative to the venture capitalist. In addition, because most entrepreneurial firms have little or no track
record, these asymmetries are magnified.
Unknown ability is likely to be an important concern for venture capitalists. Because the
project's success is so dependent upon the entrepreneur's human capital, the venture capitalist spends
significant time and resources determining the management team's ability. The single most important
factor determining whether a project is funded or not is the entrepreneur's perceived ability. Lack of
management skills is the reason cited most often for failure of venture capital-backed projects [Gorman
and Sahlman (1989)]. In designing contracts, venture capitalists must always be wary of the desire
13
incompetent entrepreneurs have of seeing their projects funded.
Venture capitalists need to be concerned about actions that the entrepreneur might take to
increase the riskiness of a project. Although venture capitalists take an active role in advising and
monitoring entrepreneurs, they are usually not involved in the day-to-day activities of the firm unless
things go drastically wrong. Entrepreneurs are free to cut corners in the desire to get to market
quickly, even if this substantially increases risk. Venture capitalists usually cannot observe or verify
these "cut corners" or changes in strategy. One mechanism to reduce the desire to take such risks is to
use convertible securities.
The widespread use of convertible securities in venture financing is demonstrated by Table 1
which presents the mid-year summary from the investments of an early stage venture capital limited
partnership. Of the 28 financing rounds for the five companies listed, all but five are convertible
preferred equity. Common stock is purchased, but only in later rounds. This summary is consistent
with the predictions of the incentive/screening model. Early financings are predicted to be convertible
securities. Only after more information is available about the entrepreneur and the company would the
venture capitalist choose to utilize common equity.
4.2. Conversion provisions
The incentive/screening model emphasizes the asymmetric information about the entrepreneur's
ability and the riskiness of the project. If convertible securities are used to sort out low ability
entrepreneurs and reduce risk taking, then the venture capitalist would want to either delay conversion
until an exit is achieved or until information arrives that signals the project is a success and the
14
2
entrepreneur has high ability. If the entrepreneur could call the debt before new information about the
project outcome arrives, the equilibria of the model unravel.
An analysis of the common features of venture capital contracts shows that their features are
consistent with the model developed in this paper. A random sample of fifty convertible preferred
venture capital private placement agreements were examined from the files of the Aeneas Group. The
Aeneas Group is the affiliate of Harvard Management Company that handles the University
endowment's private-market investments. Their files on venture investments date back to the late
1970s. Aeneas' venture investment strategy was shaped by the philosophy of Walter Cabot, who ran
Harvard Management between 1974 and 1990. While investing in risky asset classes such as venture
capital and oil and gas, he emphasized the importance of conducting business with established and
reputable financial intermediaries [Grassmuck (1990)]. Although the Aeneas Group has invested
primarily in venture capital limited partnerships, they often look to coinvest in certain promising deals
that these venture funds finance, i.e., Aeneas will make a direct investment in one of the portfolio
companies identified by their venture capitalists. As such, their files include convertible preferred
venture investments that represent coinvestments with many different venture capital organizations.
This sample provides a more diverse group of contracts than if the investments of one venture capital
firm had been examined.
Summary statistics for the conversion characteristics of the fifty Aeneas contracts are presented
in Table 2. The average closing date for these fifty contracts was December 1988. On average, the
2
If the project is a success, the optimal strategy is for the venture capitalist to take compensation as
equity. Low ability entrepreneurs still have no incentive to accept the financing if conversion occurs
only after information of success arrives.
15
contracts represented the purchase of 2.2 million shares at an average price of $2.83 per share. None
of the issues were callable within a five year period and only 8% (4 contracts) allowed the entrepreneur
to voluntarily redeem the convertible after that time. Because most firms achieve some exit within five
years [Gompers (1996) shows that the median holding period is approximately three years from the
first round venture investment to a firm’s initial public offering], the call protection is effectively 100%.
92% of the contracts had mandatory conversion that occurs at the time of IPO. The conversion at
IPO was contingent upon the price per share and the amount of money raised by the firm. The average
minimum IPO price for automatic conversion was $7.25 per share and the average minimum IPO
valuation was $10,463,000. In all cases, both criteria must be satisfied for automatic conversion to
occur. This type of a transaction would be a strong signal that the firm has been successful.
A substantial fraction (38%) were automatically converted if certain profit, sales, and/or
performance milestones were attained. For those with income targets, automatic conversion to
common would occur if annual income exceeded $5.7 million. Similarly, if five years elapsed from the
time of financing without redemption of the convertible, some shares would automatically convert to
common equity. These milestone would also be associated with successful investments.
A reasonable estimate of the number of contracts that are converted is between twenty and
thirty percent, the fraction of venture-backed projects that eventually go public. A small number are
likely converted when a venture-financed company is acquired by an already public firm.
Benton and Gunderson (1983) describe the conversion features in their legal textbook on
venture capital contracts:
"Venture capitalists are often reluctant to invest in a Preferred Stock that is callable. ...
Accordingly, most venture capitalists will opt for automatic conversion events instead
16
of agreeing to voluntary redemption provisions. ... The venture capitalist will prefer
automatic conversion provisions to voluntary redemption provisions, however, because
the venture capitalist can, at the investment's outset, agree upon automatic conversion
events that, if achieved, will mean that the venture capitalist's investment has been a
3
successful one (by the venture capitalist's own standards)."
Clearly, venture capitalists only want conversion when they have some information about a project’s
outcome, consistent with the incentive/screening model presented in this paper.
All contracts also contained some form of antidilution provision that adjusted the number of
common shares that the preferred equity converted into if the company sold equity at a price below the
implied conversion price.
Table 3 examines the factors affecting various aspects of conversion in the sample of
convertible contracts. The dependent variables examined are: a dummy variable that equals one if the
convertible contract contains automatic conversion based on performance milestones other than an
initial public offering (e.g., sales or income targets), the price of and dollar value of an IPO that induces
conversion, and the value of annualized income that forces conversion for those contracts that have
income triggers.
The independent variables include a dummy variables to indicate whether the investment is in
early stage company or not. The dummy variable equals one if the convertible preferred is either Series
A or B. Early stage firms are more prone to asymmetric information and controlling the entrepreneur
through tighter restrictions may be necessary. The price per share paid in the investment round and
the total size of the investment are included as independent variables as well in order to control for
3
Parentheses are in original.
17
scale effects.
I also include several accounting measures to proxy for potential agency costs. Because
accounting data for private firms is unavailable, I collect annual SIC industry averages from
COMPUSTAT for each firm that received venture capital financing. I match each of the fifty
firms in the sample to a three digit SIC group. Variables were collected to calculate various
industry measures of asset tangibility (the ratio of tangible assets to total assets), growth
opportunities (market value of equity to book value), and research intensity (the ratio of R&D
expenditures to sales). The data were matched by date and industry to each firm at the particular
round of financing.
I calculate equal weighted averages for these ratios for all firms with
COMPUSTAT data in the three digit SIC industry.
This matching technique was used in
Gompers (1995). These industry measures were extremely useful as proxies for expected agency
costs.
From the previous discussion, firms that are subject to greater agency costs should have
tighter covenants and restrictions and may have higher conversion hurdles. The ratio of tangible
assets to total assets for the industry should be related to the liquidation value of the firm.
Tangible assets lower expected agency costs because a higher fraction of the investment can be
recovered if the firm does poorly. The market-to-book ratio should rise as the fraction of growth
options in firm value rises. Because potential agency costs associated with investment behavior
rise with growth options, the need to potentially control entrepreneurs with more restrictive
contracts (e.g., more covenants and higher conversion targets) increases. I also include a measure
of research and development intensity, R&D expenditure to sales. R&D intensive firms are likely
18
to accumulate physical and intellectual capital that is very industry- and firm-specific. As asset
specificity increases, so do expected losses in liquidation and expected agency costs. Once again,
the need for controlling the entrepreneur rises.
In addition to measures of potential agency costs, I include a measure of the supply of
venture capital funds. I utilize information from Gompers and Lerner (1997b) who analyze
factors affecting the flow of capital into the venture industry. I include the amount of money
committed to new venture capital limited partnerships in the prior year (in constant 1992 dollars)
as a measure of the supply of venture capital. If relative supply and demand affects contractual
restrictiveness, then periods of greater fundraising would lead to fewer restrictions and lower
conversion hurdles.
The only variable that is related to the inclusion of automatic conversion provisions is whether
the company was an early stage investment. The probability of including such an automatic conversion
covenant increases if the investment is early stage. This is consistent with the predictions of the
incentive/screening model. Conversion of early stage investments would be tied more closely to
indicators of success.
The second and third regressions examine IPO characteristics that are associated with
automatic conversion. The price per share and value of an initial public offering that induce conversion
are highly dependent upon the price per share paid in the investment round. Investors appear to tie
conversion to some multiple of the price paid for the shares or the investment size. The price per share
at IPO is more closely related to the size of the investment. Bigger investments lead to higher IPO
share price targets. The value of the IPO necessary to force conversion is related to the price of
19
investment but not the size of investment.
The final regression in Table 3 examines the factors affecting the income benchmark that is
associated with automatic conversion. The regression shows that the industry ratio of tangible assets
to total assets is negatively related to income conversion hurdle. Firms that have substantial intangible
assets have higher income targets that force conversion. Similarly, as the size of the investment
increases, the hurdle also increases. Finally, when the supply of venture capital increases, the level of
income that forces automatic conversion declines. This decline in hurdle rates suggests that when
venture capital is readily available, the restrictiveness of the contracts may decline.
4.3. Separation of cash flow allocation and control rights
Marx (1994) and Berglöf (1994) both emphasize the control and intervention incentives
imparted by the end of period payoffs using convertible preferred equity in venture capital financing.
The actual contracts between venture capitalists and entrepreneurs separate control and cash flow
allocation, however. First, the contracts usually contain explicit control rights (discussed in Section 4)
that are allocated to the venture capitalist independent of the allocation of cash flows. In addition,
Gompers (1995) demonstrates that the staged investment structure of venture capital can effectively
control the entrepreneur. The threat of withholding additional financing is, as Sahlman (1990) points
out, the most important control mechanism that the venture capitalist can employ.
Ownership percentages in venture capital-backed companies are often insufficient to give
voting control to the venture investors. Table 4 gives the financing history of eight venture capitalfinanced firms which eventually went public. Their experience illustrates the typical evolution of
ownership stakes in venture-backed companies. All but one of the firms, Seagate, received multiple
20
rounds of venture financing. In only two of the eight cases, Midway Airlines and Staples, did the first
round venture investment give voting control to the venture capitalists. On average, venture capitalists
receive 41.4% of the firm's equity in the first round of financing. These early stages investments occur
at perhaps the most important time for oversight of the company. Clearly, other control mechanisms
need to be outlined in the financing documents.
Separation of control and cash flow allocation may be important in an entrepreneurial setting.
The use of financing choice as an incentive and screening device is effective because the entrepreneur's
ability and effort are critical to the success of the new company. Rewarding the entrepreneur when the
firm is sold or goes public ensures that the entrepreneur's incentives are closely aligned with those of
the venture capitalist. Large private benefits of control, however, may make it difficult to control
opportunistic behavior and provide proper incentives to exert effort. Explicitly assigning certain
control rights to the venture capitalist (independent of cash flow allocation) may improve efficiency.
Venture capitalists often remove entrepreneurs from the firm or bring in a new CEO when the
entrepreneur is no longer the best manager. These changes in control are the result of explicit control
rights.
Table 5 tabulates the various control features of the fifty Aeneas contracts. Every contract had
covenants that restricted various decisions of the entrepreneur. The covenants tabulated included those
covenants that were included in more than 10% but less than 90% of the contracts. This ensured that
the restrictions were not unimportant because of their rare frequency or that they were not simply
boilerplate items included in every contract.
One important mechanism of control is representation on the board of directors. When
21
classifying the number of board seats controlled by the venture investors, I assume board seats
requiring the approval of both the venture capitalists and the common shareholders (normally the
founders) are essentially appointed by the venture capitalists. Each party has veto power, but the
venture capitalist probably has more control. Venture capitalists controlled 2.68 seats on average,
essentially giving them control of the board of directors.
Covenants and restrictions in the convertible preferred documents showed considerable
variation.
In each contract, acquisitions were treated like liquidations.
Convertible preferred
shareholders would receive highest priority and receive the return of their total investment before the
common shareholders receive anything in all cases. Over half (66%) combined the claims of the
convertible preferred and common in any claim after the initial amount given back to the convertible
4
shareholder, essentially superpriority. 54% of the contracts gave the common some specified payoff
before the residual claims of the preferred and common were lumped together. In addition, over half of
the contracts (68%), gave the venture investors optional redemption rights. These optional redemption
rights give venture investors the ability to put the stock to the company, forcing them to repay the face
value of the convertible plus any accrued but unpaid dividends.
Major asset sales were also restricted. 58% of the financings included provisions which limited
the ability of the firm to dispose of or sell assets. A related covenant often limited the ability of the
entrepreneur to transfer control of the company to another party either by selling the firm or selling a
controlling equity stake. 62% of the contracts limited such control transfers without the approval of
4
The convertible preferred shares were treated as the maximum number of common shares into which
they convert for determining their share in this residual claim at liquidation.
22
the venture investors.
A substantial fraction of the documents (56%) had restrictions on major purchases of assets
that required approval of the venture investors. Similarly, all contracts restricted the ability of the
entrepreneur to issue new securities that were senior to the current issue. 66% of the contracts
restricted the entrepreneur from issuing any new security (junior or senior) without the consent of the
limited partners.
Using these types of covenants and restrictions give the venture investors
considerable control over the firm's activities.
In Table 6 I examine factors that are related to the size of the board of directors and the
allocation of board seats to venture capital investors. Independent variables include whether the firm
being financed is an early stage company, industry accounting variables to measure potential agency
costs, and the amount of venture fundraising in the previous year.
None of the independent variables appears to be related to board size. The number of directors
appears to be exogenously determined. The regression results for percentage of board seats controlled
by venture investors, however, support the predictions of the incentive/screening model. Firms that are
in industries with a greater fraction of intangible assets are associated with venture investors controlling
a higher fraction of the board of directors. If potential agency costs are higher for such firms, the
contracts would assign greater control to the venture capitalists. Similarly, in periods of greater
venture fundraising, the fraction of board seats controlled by the venture capital investors declines.
Greater competition for investing may give the entrepreneur greater bargaining power and allow him to
retain greater control of the firm.
Before analyzing the inclusion or exclusion of covenants and restrictions, Simple correlation
23
coefficients between the various covenants are presented in Table 7. While correlation among the
various covenant classes is always positive and is often significant, all but one of the correlation
coefficients are below 0.5. While covenant inclusion is correlated, the regression results will not be
driven by an all or nothing choice about covenants inclusion. The contracts are very heterogenous in
terms of restrictiveness.
Table 8 presents logit regressions for the inclusion of each of the six covenant classifications.
The dependent variable is a dummy variable that equals one if the convertible preferred contract
included the covenant. Independent variables include the percentage of the board controlled by venture
capitalists and a dummy variable that equals one if the firm is an early stage company. I include
percentage of board controlled to determine whether board control is a compliment or substitute for
other control mechanisms.
I also include the industry ratios of R&D expenditure to sales, market value of equity to book
value, and tangible assets to total assets. These ratios proxy for potential asymmetric information and
agency costs. Finally, I include the amount of money committed to new venture capital funds in the
previous year to measure venture capital supply.
In general, the results are consistent with the predictions of the agency cost explanation for
covenant inclusion. The percentage of board seats controlled by venture capitalists is negatively related
to the inclusion of superpriority restrictions, but positively related to the inclusion of mandatory
redemption provisions. It thus seems as if board control is neither a substitute nor a compliment for
other control mechanisms. The probability of including mandatory redemption provisions is higher for
early stage companies. R&D intensity is, in general, positively related to the probability of inclusion of
24
individual covenants and is significantly related to superpriority inclusion. Higher R&D intensities
increase the probability of agency conflicts and thus increase the need for covenants.
The factor that is consistently and significantly related to the probability of covenant inclusion is
the industry market-to-book ratio. Firms in industries with high market-to-book ratios have firm values
that are dependent upon the exercise of future growth options. The potential for agency conflicts is
high and the need to control the entrepreneur via specific covenants increases. Potential agency costs
related to growth options may be very important considerations for venture capitalists.
Table 9 analyzes the number of covenants included in the convertible financing agreement. The
number of covenants is one potential metric for contractual restrictiveness. Because the dependent
variable is an integer, i.e., the number of covenants from (one to six) included in the financing, I utilize
Poisson regressions to estimate parameter values. The more the venture capitalists are concerned
about conflicts, the more covenants they will demand.
Again consistent with the agency cost
explanation for covenant inclusion, early stage firms are associated with more covenants. In addition,
both industry R&D intensity and industry market-to-book ratios are positively related to the number of
covenants in the convertible preferred. Early stage companies and companies in industries with high
R&D intensities or lots of growth options are associated with greater potential asymmetric information
and potential agency conflicts. As such, contracts explicitly assign greater control rights to the venture
investors in these cases, independent of the equity ownership purchased at the time of investment to
control such behavior.
5. Conclusion
The design of venture capital control structures provides important insights into the nature of
25
information and incentives. The separation of equity ownership and control improves efficiency in
entrepreneurial firms. The use of convertible securities in venture capital can be seen as a response to
the unique environment in which multiple incentive problems and asymmetric information exist. The
multiplicity of control mechanisms in venture capital financing effectively reduces agency costs. This
makes venture capital investments a likely environment to separate the allocation of control rights from
the allocation of cash flows. Control rights are explicitly enumerated in the financing document.
Capital structure and financial instruments in venture investments may provide powerful incentives for
a firm's founder. The entrepreneur receives little salary and his payoff depends almost entirely on end
of period return on the firm's assets. This paper shows that convertible preferred equity is a potentially
effective means of screening out low ability entrepreneurs and providing proper incentives for a startup firm's founders.
The summary of terms in venture capital convertible contracts in this paper shows that they are
structured to minimize potential agency conflicts. Conversion to common stock occurs either at the
discretion of the venture investor or at milestones that indicate success, e.g., initial public offering or
surpassing performance targets. Similarly, the restrictiveness of the contracts, both the probability of
including specific covenants and the number of covenants included, are positively related to potential
agency costs. These agency costs are higher for early stage firms and firms in industries with high
R&D intensities, high market-to-book ratios, and low ratios of tangible assets to total assets.
Why use financial instruments to align incentives and separate control allocation from cash flow
allocation? State contingent contracts or other more complex incentive schemes could be used. One
advantage of using financial securities is that the incentive scheme is self-financing. Entrepreneur's
26
receive little cash salary. Their final payoff occurs at the time of an exit and does not depend upon an
infusion of new money by the venture capitalist. This is important in our legal environment where
corporate shareholders are endowed with limited liability. Entrepreneurs are often wealth constrained
and would not have enough money to post a bond up front. In addition, the use of financial securities
may lessen the need for ex post renegotiation. By basing compensation on a final period outcome that
is determined at the time the venture capitalist and entrepreneur choose to exit, the ability of the
entrepreneur to force renegotiation may be limited. Entrepreneurs are less likely to hide revenues with
accounting techniques or by inflating costs if their reward depends on final period returns.
The separation of cash flow allocation and control rights allocation deserves further attention.
Clearly, ownership is not a zero/one variable. The ability to make decisions concerning a firm is limited
by the contracts that are signed. Understanding contracts in terms of their use in allocation of control
rights seems useful. This paper has begun the empirical exploration of the role of this separation.
The issues of corporate structure and governance are important.
Venture capital and
entrepreneurial activities have been vital to the U.S. economy. The relative success of entrepreneurial
firms may be partially a result of the better incentives that are achieved with the use of various control
mechanisms (including convertible securities) by venture capitalists. Understanding the venture capital
investment and monitoring process is important in fostering more efficient allocation of capital and
resources to start-up firms.
27
References
Akerlof, G., 1970, The market for 'lemons': Qualitative uncertainty and the market mechanism,
Quarterly Journal of Economics 84, 488-500.
Amit, R., L. Glosten, and E. Muller, 1990a, Does venture capital foster the most promising
entrepreneurial firms?, California Management Review, 102-111.
Amit, R., L. Glosten, and E. Muller, 1990b, Entrepreneurial ability, venture investments, and risk
sharing, Management Science 36, 1232-1245.
Barry, C., C. Muscarella, J. Peavy, and M. Vetsuypens, 1990, The role of venture capital in the
creation of public companies: Evidence from the going public process, Journal of Financial
Economics 27, 447-472.
Benton, L., and R. Gunderson, 1983, in eds. M. Halloran, L. Benton, and J. Lovejoy, Venture Capital
and Public Offering Negotiation, Harcourt Brace Jovanovich, Publishers, New York, New York.
Berglöf, E., 1994, A control theory of venture capital finance, Journal of Law, Economics, and
Organizations 10, 247-267.
Black, B., and R. Gilson, 1997, Venture capital and the structure of capital markets: Banks versus
stock markets, Columbia Law School working paper.
Gompers, P., (1993), The theory, structure, and performance of venture capital, Unpublished Ph.D.
manuscript.
Gompers, P., 1995, Optimal investment, monitoring, and the staging of venture capital, Journal of
Finance 50, 1461-1490.
Gompers, P., 1996, Grandstanding in the venture capital industry, Journal of Financial Economics 42,
133-156.
Gompers, P., and J. Lerner, 1996, The use of covenants: An empirical analysis of venture partnership
agreements, Journal of Law and Economics 39, 463-498.
Gompers, P., and J. Lerner, 1997a, "The valuation of private equity investments," Unpublished
working paper, Harvard University.
Gompers, P., and J. Lerner, 1997b, "Venture capital fundraising, firm performance, and the
capital gains tax," Unpublished working paper, Harvard University.
28
Gorman, M., and W. Sahlman, 1989, What do venture capitalists do?, Journal of Business Venturing
4, 231-248.
Grassmuck, K., 1990, "The Much-Praised and Often-Criticized 'Architect' of Harvard's Endowment
Growth Steps Down," Chronicle of Higher Education. 36 (June 6), A25-A27.
Green, R., 1984, Investment incentives, debt, and warrants, Journal of Financial Economics 13, 115136.
Grossman, S., and O. Hart, 1983, An analysis of the principal-agent problem, Econometrica 51, 7-45.
Grossman, S., and O. Hart, 1986, The costs and benefits of ownership: a theory of vertical and lateral
integration, Journal of Political Economy 94, 691-719.
Hart, O., 1991, Theories of optimal capital structure: a principal agent perspective, Harvard University
working paper.
Hart, O., and B. Holmstrom, 1987, The Theory of Contracts, in T. Bewly (ed), Advances in Economic
Theory, Fifth World Congress, Cambridge, Cambridge University Press.
Hart, O., and J. Moore, 1989, Default and renegotiation: a dynamic model of debt, Harvard University
working paper.
Hart, O., and J. Moore, 1990, Property rights and the nature of the firm, Journal of Political Economy
98, 1119-1158.
Hellman, T., 1994, Financial structure and control in venture capital, Stanford University working
paper.
Holmstrom, B., 1982, Moral hazard in teams, Bell Journal of Economics 13, 324-340.
Holmstrom, B., and P. Milgrom, 1987, Aggregation and linearity in the provision of intertemporal
incentives, Econometrica 55, 303-328.
Holmstrom, B., and P. Milgrom, 1990, Multi-task principal-agent analysis, MIT working paper.
Jensen, M., and W. Meckling, 1976, Theory of the firm: managerial behavior, agency costs, and capital
structure, Journal of Financial Economics 3, 305-360.
Lerner, J., 1994, The syndication of venture capital, Financial Management 23, 16-27.
29
Marx, L., 1994, Negotiation and renegotiation of venture capital contracts, University of Rochester
working paper.
Modigliani, F., and M. Miller, 1958, The cost of capital, corporation finance, and the theory of
investment, American Economic Review 48, 261-297.
Myers, S., 1984, The capital structure puzzle, Journal of Finance 39, 575-592.
Sahlman, W., 1990, The structure and governance of venture capital organizations, Journal of
Financial Economics 27, 473-524.
Smith, C., Jr., and J. Warner, 1979, "On Financial Contracting: An Analysis of Bond Covenants,"
Journal of Financial Economics. 7, 117-61.
Venture Economics, 1988, Exiting Venture Capital Investments. Needham: Venture Economics.
30
Appendix A
Summary of principal terms of a typical convertible preferred stock agreement between a venture
1
capitalist and an entrepreneur.
A. Number of Shares
1,000,000.
B. Price
$5.00
C. Dividend
Cumulative dividends of $0.20 per share per
annum, payable each July 1. Senior to dividends
of Series A, which are $0.10 per share per annum
and are noncumulative.
D. Liquidation Preference
$5.00 per share plus all accrued but unpaid
dividends. Senior to liquidation preference of
Series A.
E. Optional Redemption
Redemption at Company's option after 5 years at
redemption price of $5.50 per share plus accrued
but unpaid dividends.
F. Mandating Redemption
Sinking fund redemption at redemption price of
$5.00 per share plus accrued but unpaid dividends
commencing July 1, 1991, as follows:
Date
July 1, 1992
July 1, 1993
July 1, 1994
July 1, 1995
Number of
shares redeemed
100,000
250,000
300,000
350,000
G. Conversion Features:
(1) Conversion Price
$5.00 per share of Common Stock (one-for-one
conversion)
(2) Automatic Conversion
(a) Firmly underwritten public offering covering
primary sale of Common Stock at public offering
price of $10.00 per share or above with gross
proceeds of $10 million or more
31
(b) Audited financials for fiscal year reporting at
least $50 million in consolidated revenues and
pretax profit (before extraordinary items) of at
least 15% of revenues for the same period. [Noteaccrued but unpaid dividends must be paid at the
time of automatic conversion, either in cash or
Common Stock valued at the effective Conversion
Price.]
(3) Antidilution Protection
(including exceptions)
H. Voting Right
Proportional adjustments for splits, dividends,
recapitalizations, and the like.
Formula
adjustments for issuances below the Conversion
Price. Exceptions for Common Stock issuable
upon conversion of Preferred Stock and for
165,000 shares of Common Stock issued pursuant
to stock purchase, option, and related plans.
(a) General voting: Holders of Series B have
number of votes equal to largest number of full
shares of Common Stock into which Series B may
be converted.
(b) Normal election of directors: Holders of Series
B can elect two directors. Holders of Series A
and Common Stock can elect the remaining
directors.
(c) Contingent voting rights: Holders of Series B
can elect majority of Board in case of certain
events:
(i) $250,000 loss in any quarter
(ii) consolidated tangible net worth
less than $3,000,000.
(iii) default in two annual
dividends; or
(iv) default in redemption
32
I. Restrictions and Limitations
(a)
Company needs consent of two-thirds of
both Series A and Series B to:
(i) repurchase any Preferred Stock
(ii) repurchase any Common Stock other
than pursuant to redemption provisions;
(exception for cost buy-backs under
employee and related plans, not to
exceed $25,000 in any 12-month
period.);
(iii) authorize or issue any senior equity
security;
(iv) certain sales and transfers of
assets and other corporate
reorganizations;
(v) permit any subsidiary to sell, or
sell itself, any stock of such
subsidiary; or
(vi) increase or decrease authorized
Preferred Stock.
(b) Company needs consent of holders of twothirds of Series A and Series B for amendment of
Articles changing rights, preferences, or privileges
of Preferred Stock.
1
Taken from L. Benton and R. Gunderson, 1983, in M. Halloran, L. Benton, and J. Lovejoy, Venture
Capital and Public Offering Negotiation, Harcourt Brace Jovanovich, Publishers, New York, New
York. 259-262
33
Table 1
Investment history for an early stage venture capital partnership. The sample is an interim report for an early
stage venture capital limited partnership from July 1996. Valuations are as of July 1, 1996.
Company/
Type of Security Purchased
Company 1
Convertible Preferred Series A
Convertible Preferred Series A
Convertible Preferred Series A
Convertible Preferred Series B
Convertible Preferred Series C
Convertible Preferred Series D
Common
Purchase
Date
Price per
Share
Number of
Shares
Total
Cost
Fair
Value
Unrealized
Gain
10/18/88
12/15/89
2/21/90
12/20/90
7/1/91
10/20/91
5/27/92
$0.90
$1.00
$1.00
$3.00
$2.70
$2.27
$2.00
1,641,66
1,477,500
492,500
738,750
1,477,500
650,881
246,250
$1,477,500
$1,477,500
$492,500
$2,216,250
$3,989,250
$1,477,500
$492,500
$9,029,169
$8,126,250
$2,708,750
$4,063,125
$8,126,250
$3,579,846
$1,354,375
$7,551,668
$6,648,750
$2,216,250
$1,846,875
$4,137,000
$2,102,346
$861,875
$25,364,764
Company 2
Convertible Preferred Series B
Convertible Preferred Series C
Convertible Preferred Series D
Convertible Preferred Series E
Common
Convertible Preferred Series F
Common
6/24/90
2/14/92
1/6/94
4/28/95
4/28/95
6/26/96
6/26/96
$0.70
$1.60
$2.50
$1.00
$0.02
$2.00
$0.07
1,266,428
615,625
78,003
366,303
1,831,515
216,009
864,036
$886,500
$985,000
$195,008
$366,303
$36,630
$432,018
$60,483
$582,557
$283,188
$35,881
$168,499
$128,206
$432,018
$60,483
($303,943)
($701,813)
($159,126)
($197,804)
$91,576
$0
$0
($1,271,109)
Company 3
Convertible Preferred Series A
Convertible Preferred Series A
Common
Convertible Preferred Series C
1/15/91
7/22/92
7/1/93
6/7/95
$1.41
$0.26
$1.41
$4.38
1,561,890
3,320,855
723,035
155,344
$2,202,265
$684,108 ($1,518,157)
$863,422 $1,454,534
$591,112
$1,019,479
$316,689 ($702,790)
$680,407
$680,407
$0
($1,629,835)
Company 4
Convertible Preferred Series A
Convertible Preferred Series B
Convertible Preferred Series C
Common
4/14/92
2/26/93
7/23/94
6/15/95
$1.00
$1.00
$1.00
$0.01
3,274,377
97,011
1,188,678
3,438,160
$3,274,377 $6,548,754 $3,274,377
$97,011
$194,022
$97,011
$1,188,678 $2,377,356 $1,188,678
$34,382
$171,908
$137,526
$4,697,592
Company 5
Convertible Preferred Series C
Convertible Preferred Series D
Convertible Preferred Series D
Convertible Preferred Series E
Convertible Preferred Series E
Convertible Preferred Series F
5/23/88
9/26/89
10/31/91
8/20/93
9/13/94
3/18/96
$1.85
$2.53
$2.40
$3.90
$3.90
$0.70
559,054
237,578
141,848
91,506
100,849
680,833
Total Unrealized Gain
$1,034,250
$601,072
$340,435
$356,873
$393,311
$476,583
$391,338
$166,305
$99,294
$64,054
$70,594
$476,583
($642,912)
($434,768)
($241,142)
($292,819)
($322,717)
$0
($1,934,357)
$25,227,055
Table 2
Conversion characteristics of convertible preferred equity contracts. The sample is 50 convertible preferred equity
financings by venture capital firms randomly selected from the Aeneas Fund at Harvard Management Company.
Averages and medians [in brackets] for various contract characteristics are tabulated.
Closing date of financing:
Dec. 1988
[Sept. 1989]
Number of shares purchased:
[in thousands]
2,243
[1,750]
Price per share:
$2.83
[$2.45]
Company is early stage
58%
Percent converting automatically at IPO:
92%
If price at IPO greater than:
Value of IPO greater than:
[in thousands]
Percent containing automatic conversion covenants prior to IPO:
If annual income greater than:
[in thousands]
If time from financing greater than:
[in years]
$7.25
[$5.50]
$10,463
[$10,000]
38%
$5,731
[$5,000]
5
[5]
Table 3
Regressions for factors influencing conversion features of convertible preferred contracts. The independent variables are a dummy variable
that equals one if the contract includes automatic conversion provisions other than provisions tied to an initial public offering, the minimum initial
public offering price per share to force automatic conversion, the value of the IPO that forces automatic conversion, and the value of annualized net
income that forces automatic conversion. Independent variables include a dummy variable that equals one if the investment was in an early stage
company, the price paid per share in the investment round, the size of the investment (in millions of dollars), average industry ratios of R&D to sales,
market value of equity to book value of equity, and tangible assets to total assets, as well as the amount of venture capital committed to new funds in the previous
year. The regressions for price per share, value of public offering, and value of annualized income are ordinary least squares. Regression for inclusion
of automatic conversion provisions is a logit regression.
Independent Variables
Dependent Variable
Is the investment in an early stage
company?
Average industry ratio of R&D
expenditure to sales
Average industry ratio of market
value of equity to book value
Average industry ratio of tangible
assets to total assets
Amount of money raised by
venture industry in previous year
Price per share paid in the
investment round
Size of the investment (millions of
dollars)
Constant
2
Log-likelihood ratio/ Adjusted R
2
p-value of F- or χ statistic
Number of observations
Does the convertible
preferred document
contain automatic
conversion provisions?
Price per share in an
initial public offering
that forces automatic
conversion into
common
Value of an initial
public offering that
forces automatic
conversion
into common
Value of annualized
income that forces
automatic conversion
into common
2.079
[2.28]
-0.341
[-0.50]
-1.739
[-1.25]
-0.538
[-0.22]
-10.14
[-0.44]
-56.08
[-3.09]
32.37
[0.85]
-23.45
[-0.70]
0.445
[0.48]
1.179
[1.59]
-0.270
[-0.18]
2.382
[1.17]
-1.286
[-0.51]
1.823
[0.92]
-0.802
[-0.19]
-6.956
[-1.84]
-0.0000
[-0.09]
0.0001
[0.31]
-0.0006
[-1.00]
-0.0009
[-1.81]
-0.150
[0.62]
-0.534
[-2.50]
1.281
[2.95]
-0.274
[-0.48]
0.373
[1.51]
0.410
[1.94]
0.152
[0.34]
0.632
[2.16]
-2.266
[-0.62]
1.352
[0.49]
9.020
[1.56]
9.488
[1.91]
-22.57
0.256
0.290
0.670
0.045
0.028
0.009
0.059
44
36
41
13
Table 4
Investment history at eight venture capital-backed companies.
Amount
Company
Apple
Cray Research
Investor
Date
Funded
($,000)
Cumulative
Stock
Funding ($,000) Received(,0
00)
Total Shares
Outstanding
(,000)
Percent
Ownership
Acquired
Fully Diluted
Valuation
($,000)
Price per
Share($)
Estimated Ending
Ownership
Founders
Mar-77
$1
$1
16,640
16,640
100.0%
$1
$0.00
30.7%
Founders
Nov-77
$115
$116
10,480
27,120
38.6%
$298
$0.01
19.3%
Venture 1
Jan-78
$518
$634
5,520
32,640
16.9%
$3,063
$0.09
10.2%
Founders
Jul-78
$426
$1,060
4,736
37,376
12.7%
$3,362
$0.09
8.7%
Venture 2
Sep-78
$704
$1,764
2,503
39,879
6.3%
$11,216
$0.28
4.6%
Venture 3
Dec-80
$2,331
$4,095
2,400
43,306
5.5%
$42,061
$0.97
4.4%
IPO
Dec-80
$101,200
$105,295
4,600
54,215
8.5%
$1,192,730
$22.00
8.5%
Founders
Aug-72
$2,550
$2,550
2,869
2,869
100.0%
$2,483
$0.89
24.4%
Venture 1
Jan-74
$2,675
$5,225
2,006
4,875
41.1%
$6,501
$1.33
17.0%
Venture 2
Jan-75
$642
$5,867
387
5,302
7.3%
$8,796
$1.66
3.3%
Venture 3
Apr-75
$2,720
$8,587
1,530
6,832
22.4%
$12,146
$1.78
13.0%
IPO
Mar-76
$10,890
$19,477
4,950
11,782
42.0%
$25,923
$2.20
42.0%
Federal
Founders
Jan-72
$4,745
$4,745
100
100
100.0%
$4,745
$47.45
0.7%
Express
Venture 1
Sep-73
$12,250
$16,995
60
160
37.5%
$32,667
$204.17
0.4%
Venture 2
Mar-74
$6,400
$23,395
872
1,032
84.5%
$7,574
$7.34
6.4%
Venture 3
Sep-74
$3,876
$27,271
6,200
7,232
85.7%
$4,521
$0.63
45.8%
IPO
Apr-78
$25,800
$53,071
4,300
13,535
31.8%
$81,210
$6.00
31.8%
Founders
Jan-76
$126
$126
3,200
3,200
100.0%
$126
$0.04
41.4%
Venture 1
Apr-76
$850
$976
1,180
4,380
27.6%
$3,083
$0.07
15.3%
Venture 2
May-78
$950
$1,926
475
4,945
9.6%
$9,890
$2.00
6.1%
Corporate
Sep-79
$10,000
$11,926
1,000
6,348
15.8%
$63,480
$10.00
12.9%
$38,500
$50,426
1,100
7,724
14.2%
$270,340
$35.00
14.2%
Genentech
IPO
Oct-80
Table 4 (continued)
Cumulative
Stock
Total Shares
Percent
Fully Diluted
Price per
Estimated
Raised
Funding
Received
Outstanding
Ownership
Valuation
Share
Ending
($,000)
($,000)
(,000)
(,000)
Acquired
($,000)
Company
Investor
Lotus
Founders
Apr-82
$13
$13
4,410
4,410
100.0%
$13
$0.00
30.9%
Venture 1
Apr-82
$1,000
$1,013
3,500
7,910
44.2%
$2,260
$0.03
24.5%
Venture 2
Dec-82
$3,755
$4,768
3,767
11,677
32.3%
$12,044
$1.03
26.4%
IPO
Oct-83
$46,800
$51,568
2,600
14,277
18.2%
$256,988
$18.00
18.2%
Founders
Jun-76
$7
$7
700
700
100.0%
$7
$0.01
18.8%
Venture 1
Jul-79
$5,739
$5,746
1,380
2,080
66.3%
$8,650
$4.16
37.1%
Venture 2
Sep-80
$6,000
$11,746
789
2,869
28.3%
$23,620
$7.60
21.2%
IPO
Dec-80
$11,475
$23,221
850
3,719
23.4%
$53,433
$13.50
22.9%
Founders
Oct-79
$161
$161
11,723
11,723
100.0%
$161
$0.01
64.1%
Venture 1
Jun-80
$1,000
$1,161
3,125
14,848
21.0%
$4,751
$0.32
17.1%
IPO
Sep-81
$25,000
$26,161
2,500
18,277
13.7%
$182,770
$10.00
13.7%
Founders
Jan-86
$4,425
$4,425
1,844
1,844
100.0%
$4,425
$2.40
20.2%
Venture 1
Jan-87
$13,927
$18,352
2,211
4,055
54.5%
$25,543
$6.30
24.2%
Venture 2
Dec-87
$13,597
$31,949
1,563
5,618
27.8%
$4,871
$8.70
17.1%
Venture 3
Sep-88
$2,800
$34,749
267
5,885
4.5%
$61,782
$10.50
2.9%
IPO
Apr-89
$61,750
$96,499
3,250
9,135
35.6%
$173,546
$19.00
35.6%
Midway
Airlines
Seagate
Staples
Date
Amount
Source: Annual Reports and Prospectuses.
Venture 1, etc., represents rounds of financing from venture capitalists.
IPO = Initial Public Offering
($)
Ownership
Table 5
Control characteristics of convertible preferred equity contracts. The sample is 50 convertible preferred
equity financings by venture capital firms randomly selected from the Aeneas Fund at Harvard Management
Company. Averages and medians [in brackets] for various contract characteristics are tabulated.
Total number of board seats
5.24
[5]
Number of board seats controlled by venture investors
2.68
[3]
Percentage of board seats controlled by venture investors
51.4%
[50%]
Venture investors have superpriority
66%
Venture investors have redemption rights
68%
Venture investors must approve asset sales
58%
Venture investors can restrict transfer of control
62%
Venture Investors must approve large expenditures
56%
Venture Investors can restrict issuance of new securities
66%
Table 6
Factors influencing composition of board of directors for venture-financed companies. The sample is
50 convertible preferred equity financings by venture capital firms randomly selected from the Aeneas Fund at
Harvard Management Company. The dependent variable is the size of the board of directors and the fraction of
board seats controlled by venture capitalists. Independent variables include a dummy variable that equals one if
the firm is an early stage company, average industry ratios of R&D to sales, market value of equity to book value
of equity, and tangible assets to total assets, as well as the amount of venture capital committed to new funds in
the previous year. Estimation for number of seats are Poisson regressions and for percentage of seats controlled
by venture capitalists are Tobit regressions.
Dependent Variables:
Independent Variables:
Number of board seats
Is the investment in an early stage
company?
0.036
[0.24]
Fraction of board
controlled by venture
capitalist
0.010
[0.33]
Average industry ratio of R&D
expenditure to sales
1.301
[0.32]
0.448
[0.50]
Average industry ratio of market
value of equity to book value
-0.012
[-0.07]
0.006
[0.16]
Average industry ratio of tangible
assets to total assets
0.267
[0.59]
-0.116
[-1.80]
Amount of money raised by
venture industry in previous year
-0.013
[-0.44]
-0.000
[-1.76]
Constant
1.412
[2.27]
0.623
[4.65]
-82.63
0.0255
0.996
0.133
50
50
Log-likelihood ratio
2
p-value of χ statistic
Number of observation
Table 7
Correlation coefficients among various covenants. The sample is fifty venture capital convertible preferred investments from the Aeneas Fund of Harvard
Management Company. The correlation coefficient for restriction inclusion [with p-value in brackets] are tabulated for each pair of covenants.
Automatic conversion
Automatic
Conversion
1.000
Super-priority
Mandatory
Redemption
Prohibition on Restrictions on
Sale of Assets Control Transfer
Restrictions on
Expenditures
Super-priority
0.164
[0.27]
1.000
Mandatory Redemption
0.258
[0.08]
0.232
[0.11]
1.000
Prohibition on Sale of Assets
0.352
[0.02]
0.465
[0.00]
0.322
[0.02]
1.000
Restrictions on Control
Transfer
0.229
[0.12]
0.482
[0.00]
0.081
[0.57]
0.134
[0.35]
1.000
Restrictions on Purchases
0.183
[0.31]
0.413
[0.00]
0.449
[0.00]
0.322
[0.02]
0.170
[0.24]
1.000
Restrictions on New Securities
0.164
[0.27]
0.465
[0.00]
0.232
[0.11]
0.822
[0.00]
0.134
[0.35]
0.232
[0.11]
Restrictions on
New Securities
1.000
Table 8
Regressions for factors influencing control allocation in venture capital convertible preferred financing documents. The independent variables
are dummy variables that equal one if the contracts give the venture investors superpriority in liquidations, redemption rights, control of asset sales,
transfers of control, expenditures, or the issuance of new securities. Independent variables include the percentage of board seats controlled by the venture
investors, a dummy variable that equals one if the firm is an early stage company, average industry ratios of R&D to sales, market value of equity to book value
of equity, and tangible assets to total assets, as well as the amount of venture capital committed to new funds in the previous year. All regressions are logit
regressions.
Dependent Variables: Does financing agreement include:
Percentage of the board controlled
by venture capitalists
Super-priority
-13.06
[-1.98]
Mandatory
Redemption
33.67
[2.82]
Prohibition on
Asset Sales
2.832
[0.55]
Restrictions on
Control Transfer
-0.607
[-0.15]
Restrictions on
Expenditures
7.216
[1.43]
Is the investment in an early stage
company?
-0.0013
[-0.01]
2.481
[2.12]
0.838
[0.92]
0.316
[0.44]
0.518
[0.61]
Average industry ratio of R&D
expenditure to sales
97.15
[1.98]
-31.79
[-0.86]
33.36
[1.05]
17.93
[0.80]
48.08
[1.56]
Average industry ratio of market
value of equity to book value
3.920
[2.34]
3.316
[1.82]
3.052
[2.31]
1.468
[1.81]
2.465
[2.04]
Average industry ratio of tangible
assets to total assets
-0.776
[-0.13]
-4.614
[-1.07]
-0.164
[-0.04]
0.834
[0.31]
4.187
[1.12]
Amount of money raised by
venture industry in previous year
-0.0002
[-0.33]
0.0004
[0.84]
-0.0000
[-0.01]
0.0004
[1.24]
-0.0002
[-0.51]
Constant
0.0480
[0.01]
-18.19
[-2.04]
-6.548
[-1.11]
-4.157
[-0.99]
-11.22
[-1.94]
[1.68]
1.565
[0.24]
Log-likelihood ratio
-13.50
0.0000
-13.72
0.0000
-18.32
0.0001
-27.44
0.0732
-19.62
0.0007
-17.96
0.0001
50
50
50
50
50
50
Independent Variables
p-value of χ2 statistic
Number of observation
Restrictions on
New Securities
2.013
[0.39]
-0.341
[-0.35]
32.87
[1.15]
2.601
[2.10]
-9.812
[-1.57]
0.007
Table 9
Regressions for factors influencing number of covenants included in the convertible preferred financing
agreement. The independent is the number of covenants included in the financing agreement (from 0 to 6).
Independent variables include a dummy variable that equals one if the firm is an early stage company, average industry
ratios of R&D to sales, market value of equity to book value of equity, and tangible assets to total assets, as well as the
amount of venture capital committed to new funds in the previous year. All regressions are Poisson regressions.
Dependent Variable:
Independent Variable:
Number of Covenants
Percentage of the board controlled by
venture capitalists
0.1887
[0.23]
Is the investment in an early stage
company?
0.317
[2.02]
0.324
[2.10]
Average industry ratio of R&D
expenditure to sales
6.969
[1.62]
7.135
[1.68]
Average industry ratio of market value of
equity to book value
0.345
[2.01]
0.347
[2.03]
Average industry ratio of tangible assets to
total assets
-0.155
[-0.40]
-0.172
[-0.45]
Amount of money raised by venture
industry in previous year
-0.0000
[-0.45]
-0.0000
[-0.51]
Constant
0.415
[0.58]
0.522
[0.97]
Log-likelihood ratio
-91.22
0.0000
-91.25
0.0000
50
50
p-value of χ2 statistic
Number of observation