Aspects of Financial Contracting in Venture Capital

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ASPECTS OF FINANCIAL by William A. Sahlman,
CONTRACTING IN Harvard Business School
During much of the 1960s and 1970s, academic discussions of corporate capital structure routinely began with the assumption that a firm’s financing decisions had no material effect on its intrinsic economic value. Setting aside tax consequences and the possibility of a costly bankruptcy, the value of the firm was assumed to depend solely on the level and risk of a firm’s operating cash flows. And operating profitability in turn was assumed to depend entirely on corporate investment decisions that are made prior to, and completely independently of, financing choices.1 In the last ten years or so, however, finance scholarship has progressively reversed this assumption while entertaining the possibility that the way a transaction is financed can influence operating outcomes in predictable, systematic ways2 And the results of this new thinking–especially the contribution of the “agency cost” literature to our understanding of the current wave of financial restructurings – have been interesting.3

Further support for this relatively new direction in finance may also come from an area of study beyond the usual academic focus on public corporations: namely, the venture capital markets. For, the interaction of entrepreneur and venture capitalist has resulted in the evolution of a unique set of financial contracts. And in no other kind of transaction does the implied link between value and financial structure appear so strong and direct as in the typical venture capital deal. As I hope to show in this article, an effective financial design may well be the difference between a flourishing and a failed (if not a still-born) enterprise. 1. The original formulation of the capital structure “irrelevance” argument was by Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 53 (June 1958). 2. The first major theoretical departure from the capital structure “irrelevance” argument came with the formulation of the “agency cost theory” by Michael C. Jensen and William Meckling, “Theory of the Firm: Mangerial Behavior, Agency Costs and Capital Structure,” Journal of Financial Economics, 3 (October 1976). 3. I am thinking, especially, of Michael Jensen’s article, “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review (May 1986). For an extended elaboration of Jensen’s arguments, see also Vol. 1 No. 1 of this journal. 23

As is true of all financial transactions, structuring
a venture capital deal involves the allocation of economic
value. Value, in turn, is determined by the interaction
of three major ingredients: cash, risk, and time.
My colleague Bill Fruhan argues that all financial
transactions can be classified into three categories:
those that create value, those that destroy value,
and those that transfer value between two or more
parties. 4 This taxonomy can be readily transferred to
venture capital because almost all venture capital
deals either create, destroy, or transfer value. For example, a sound deal that provides appropriate incentives
for an entrepreneur is likely to result in
significantly higher value to be shared by entrepreneur
and venture capitalist alike. The same deal,
while increasing total value, may also have opposite
effects on the value of two different claims on total
value (for example, debt and equity), thus providing
an example of a value transfer. Finally, a promising
deal that is not well-designed can result in a failed
venture, the extreme case of value destruction.
A Simple Example
Before turning to the case of venture capital,
let’s begin by considering a very simple project with
the following characteristics:
Investment Required at Time 0............................$1000 Annual Cash...
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