Control rights in venturecontracts

Transcription

1 Control rights in venturecontracts and convertible securities. Klaas Schouten ANR Bachelor Thesis August 2007 Tilburg University Department of Finance Supervisor: I. Loncarski

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3 Contents Section I Introduction... 4 Section II Property rights and financial contracting Theory of capital structure Control Rights The property rights approach Contracts in the Firm... 7 Section III Financial contracting and venture capital Venture Capital The theory of venture capital financing Contents of a VC contract... 9 Section IV Venture capital and optimal control right allocation Financial contracting theories Empirical research to capital structure in VC financing International comparison Section V Control right allocation and convertible securities A recent model of venture capital financing Predictions Validity Different definitions Section VI Discussion: Method Discussion: Interdisciplinary relations Discussion: Applied financial contracting Conclusion Bachelor Thesis 3

4 Section I 1.1 Introduction Recently, one of the largest pension funds of the Netherlands, PGGM, announced that it would screen its investments on the fulfillment of ethical standards 1. The fund wants to use its ownership right to enforce a proper firm policy. Ownership is defined by Grossman and Hart (1986) as the power to exercise control. The owner is someone who has (residual) control. The objective of this thesis is to review the concept of control in financial theory. Furthermore the role of convertible securities in control allocation is analyzed. While corporations are in majority financed with debt and equity, most ventures are financed with convertibles (Kaplan and Stromberg, 2003). In this thesis, a venture is defined as the entrepreneurial initiative that is the starting point of a corporation. In a firm where control is as explicitly and rationally allocated as is usual with venture capital financings, the use of convertibles is common. The aim of this thesis is to show how the control right is interwoven through financial literature. The thesis is organized as follows. Sections II, III and IV describe the literature about control in finance. Section V makes theory understandable through a model. Section II starts with theory about capital structure and introduces the strand of literature about control rights. This strand has developed in the context of security design and financial contracting. Control is not only allocated through capital structure but also through e.g. the firm s charter (Barca and Becht, 2001). In section III the theory of financial contracting is described. In a venture, firm charter and capital structure are determined simultaneously. Financial 1 'PGGM scherpt beleggingsbeleid aan', , NRC Handelsblad. Bachelor Thesis 4

5 contracting theory has developed hypothesis about how control is best organized. The literature about optimal venture contracts is reviewed in section IV. In section VI the venture capital model of Hellman (2006) is described more closely and the particular function of convertibles is analyzed. Section II Property rights and financial contracting 2.1 Theory of capital structure The theory of capital structure found its origin with the irrelevance theorem (Modigliani and Miller, 1953). According to this theory, when its investments policies are not affected by the way they are financed, the capital structure of a firm is irrelevant. The value of the firm is equal to the market value of the claims it issues. From this starting point new theories were developed. The assumption that investments and capital structure are independent was questioned first. The relation between investors and managers, which follows from the separation of ownership and control, was explored in a branch of literature called agency problems (Jensen and Meckling, 1976). Investors and managers do not always have the same goals. The managers must be given the right incentives to align their targets with the investors, the optimal solution provides both parties with the highest benefits. The biggest hurdle in this branch is the problem of information asymmetries. Informational asymmetries may prevent outsiders from hindering insider behavior that jeopardizes their investment. Incentive schemes in the form of a financial contract should solve this problem. The second branch of literature addresses both insiders and outsiders incentives by viewing the role of outsiders as much more active. The solution of the agency problem is not only searched for in a contract between agent and principle, agents can also be disciplined by the threat of external interference in management. Not only management must be given incentives to behave, Bachelor Thesis 5

6 claimholders must be given proper incentives as well. In contrast with the irrelevance theorem, the division of investors total return among the several classes of claimholders now has real implications and security design is no longer trivial. In first instance the theory developed around the incentives of outsiders to monitor the firm s management, the threat of interference would be a predefined action, e.g. to fire the management. A better description of this subject might be the study of financing in the presence of multiple insiders (Tirole, 2006). Later on the control-rights approach to corporate finance evolved. A firm that is constrained in its ability to secure financing must allocate (formal) control rights between insiders and outsiders (Grossman and Hart, 1986). The traditional boundary of the theory about capital structure, i.e. the separation of ownership and control, fades away in the games of financial contracting theory. 2.2 Control Rights A control right is the right to decide in a situation that is not pre-specified in a contract. For example the right to fire management or to decide which internal investment project to undertake. The control rights approach of capital structure is insightful for the design of securities. In a financial contract covenants are imperfect instruments in determining a firm s future course of action. Covenants can describe situations under which control rights transfer from one party to another. Control rights can have different appearances: they can be contingent, they can cover certain decisions but not others or they may be induced by another control right. 2.3 The property rights approach The property rights approach and the question of optimal capital structure has been brought together by Oliver Hart (1995) and Grossman and Hart (1986). Hart (2000) notes that incentive problems alone do not yield a satisfactory theory of financial structure. As the relationship between an entrepreneur (or manager) and investors develops over time, eventualities arise that could not Bachelor Thesis 6

7 easily have been foreseen or planned for in an initial deal between the parties. Economists use the term incomplete to refer to a contract that does not lay out all the future contingencies. The reappraisal of the control right in financial theory has developed in a broader context of theory about power, authority and the fundamentals of capitalism (Rajan and Zingales, 1998). It started with the observation that economic theory had explained the existence of the firm with several theories, e.g.. agency theories, transaction costs, but did not predict the boundary of real world firms. Where does the firm cease to be more efficient than the market? Compared to existing theories, the property rights approach to the firm (Hart, 1995), describes the firm as an incomplete contract that is not only incomplete due to high contracting costs, but also because future actions and events are non-verifiable or indescribable. 2.4 Contracts in the Firm A firm is often described as a nexus of contracts, while formally it is a legal fiction. (Jensen and Meckling, 1976) At the basis of the firm is the firm s charter. It defines the legal status and the limited liability of shareholders and management. All suppliers, customers and employees are associated to the firm through a contract. The suppliers of capital become associated through a security. A security can be seen as a financial contract between the firm and an investor/financial intermediary. A financial contract can be scaled in a continuum of completeness and standardization. A standardized contract is better tradable (more liquid) compared to a more specific contract, also the legal implications of provisions are better known in advance. The contracts completeness is a trade-off function between transaction cost of writing a more complete contract and the expected cost of future renegotiation of both parties. A less complete contract provides the contractors with discretion about future decisions. Bachelor Thesis 7

8 A key question that arises with respect to an incomplete contract is: how are future decisions taken? Given that an incomplete contract is silent about future eventualities, and given that important decisions must be taken in response to these eventualities, how will this be done? The financial literature takes the view that, although the contracting parties cannot specify what decisions should be made as a function of non-verifiable future contingencies, they can choose a decision-making process in advance (Tirole, 2006). One way they do this is through their choice of capital structure. Section III Financial contracting and venture capital 3.1 Venture Capital In small entrepreneurial firms, venture capital is used to finance their start-up, most often in high-tech industries. Venture capitalists specialize in highly risky projects. They fail to recoup their investments in many of the selected firms, but make very high profits on a few. The venture capital contract is an agreement between an entrepreneur and a venture capitalist (VC). The entrepreneur has an idea or specialist knowledge of some value which can make a project successful, but not enough wealth of his own to initiate the project. A potentially successful project is an opportunity with a positive net present value. Besides the venture capitalist, there are other ways of financing a start-up project. The VC contract is developed by VC funds which have specialized in designing and supporting such projects. They carefully structure deals, monitor the firm and bring expertise and industry contacts. The aim of this section is to make clear that the control right in business can best be studied in a venture capital context. Financial contracting and capital structure theory cross at the entrepreneurial stage in theory and practice. Bachelor Thesis 8

9 3.2 The theory of venture capital financing One branch of literature in financial contracting is about the contract that lies at the foundation of a start-up company. The financial contracting literature has tended to focus on small entrepreneurial firms, rather than a publicly traded company or corporation. (Hart, 2000) The distinguishing characteristic of these financings is that they allow to separately allocate cash flow rights, board rights, voting rights, liquidation rights and other control rights. (Kaplan and Stromberg, 2003) In a VC financing, the provisions of the VC contract are subject of negotiation. The conditions in which every party acquires or has to transfer rights to the other, are described in detail. The rights that are in corporations associated with the capital structure are subject of the bargaining as well. While in traditional literature about capital structure the ratio of debt and equity are of main concern, in the negotiation between VC and entrepreneur the design of the security is most important. This accounts for the literature about venture capital as well. The domains of security design and capital structure are unified in the venture capital literature. When entrepreneur and VC negotiate about the VC contract, they will derive the solution that is from their point of view most optimal. 3.3 Contents of a VC contract A venture capital contract is very much like a firm charter with an attached covenant about capital structure. However, it is much more specific, since it contains: - An outline of the various stages of financing. At each stage the firm is given just enough cash to reach the next stage. -The right for the VC to stop the funding unilaterally. - The right of the VC to fire management if some key investment objective is not met. Bachelor Thesis 9

10 - The right to control future financing. VC s have preemptive rights to participate in new financing. - The VC s ownership of, most common, preferred stock (often convertible into common stock), that is, a claim senior to the manager s claim in liquidation. A conversion feature defines a conversion price or a condition for automatic conversion. -An exit mechanism for the VC. The expectation is that at some stage, the firm will go public and will sell shares in an IPO or the start-up will be purchased by another firm. At this stage the VC will sell all or part of its share. A VC has initially many control (like board seats, voting right and liquidation right) and cash flow rights. Mostly contingent on verifiable measures of performance, e.g. EBIT or a patent grant. If these contingencies are met, the entrepreneur gains more rights as a reward. The input of a VC in a start-up, instead of other financial intermediaries, is common in practice. It is also a necessary input, this is demonstrated by Hellman and Puri (2006). The typical content (provisions, rights, restrictions) of a VC contract is described by Gompers (1997). Section IV Venture capital and optimal control right allocation 4.1 Financial contracting theories In the last two decades theories that analyze venture contracts have been published (Hellman, 2006, Smith, 2003). The theoretic models where developed after the publication of empiric researches about VC contracts (Sahlman, 1990, Gompers, 1997, Hellman and Puri, 2002, Kaplan and Stromberg, 2003). A long strain of theories followed, more general approaches where the contributions of Hart and Moore (1998) and Aghion and Bolton (1992). These articles are seminal contributions to contracting theory, the first analyzes the liquidation right, the latter analyzes the allocation of the control right in dynamics Bachelor Thesis 10

11 of incompleteness, both derive as a conclusion the optimality of debt and equity as separate parts of a capital structure. Aghion and Bolton furthermore argue that when contracts are incomplete, control rights are valuable. Because actions are observable, but not verifiable (i.e. cannot be enforced or proven in court), the result of agent s actions may not be contractible, in an agent-principle situation. According to Aghion and Bolton different control rights are as important as the difference in revenue-streams or tax-treatments. They prove that in situations of a certain optimal control allocation it is best to choose a corresponding capital structure. If external financing capacity increases (high profitability, less treat of conflicting interests), control moves from more investor control to more entrepreneur control (Kaplan and Stromberg, 2003). With decreasing external financing capacity there should be a capital structure that transfers control to investors only in bad states of the world. Their conclusion about optimal capital structure in relation to control allocation can be described as a pecking order, where entrepreneurial control is most preferable. Hart and Moore (1998) have analyzed the role of debt in persuading an entrepreneur to pay out cash flows, rather than to steal them. Investors would prefer to have debt because they can empower their claim with the liquidation right and they can secure a predefined fixed payment in case of non-verifiability. Debt or debt-like claims are therefore characterized as promising a fixed payment to the investor and giving the investor the right to take control of the project and liquidate assets if the payment is not made. The optimality of the contract is based on the incentive for the entrepreneur to reinvest project returns in profitable states. Schmidt (2003) examines a sequential investment problem where the entrepreneur completes her private investment before the investor makes his. The convertible, in the standardized form usual in corporations, provides an Bachelor Thesis 11

12 optimal incentive mechanism that ensures that the investor converts if and only if the entrepreneur invested efficiently. Schmidt focused on the problem of double moral hazard. This problem refers to the fact that there are two agents who can affect the value of the project. First, the entrepreneur s effort is needed. Second, also the outside advising or management support exerted by a specialized venture capitalist can contribute to the project value. Because these agents can either make private choices and not to exert a socially efficient level of effort, the problem of moral hazard is called double-sided. Berglöf (1994) mentions that in a venture capital arrangement the possibility to sell control is of importance. Conflicts can arise between venture capitalist and the entrepreneur with the possibility of a sale. In the good state about private benefits, in the bad state about firm value. On the one hand, the capital structure choice is, from the VC s perspective, a trade-off between having protection of dilution (debt) and, on the other hand, free riding by a buyer on potential value improvements (prevented by having equity). In general Berglöf describes two optimizing mechanisms, bankruptcy optimizes between insiders and a takeover optimizes between insiders and outsiders. Therefore debt and equity are complementary from the perspective of exit-decisions. However debt converting into non-voting equity is in this model optimal to extract as much value as possible from a potential acquirer. Hellman (2006) combines the models of Schmidt (2004), Berglöf (1991) and Aghion and Bolton (1992). Of all the previous models, Hellmann s is most advanced. It makes a distinction between two kinds of convertibles: simple convertible debt and participating convertible preferred. Convertible debt is a loan that is interchangeable upon request of the lender for shares. Convertible participating preferred is much the same, though it has the option of losing its debt-like claim, which will only be exercised (automatically) in case of an IPO. Based on this model, Hellmann makes predictions about which venture contracts are most common. The model will be more closely analyzed in section V. Bachelor Thesis 12

13 4.2 Empirical research to capital structure in VC financing Hellman and Puri (2002) question whether the association of a start-up with a venture capitalist, has an effect on management of the new company, beyond the role that traditional financial intermediaries have. The results prove that double moral hazard can be a relevant problem, because VC s influence management a lot. Whether a venture capitalist s effort is a condition to success, as the models assume, appeared not significant. In general, the companies in the sample that fail and go bankrupt are not systematically related to any way the VC can be involved in management s matters. The sample does not examine stock price or balance sheet data and therefore infers the state of the firm through reaching certain stages in the project. In the cases where a milestone such as IPO or product launch, was not reached, the VC was more likely to replace the founders by a professional CEO. This can be related to the presence of contingent control features in the VC contract. However, it is not explicitly clear whether the experience of a bad state gives VC s, either or both, the right or incentive to exercise control. Gompers (1997) analyzes a set of venture capital projects initiated by a Harvard University owned investment fund. His sample proves that convertibles are commonly used in VC s. In his sample of 50 projects actually all of them are financed with convertibles. An interesting analysis by Gompers is the venture s industry ratio of tangible assets to total assets compared to income targets. According to Grossman and Hart (1998) the VC will have more liquidation rights and less control rights if there are lot of tangible assets, and henceforth liquidation value is high. Some other aspects like the relative amount of VC capital requirement influence control and liquidation right allocation. However in Gomper s analysis income targets are higher when there are more tangible assets, which contradicts the theory about liquidation right allocation. Bachelor Thesis 13

14 Kaplan and Stromberg (2003) test the available models on a sample of venture capital contracts. In their sample straight debt, equity or standard convertibles are barely used, while 84% of capital structures are defined as custom-made convertible capital structures are (84%). The structures are not standard securities, the contingencies on which the conversion right is based is specific. VC and entrepreneur characteristics are compared to the security type (voting, liquidation and redemption rights, automatic conversion, anti-dilution provision, maturity, seniority, cumulative dividend rate), control and CF transfers, board composition, vesting and non-compete clauses. Consistent with Gompers (1997), convertible preferred stock is the most commonly used security. VC financings however (1) do not always use convertible preferred stock; and (2) frequently include securities in addition to convertible preferred stock. VCs use a variant of convertible preferred called participating preferred in 38% of the cases. Upon the liquidation or exit of a participating convertible preferred, investors receive both the principal amount of the preferred as they would in an investment of straight preferred and the common stock promised under the conversion terms. Securities in VC financings often include automatic conversion provisions in which the security held by the VCs automatically converts into common stock under certain conditions. These conditions relate almost exclusively to an initial public offering (IPO) and require a minimum common stock price, dollar amount of proceeds or market capitalization for the company. The effect of these provisions is to require the VCs to give up their superior control, voting, board and liquidation rights if the company attains a desired level of performance. Upon such performance, the VCs retain only those rights associated with their ownership of common stock. If the company does not deliver that performance, the VCs retain their superior control rights. This provides the entrepreneur an incentive to perform in addition to the monetary incentive. An automatic conversion provision is present in 95% of the financing rounds Bachelor Thesis 14

15 Kaplan and Stromberg conclude that VCs use convertible securities most frequently. VCs make frequent use of participating convertible preferred which is the equivalent of a position of preferred stock convertible into common stock. Rights are allocated such that if the company performs poorly, the VCs obtain full control. As company performance improves, the entrepreneur retains/obtains more cash flow rights and control rights. If the company performs very well, the VCs relinquish most of their control and liquidation rights. For VCs it is quite usual to include non-compete and vesting provisions to mitigate the potential hold-up problem between the entrepreneur and the investor. Finally, control rights, voting rights, cash flow rights, and future financings are frequently contingent on observable measures of financial and non-financial performance. These state contingent rights are more common in first VC and early stage financings. 4.3 International comparison Kaplan, Martel and Stromberg (2003) have researched the influence of legal differences on financial contracts. They have found that the most experienced VCs implement U.S. style contracts. And that projects with these style of contracts are most successful. Moreover, more experienced VCs outperform less experienced VCs. The most typical characteristic of U.S. style contracts is the use of convertible or participating preferred stock, 91 % of the companies in the sample that ceased to exist did not use convertibles. Of the ventures that consequently used preferred stock none failed. The authors interpret this result as follows. They refer to the conclusion of Kaplan and Stromberg (2003) that many elements of U.S. style contracts are consistent with the predictions of optimal contracting theories. Because U.S. venture capitalists were first to specialize in risky entrepreneurial projects, they have gained most experience and learned about optimal and effective contracts. Bachelor Thesis 15

16 Section V Control right allocation and convertible securities In this section the optimality of convertible securities is examined further. It will be explained why, according to theory, convertibles are so often used in ventures. For this purpose the most recent model in financial contracting theory (Hellmann, 2006) that captures the greatest amount of empirical data, is singled out. 5.1 A recent model of venture capital financing In Kaplan and Stromberg (2003) participating convertible preferred stock (CP) and convertible debt (CD) are viewed as being identical securities. CP has the right, as other preferreds, on a fixed dividend payment, as is the fact with CD. Also both securities have seniority over common stock in case of liquidation. The conversion option converts CD and CP in common stock. One should think intuitively that the conversion of a convertible itself changes control. However holders of CP usually have voting rights as if the security is already converted. Automatic conversion in common stock can be seen as a degradation, because the right to convert simply expires. The option is only exercised automatically in case of an IPO. The difference between of payout scheme of a capital structure of CD and CP can be compared in figure 2 and 3. The horizontal axis firm indicates firm value, the vertical axis is the firm state. If the realized state is below d, the owner of CD will liquidate the firm and sell assets. If the firm value above the point where ev crosses d, it will convert. Total firm value is indicated by the line v=v. The owner of CP receive a principle payment before dividends. If they convert they will receive only a dividend, furthermore there seniority right in case of liquidation expires, hence they will only convert if they are forced to. Bachelor Thesis 16

17 Figure 1 Pay-out scheme of participating convertible preferred equity (Hellmann, 2006) Figure 2 Pay-out scheme of simple convertible debt (Hellmann,2006) Figure 2 Pay-out scheme of simple convertible debt In the model the venture can choose two paths. Exit through selling the company, in this case entrepreneur and VC care only about their respective stakes in the acquisition sum. The second option is to remain autonomous by going public (IPO), in this case both parties need an incentive to invest additional effort. When there is a high need of external funding, which is quite common in venture projects, CP is the optimal solution. An acquisition is equally treated as liquidation, and the venture capitalist can exercise its senior claim to extract sufficient funds. Control with low financing need should be optimally allocated to the entrepreneur. But if the VC has to bring in a great part of capital, he will insist on a strong bargaining position when it comes to renegotiation of the contract. The optimal contract should therefore be contingent on reaching certain milestones, e.g. the grant of patent, reaching a level of sales or EBIT or the introduction of a newly developed product to the market. Bachelor Thesis 17

18 Table 1 (adapted, Hellmann (2006)) Financing need Optimal security Control allocation High CD or CP Contingent Intermediate CD or CP Entrepreneur or Contingent Low Pure equity Irrelevant The stages of this model are visualized in Figure 4. The initial contract allocates cash flow and control rights. The control right in the model and in the figure pertains to the exit decision. The double moral hazard problem appears when the parties have to invest effort (after date 1), they can be induced to invest effort optimally with a monetary incentive. The model simplifies from private benefits, which are the key in Berglöf s model. The result of the negotiation at date 1 depends on who is in control initially and on the expected of IPO and acquisition (I and A). Hellmann solves the security design problem by first deriving the optimal contract and then show how it can be implemented with standard securities. Table 1 shows the results. If financing need is high a contingent control allocation is optimal, this is done with the use of CD or CP. If financing need is low, the allocation of control does not matter, there is no optimality. Hellmann emphasizes that the optimal outcome cannot be replicated by a combination of debt and equity. A contingent control allocation can only be replicated with convertible securities. Bachelor Thesis 18

19 Figure 3 Timeline of the game in Hellmann (2006) 5.2 Predictions If, based on the rationale of the model, predictions can be made, it is possible to verify the model. A problem with financial evidence is that the model is based on the same observations for which it makes predictions. Because empirical evidence about venture capital financing is scarce, there will be a bias in the tested predictions. However, the model could be falsified if predictions and evidence do not fit at all. First I will present the predictions made by Hellmann in accordance with his model. Then some empirical evidence will be discussed. Berglöf (1994) predicts that control rights will be allocated as CD which can be converted in non-voting equity to the VC. This structure enables VCs and Bachelor Thesis 19

20 entrepreneurs to capture a maximum amount of rents in case that the venture will be sold to third-party buyers. Extending this model, Hellmann (2006) predicts that the conversion price is related to the abilities of the entrepreneur. Because of this, experienced entrepreneurs will be confronted with low conversion prices of the convertible held by the VC. Also entrepreneurs retain less equity when dealing with experienced VCs. As external financing need increases, leverage increases and therefore liquidation risk, this is called external risk. When external financing need is high, VCs will expect more downward protection. Downward protection can be explained as liquidation preferences, or seniority rights. On the other hand, when external financing need is low, entrepreneurs will retain more control rights and VCs have less downward protection. Apart from low amounts of leverage, external risk is low in time of an economic boom, and high in times of recession. Accordingly downward protection will be higher when the firm started in economic malaise and vice versa. Hellmann gives an explanation for the existence of convertible participating preferred which has a negative conversion value which automatically converts in case of an IPO. VCs prefer an acquisition to an IPO if they have control rights, therefore VC control will be positively related with exit through acquisition. 5.2 Validity The relation between the use of CD and CP with financing need is proven to be valid by Kaplan and Stromberg (2003). Automatic conversion at an IPO is indeed an often observed covenant. Most predictions by Hellmann hold, however the prediction that for the lower levels of external financing pure equity will be used is not supported by empirical evidence. The cyclical pattern in capital structures, associated with external risk, is consistent with empirical data. Downward protection was less in the boom period , but increased in the recession period Recently this protection level for VCs came down again. (Fenwick and West, 2003) Bachelor Thesis 20

21 5.3 Different definitions Convertible securities can be addressed from different perspectives, from the irrelevance perspective, or in the context of financial contracting. In financial contracting the definition of convertible is different compared to traditional capital structure literature. Instead of a hybrid security, it is modeled as a contingent control right, much like the liquidation right in corporations. In a VC contract the content of the convertible security is disassembled. Cash flow rights and control rights are separated. There seem to be a lot of differences between the convertibles that are used in corporations and the type of convertible securities used in VC financing. These differences can be attributed to the small impact on control allocation when a corporation issues convertibles. But the corporation is not immune for the control rights discussion. The analysis of control rights in VCs could be relevant for theory about corporations (Hart, 1995), because the consequences of double moral hazard can be observed in corporations as well. Is there an explanation for the different viewpoints? Control in corporations is dispersed, the theory about convertibles in corporations does only mention convertibles as part of a capital structure, not as a way to allocate control. In venture however, where ownership is centralized, control does really matter, and is hence applied in models. The simple notion, that the state of the object determines how it is analyzed in financial research, is maybe the most important insight in this review. Bachelor Thesis 21

22 Section VI Discussion: Method Most articles about financial contracting have a formal (mathematical) and an informal (verbal) part. There is no standard model which makes all theories and derivations comparable, hence there is a much disagreement about interpretation. Articles that refer to each other pick each different elements and summarize the findings of other authors unintelligible different. It is due to the lack of mathematical knowledge of the author of this thesis, that the one argument presented, could be simply a reformulation of another. To my judgment the underlying assumptions in each model are sometimes responsible for the different findings. Assumptions are often stronger than the results of the same model Discussion: Interdisciplinary relations Financial contracting is closely related to the domains of micro-economy and law. The same is true for theory about property rights. In a dissertation of Johan (2007) titled The law and economics of private equity financing: Empirical Essays written at Tilburg University, the legal aspects of venture capital are explored in an international context. One of the papers is about social responsible institutional investment in private equity. Also in a publication of Ayyagari, Demirgürg-Kunt and Maksimovic (2006) managers perception of property rights is analyzed in relation to the legal system the firm operates in. This recent interest in the influence of property rights and legal institutions on behavior in business could lead to new valuable knowledge. These insights could give a positive turn to the normative verdicts financial academics make about how investors and managers ought to behave. Bachelor Thesis 22

23 6.1.3 Discussion: Applied financial contracting What is the theory of financial contracting good for? The efficiency of the U.S. style VC contract has been elicited by it high success rate. But this is an achievement of statistical research. The modeling underpins this success, but it is questionable whether the mathematics does anymore than to illustrate a concept that was already known by practitioners. Although control is evidently allocated efficient in VCs, this is possibly not always the case in corporations. The VC theory cannot be applied to the corporation, because of the corporations complex nature. A more advanced model which allows for dynamic evolution and constant renegotiation could replicate the more complex reality (Kaplan and Stromberg, 2003) and eventually the path dependent development of large corporations. 6.2 Conclusion In this thesis I have explored the literature about convertibles in a context of control rights. I have found that since the introduction of the property-rights approach to the firm by Hart (1995) and Grossman and Hart (1986) and Berglöf (1991) a chain of literature has developed that focuses on control rights in ventures. Only in the last decade these theories have gained credibility through empirical research. The convertible proved to be an optimal security to allocate control, to solve information problems and give both parties in a venture deal optimal incentives. The generality of some of these arguments have been proven earlier, for instance by Green (1984) and Stein (1992). However some of the reasons to use convertibles seem to flow from the peculiarities of VC financing, i.e. the high risk and high external financing need. Other motives flow from the treat of double moral hazard. Bachelor Thesis 23

24 7. References Aghion, P., Bolton, P., An incomplete contracts approach to financial contracting. Review of Economic Studies 59, pp Ayyagari, M., Demirgürg-Kunt, A. and Maksimovic, V., Juli , How Well Do Institutional Theories Explain Firms Perceptions of Property Rights? RFS Advance Acces. Barca, F., Becht, M., 2001, The Control of Corporate Europe. Oxford University Press, Oxford. Berglöf, E., A control theory of venture capital finance. Journal of Law, Economics and Organization 10, pp Bolton, P., Dewatripont, M., 2005, Contract Theory. MIT Press, Cambridge Mass. Brennan, M.J., Schwartz, E.S., 1977, Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion. The Journal of Finance 32, pp Cornelli, F., Yosha, O., Stage financing and the role of convertible debt. Review of Economic Studies 70, pp Fenwick, West, L.L.P., 2003, Trends in Legal Terms in Venture Financing. Gompers, P., Ownership and control in entrepreneurial firms: an examination of convertible securities in venture capital. Mimeo, Harvard Business School. Green, R., Investment incentives, debt and warrants. Journal of Financial Economics 13, pp Grossman, S.J., Hart, O.D., 1986, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration. The Journal of Political Economy 94, pp Jensen, M.C, Meckling, W.H., 1976, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3, pp Hart, O., 1995, Firms Contract and Financial Structure. Claredon Press, Oxford. Bachelor Thesis 24

25 Hart, O., October 2000, Financial Contracting. Working paper, Harvard University. Hart, O., Moore, J., Default and renegotiation: a dynamic model of debt. Quarterly Journal of Economics 113, pp Hellmann, T., 2006, IPOs, Acquistions and the use of convertible securities in venture capital. Journal of Financial Economics 81, pp Hellmann, T., Puri, M., 2002, Venture capital and the professionalization of startup firms: empirical evidence. Journal of Finance 57, pp Johan, S.A.B., 2007, The Law and Economic of Private Equity Financing: Empirical Essays. Tilburg University. Kaplan, S., Martel, F., Stromberg, P., Nov. 2003, How do legal differences and learning affect financial contracts? Working Paper 10097, National Bureau of Economic Research. Kaplan, S., Strömberg, P., 2003, Financial contracting meets the real world: an empirical study of venture capital contracts. Review of Economic Studies 70, pp Loncarski, I., Horst, J.,Veld, C., 2006, Why do companies issue convertible bonds? A review of theory and emperical evidence. Advances in Corporate Finance and Asset Pricing, ed. L.D.R. Renneboog, Elsevier, Amsterdam. Moore, J., Repullo, R., Subgame perfect implementation. Econometrica 56, pp Noddings, T.C., Christoph, S.C., Noddings, J.G., 2001, The international Handbook of Convertible Securities, 2 nd edition. The Glenlake Publ. Comp., Chicago. Rajan, R.G., Zingales, L., 1998, Power in a Theory of the Firm. The Quarterly Journal of Economics 113, pp Repullo, R., Suarez, J., Venture capital fiance: a security design approach. Review of Finance 8, pp Sahlman, W., The structure and governance of venture capital organizations. Journal of Financial Economics 27, pp Bachelor Thesis 25

26 Schmidt, K., Convertible securities and venture capital finance. Journal of Finance 58, pp Stein, J., Convertible bonds as backdoor equity financing. Journal of Financial Economics 32, pp Tirole, J., 2006, The Theory of Corporate Finance. Princeton University Press, Princeton. Bachelor Thesis 26