The workhorse legal contract used in America is the convertible preferred stock contract. "Research," notes Cumming, "indicating the role of U.S. tax law in biasing the selected security in the U.S. towards convertible preferred equity for U.S. entrepreneurial firms (Gilson and Schizer, 2001), but not in other jurisdictions such as Canada (Sandler, 2001)."

The convertible preferred stock agreements contain the legal power and authority of the VC to obtain the desired exit. As Cumming explains, "Convertible preferred equity contracts typically also involve the right of first refusal in sale, as well as demand registration rights and piggyback registration rights. Consistent with Berglöf (1994), this indicates that convertible preferred equity mitigates trilateral bargaining problems associated with the sale of the firm and the particular associated contractual terms to mitigate this trilateral bargaining problem are complements with the selected security."

When Cumming uses the term "mitigates bargaining problems" it means that the VCs have control over selling the venture, and do not generally need to concern themselves with the financial problems of one of the three (trilateral) parties to the exit negotiation process. That legal control over the entrepreneur was obtained by the VCs at the beginning of the investment process through use of the "optimal" legal contact.

Cumming cites the extensive research on the use of these securities and their "optimality" in securing the efficient exit desired by the VC to support his own research. "Theoretical research on the optimality of convertible preferred equity in ensuring an efficient exit (Berglöf, 1994; Black and Gilson, 1998; Bascha and Walz, 2001; Hellmann, 2001; Smith, 2001; Schweinbacher, 2001).

Beyond the issues of target rates of return, the use of convertible preferred securities in any investment made by VCs is a signpost to the most interesting types of innovation that causes the most beneficial economic growth.

As Cummings notes, "If U.S. tax law colors the selected form of finance for venture-backed firms in the U.S., then it is important to test financial contracting theories using data from entrepreneurial firms in countries other than the U.S. for at least three reasons:

• Convertible preferred equity is more likely to be used with seed and early stage investments,
• and with firms in the Internet/communications sectors.
• Common equity is used more often for expansion stage investments and firms in the medical/biotech industries."

Following the venture capitalist roadmap of legal contracts means that the use of the convertible preferred is generally pointing the way to the most risky, innovative technology ventures. Those types of risky ventures are most likely the ones employing radical technological cross over between two seemingly unrelated technologies.

Those types of ventures create the greatest economic development benefit for regional metro economies, and that is what the use of the VC contracts are telling you when you see their legal contract signpost.

The VC Dr. Kervorkian Effect and Investment Opportunities In The Sub-Optimal VC Harvest

The first part of the VC road map to follow in searching for regional innovation investment opportunities is to watch what legal contracts are being used at the top of the deal creation pipeline. As a general rule, convertible preferred contracts used by the VCs are pointing the way to risky innovation investment opportunities in startups and in information technology sectors that generate the most beneficial economic growth.

The use of common equity and convertible debt contracts generally indicates a sustaining innovation in an existing product and in an existing operational company, not a risky new venture. Generally, the investments are made in existing products and in the medical technology sectors. While sustaining innovation generates regional economic benefits, the benefits in terms of creating new markets and future regional wealth are not as substantial as radical technology innovation.

The second signpost to watch in VC contracts is for the crumbs that fall off the convertible preferred plates when the VCs are feeding on new ventures. Some innovation economists use the term "spill-overs" to describe how technology evolves, (see Griliches and Mairesse 1984; Mairesse and Sassenou 1991), and this new use of the term spill-overs can be adapted to describe investment opportunities foregone by the VCs, not because the technology was bad, or the commercial applicability was bad, but because the investment did not meet the initial exacting standards of profit, (300%), arbitrarily set by the VC.

Cumming’s results covered thirty-three actual exits and 38 expected exits. His data included:

• 10 actual IPOs;
• 13 actual acquisitions;
• 10 actual write-offs;
• 12 expected IPOs;
• 25 expected acquisitions;
• and 1 expected write-down of the book value of an investment (which is analogous to a partial writeoff ; (see Cumming and MacIntosh, 2002).

In other words, of the 33 actual, real-life exits he examined, 10 of them were total write-offs, indicating a very fertile ground to till in looking for regional investment opportunities that were initially thought valuable by the VC.

The potential universe of ventures to watch for on the Dr. Kervorkian death list is not very big to begin with. Cumming notes that, "Most venture capital funds are not well diversified (the funds in this sample had between 2 and 20 investments in their portfolios)."

The funds tend to specialize in industrial sectors and technology, based upon the academic and professional experience of the VC firms.

So, watching for convertible preferreds used by VCs generally leads to a small pool of risky innovation investments, 33% of which may end up in an assisted suicide when the VC abandons ship. Presumably, after 6 months of initial due diligence before making the investment, the VC must have seen potential profit in the exit of around 300%.

The VCs apply the Dr. Kervorkian effect, generally with 24 months of making the initial investment, at the first moment when the venture does not appear to meet the required rate of profit, not because there was no profit potential.