Introduction: The Venture Capitalist Contract As A Signpost
Pointing The Way
Douglas Cumming, a professor of economics in Canada, has been
investigating the world of venture capital in both Europe and the U. S. for many
years. He has documented many differences in behavior between European and
American venture capitalists.
These differences have obvious public policy implications for both
economies if the goal of innovation economics is economic growth, and not simply
the financial rewards obtained by the VCs. Part of the differences Cumming has
documented are due to the U. S. tax code, which favors the use of convertible
preferred securities.
As he noted, "While venture capitalists in the United States
almost always use convertible preferred equity to finance entrepreneurial firms,
venture capitalists in every other country (at least those where data are
available) use a variety of forms of finance. In the European venture capital
data herein, we observe common equity used most frequently, but there are a wide
variety of securities used in venture capital transactions." (Douglas J.
Cumming, Contracts and Exits In Venture Capital Finance, April 2002).
The U. S. tax code is designed to provide tax benefits for venture
capitalists, but is not primarily designed to promote broad social benefits of
economic growth, which results from technology innovation. The tax code tends to
subsidize the "home run" risk mentality of venture capitalists’ which
subsequently increases the VC Dr. Kervorkian effect of writing off new ventures
that have potentially valuable innovation.
If the U.S. tax code is skewed in the wrong direction to promote
innovation, then the U. S. rate of technological innovation that results from
venture capital investments will be lower than Europe’s rate of innovation. The
economic result will be a national economic erosion of America’s last best
comparative economic advantage in the global economy.
In other words, when Cumming uses the term "optimal" in his
research reports, it could be argued that what is financially optimal for
taxation of the American VCs is not exactly the same thing as what is
economically optimal from a regional economic development perspective.
However, watching what types of contracts the VCs are using
provides hints as to making innovation investments that are aimed at promoting
regional economic development. Certain types of legal contracts imply certain
types investments in new ventures and point towards the intended exits by the
VCs. The use of the convertible preferred, for example, indicates an investment
in risky technological innovation that would tend to have very high economic
benefits, when it is commercialized successfully.
In one of his earlier investigations, Cumming explained how both
European and American venture capitalists used different types of legal
contracts for investing in different types of firms. His typology of contracts
is based on the desired type of exit from the VC investment and it can easily be
extended to how different types of VC contracts promote different types of
technological innovation.
Just as there is a limited set of exits from an investment for
venture capitalists at the end of the pipeline, there are very limited sets of
innovation investment categories at the top of the pipeline. Cumming’s typology
would accommodate this limited set of both exits at the end, and investments at
the beginning of the innovation investment pipeline.
To simplify matters, and not put too fine an academic veneer on
the topic, (Predicting Technology, 2007)
the types of innovation at the top of the pipeline could be broken down into two
broad classifications:
- Sustaining technological innovation in existing products.
- Radical technological innovation in "new-to-the-world" products.
Each type of technological innovation creates different economic
growth benefits, and each type of innovation has a customary and usual legal
contract associated with the investment opportunity.
What The VC Legal Contracts Tell Us About Regional Innovation
Investment Opportunities
In his 2002 research, Cumming investigated VC contracts and exits
from a sample of 179 investment rounds in 132 entrepreneurial firms by 17
European venture capital (VC) funds. He concluded that "the data indicate the
financial contracts are quite heterogeneous in terms of both the cash flow and
control rights. The use of different securities by European VC funds does not
depend on the definition of venture capital, and the securities used are not
functional equivalents."
Within the mileux of potential legal contracts to choose from at
the beginning of the due diligence process, the venture capitalist keeps her eye
on the desired type of exit. The desired exit strategy is set by the venture
capital screening criteria that sets a target rate of return for the potential
investment. If the potential investment does not possess the imaginary target
rate of return potential, the opportunity is rejected by the venture
capitalist.
Cumming notes in his research, "It is widely recognized that a
venture capitalist’s decision to invest in an entrepreneurial firm is based on
exit potential. While previous research in venture capital has identified
international differences in financial contracts and international differences
in exit strategies, the precise interaction between these two activities has not
been empirically studied."
"The returns to venture capital," notes Cumming, "are multimodal."
(MacIntosh, 1997; 1999; Cumming and MacIntosh, 1999, 2002; Smith and Smith,
2000; Cochrane, 2001):
- there is a high percentage (typically around 25% of all investments) of
write-offs (-100% return),
- many investments generate a "good" annualized return of between 25-100%,
- and the lions-share of venture capital profits comes from a few very
successful "home run" investments with returns of more than 500%."
In the very rare case, (generally less than 3 in 10), that the VC
makes an investment, the target rate of return at the beginning is matched to a
type of exit strategy, which is then matched to a legal contract. Generally, the
required annualized target rate of return for VC screening criteria is about
300%.
