New directions in research on venture capital finance - Venture Capital Special Issue

Financial Management (Financial Management Association), Autumn, 1994 by Christopher B. Barry

Other recent papers have also addressed the contracting problem. Admati and Pfleiderer (1994) focus on the investment and continuation decisions when capital is provided in stages. They identify the overinvestment problem--the problem that an entrepreneur who can attract outside funds may continue to invest in the project even when it is no longer valuable based on the entrepreneur's inside information. Even if the information would show that a project has a negative net present value, as long as it has some probability of being successful, the entrepreneur's option-like position suggests he or she will continue as long as others will provide the financing. In principle, an external investor, such as a venture capitalist, can enter the picture, invest, monitor, and become equally informed. However, having become an insider, the venture capitalist may suffer the same problem as the entrepreneur: Having invested and having learned that a project is not favorable, but has a probability of success, the venture capitalist may have an incentive to attract new outside funds as well.(5)

Thus, neither entrepreneurs nor venture capitalists can be assumed to provide unbiased views concerning the prospects of the investment. How can the issue be resolved? Admati and Pfleiderer demonstrate that a contract in which venture capitalists continue to maintain the same fraction of equity in subsequent financing rounds as they had in the earlier round will resolve the conflict. This solution neutralizes the venture capitalists' incentive to mislead. Admati and Pfleiderer also show that their contract is robust in the sense that minor changes in the set of possible outcomes will not render the contract sub-optimal.

Lerner (1994b), in a companion paper in this issue of Financial Management, provides empirical evidence in support of the Admati and Pfleiderer model. Lerner studied 651 rounds of financing for 271 biotechnology ventures. His study focused on the process of syndication. He demonstrates that the ownership stake of venture capitalists frequently stays constant in later rounds of venture capital financing.

The most common form of venture capital investment is convertible preferred stock. The preferred stock gives the venture capitalist a superior claim to cash flow and to distributions in liquidation in the event that the venture is unsuccessful. The conversion feature provides participation on the upside. The conversion price is commonly a function of performance, so that if a venture is unsuccessful, the venture capitalist stands a better chance of recovering the investment. At the same time, the increased conversion price following good performance increases the incentives to the entrepreneur.

Gompers (1993a) and Marx (1993) develop theoretical models of venture capital contracting that explain the use of convertible preferred stock. Marx shows that convertible preferred dominates pure equity and debt investments. Gompers shows that convertible preferred can overcome adverse selection and prevent excessive risk taking by entrepreneurs.