Contractual Relations between European VC–Funds and Investors: The Impact of Reputation and Bargaining Power on Contractual Design

Abstract

Abstract:The paper explores factors that influence the design of financing contracts between venture capital investors and European venture capital funds. 122 Private Placement Memoranda and 46 Partnership Agreements are investigated in respect to the use of covenant restrictions and compensation schemes. The analysis focuses on the impact of two key factors: the reputation of VC-funds and changes in the overall demand for venture capital services.We find that established funds are more severely restricted by contractual covenants. This contradicts the conventional wisdom which assumes that established market participants care more about their reputation, have less incentive to behave opportunistically and therefore need less covenant restrictions. We also find that managers of established funds are more often obliged to invest own capital alongside with investors money. We interpret this as evidence that established funds have actually less reason to care about their reputation as compared to young funds. One reason for this surprising result could be that managers of established VC funds are older and closer to retirement and therefore put less weight on the effects of their actions on future business opportunities.We also explore the effects of venture capital supply on contract design. Gompers and Lerner (1996) show that VC-funds in the US are able to reduce the number of restrictive covenants in years with high supply of venture capital and interpret this as a result of increased bargaining power by VC-funds. We do not find similar evidence for Europe. Instead, we find that VCfunds receive less base compensation and higher performance related compensation in years with strong capital inflows into the VC industry. This may be interpreted as a signal of overconfidence: Strong investor demand seems to coincide with overoptimistic expectations by fund managers which make them willing to accept higher powered incentive schemes. JEL Classification: G32

Profit distribution and compensation structures in publicly and privately funded hybrid venture capital funds

“…The investors are legally constrained from a direct involvement in the operation of the fund in order to secure preferential tax advantages. Thus, full autonomy over investment activity is given to them despite the general partners typically providing no more than 1% of the fund's total committed capital (Gilson, 2003;Sahlman, 1990;Schmidt and Wahrenburg, 2003).…”

“…The GP typically receives of a 20% share of the net capital gain of the fund (Litvak, 2004;Sahlman, 1990;Schmidt and Wahrenburg, 2003). This participation by the GP in the investment returns is known as 'carried interest'.…”

“…Before being allowed to participate in any capital distribution, GPs are often contractually required to return the LPs' total drawn-down capital with a minimum agreed level of interest, i.e. the 'hurdle rate' (Gompers and Lerner, 1999;Schmidt and Wahrenburg, 2003). Once the hurdle is met, the GP 'catches up' the distributed profits of LPs by receiving all of the capital gains until the agreed carry ratio has been reached.…”

“…Once the hurdle is met, the GP 'catches up' the distributed profits of LPs by receiving all of the capital gains until the agreed carry ratio has been reached. In addition to these capital gain incentives, the GP usually receives an annual management fee of approximately 2 -2½ % of the total committed capital of the fund (Schmidt and Wahrenburg, 2003). This fee is primarily levied to cover the agent's costs in operating the investment activities of the fund.…”

“…While the structuring of a venture capital fund has been analysed from several perspectives, including the compensation and incentives of fund managers (Cooper and Carleton, 1979;Gompers and Lerner, 1999;Schmidt and Wahrenburg, 2003), the structuring of fund agreements (Brophy and Haessler, 1994), the structures of relationships (e.g. Sahlman, 1990;Wright and Robbie, 1998), and the use of covenants in venture partnership agreements (Gompers and Lerner, 1996), these studies typically assume that all limited partners (LPs) invest on equal terms (i.e.…”