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Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

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  • Giacinta Cestone

Abstract

This article develops a theory of the joint allocation of control and cash-flow rights in venture capital (VC) deals. When the need for VC advice and support calls for a high-powered outside claim, the entrepreneur should optimally retain control in order to avoid undue interference. Hence, I predict that more high-powered claims should be associated with fewer control rights. This challenges the idea that control should always be attached to equity-like claims and is in line with contractual terms used in venture capital, corporate venturing, and partnerships between biotech start-ups and large corporations. The article also rationalizes evidence that venture capital contracts include contingencies triggering both a reduction in VC control and the automatic conversion of VC’s preferred stock into common.

Suggested Citation

  • Giacinta Cestone, 2014. "Venture Capital Meets Contract Theory: Risky Claims or Formal Control?," Review of Finance, European Finance Association, vol. 18(3), pages 1097-1137.
    • Handle: RePEc:oup:revfin:v:18:y:2014:i:3:p:1097-1137.
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    File URL: http://hdl.handle.net/10.1093/rof/rft021
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    Cited by:

    1. Dessi, Roberta & Yin, Nina, 2015. "Venture Capital and Knowledge Transfer," TSE Working Papers 15-555, Toulouse School of Economics (TSE).
    2. Suting Hong & Konstantinos Serfes & Veikko Thiele, 2020. "Competition in the venture capital market and the success of startup companies: Theory and evidence," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 29(4), pages 741-791, October.
    3. Ewens, Michael & Gorbenko, Alexander & Korteweg, Arthur, 2022. "Venture capital contracts," Journal of Financial Economics, Elsevier, vol. 143(1), pages 131-158.
    4. Wang, Lei & Zhou, Fangzhao & An, Yunbi, 2017. "Determinants of control structure choice between entrepreneurs and investors in venture capital-backed startups," Economic Modelling, Elsevier, vol. 63(C), pages 215-225.
    5. Catherine Casamatta & Carole Haritchabalet, 2014. "Dealing with Venture Capitalists: Shopping Around or Exclusive Negotiation," Review of Finance, European Finance Association, vol. 18(5), pages 1743-1773.
    6. Andrieu, Guillaume & Groh, Alexander Peter, 2018. "Specialist versus generalist investors: Trading off support quality, investment horizon and control rights," European Economic Review, Elsevier, vol. 101(C), pages 459-478.
    7. Thomas W. Archibald & Edgar Possani, 2021. "Investment and operational decisions for start-up companies: a game theory and Markov decision process approach," Annals of Operations Research, Springer, vol. 299(1), pages 317-330, April.
    8. Chang, Shih-Chung & Wang, Frank Yong, 2024. "Two-sided asymmetric information and convertible securities in venture financing," Economics Letters, Elsevier, vol. 237(C).
    9. S. Ramakrishna Velamuri & Wilson Liu, 2017. "Ownership structure, insider behavior, and IPO performance of SMEs in China," Small Business Economics, Springer, vol. 48(3), pages 771-793, March.

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