The Structure of Venture Capital Contracts

A recent 136-page review of academic papers on venture capital by Da Rin, Hellmann, and Puri provides a high-level empirical description of how venture capital contracts are structured (extra paragraph breaks added):

In two seminal papers, Kaplan and Strömberg (2003; 2004) empirically examine the structure of VC contracts....Contracts routinely separate cash flow and control rights, make extensive use of state contingent clauses, control tends to shift to the VC (entrepreneur) in bad (good) states of natures...They also find that investor-friendly cash flow and control rights tend to be complements, not substitutes.

Kaplan and Strömberg (2004) ask why VCs use certain clauses in certain deals....They find that higher internal and external risks are associated with more VC control and more contingent compensation, whereas execution risk is related to the vesting of founder shares.... Kaplan and Strömberg find that anticipation of control actions (such as founder replacement) is associated with greater VC control rights, whereas anticipation of value-adding activities is associated with larger VC equity stakes.

...Bengtsson and Sensoy (2011a) find that higher ability investors make less use of contractual clauses to protect their returns on the downside, where ability is proxied by experience. Bengtsson and Ravid (2011) find that companies and VCs in California also use considerably less downside protection; this is also the case when the VC is physically closer to the company....

Bengtsson and Sensoy (2011b) study how contracts evolve as companies secure new rounds of financing. They find that following poor company performance, the contracts for the new investors include more downside protection and the contracts of the previous round investors are more likely to be renegotiated.

Finally, Bengtsson (2011b) shows that covenants are more likely in contracts that also include higher fixed claims on the downside. Garcia-Appendini et al. (2011) find a positive relationship between the use of covenants and investment returns.

Complementing this research is Wilson Sonsini's latest quarterly analysis of trends in venture capital financing terms.