Reposting my favorite practical essay I have written and sharing an update on my series on European Tech
|Max Cutler||Jun 13|
Hello to you all. As you may or may not have noticed, I have not held my promise of publishing my Trans-Europe Express series weekly until complete. I initially decided to give myself an extra week because I wanted the upcoming third section on culture to be the best one, but then an entire afternoon’s work of bringing the piece from 80% to 99% publishable was lost. And, frankly, I was too busy enjoying New York to look at it again. In fairness as well, I was living a rather itinerant life which makes writing on the side challenging.
Anyyyways, I am now back in Berlin after six weeks in the US and feel inclined to focus yet again on my series. I am setting my strict deadline for two weeks from now, or the 27th of June. Hope to see you again before that.
Now, on to the piece appearing in this installment of Above the Loud. After giving Mattias Ljungman of Moonfire some trouble by challenging yet another non-incisive observation that a lot of money is being invested in Europe currently, I re-read Mr. Alex Danco’s stellar essay from February 2020 where he posits that tech company financing events do not encompass true ‘valuations’ per say, but, rather, more typically a fast-growing firm’s ‘valuation’ represents a signal towards a future promise. In practice, he means to say that tech companies can keep raising money at higher valuations, as long as there is a common belief that there will be a future round that offers a mark up on current pricing.
I have always greatly admired Alex’s thinking, especially when he synthesizes organizational theory and startup finance, but, it turns out, I initially found a rather novel synthesis myself as a young undergraduate, before knowing about Danco.
The following piece is far more academic than any writing I have posted on here. But that is also a virtue, as it is, without doubt, the most structured piece I have ever authored.
To provide a brief synopsis: After a brief literature review, I develop a novel synthesis that contends that the traditional understanding of a VC transaction, which holds that the firm sells equity (or shares) in exchange for cash that can be used to rapidly grow the business, is not comprehensive. Rather, the fundraising event represents the sale of shares to an investor in return for the fund’s reputational capital. The argument here is based on contracting theory, in the sense that the privileges, rights, and obligations of the transacting parties are efficiently aligned using the framework of reputational capital, especially, as I note, when both parties are focused on maximizing the possibility of an IPO-exit.
I’ll let the piece do the talking. I am still proud of this one. This brought my grade up from a C to an A- lol. Hope you enjoy!
The Impact of Reputational Capital on the Flow of Control Rights between Entrepreneurs and Venture Capitalists
This was originally written as a term paper for PPE 471, an Organizational Economics Capstone course given at the University of Pennsylvania in Spring 2019 by Giuseppe Danese. Updated on May 15, 2019.
Reputation in venture capital financings is of upmost importance. Names like Sequoia Capital, Kleiner Perkins (in the past), and Andreesen Horowitz project immensely strong signals about the viability of companies they invest in. Their reputation is, naturally, contracted out when VCs issue term sheets to early-stage firms. Writing contracts tailored to the types of contingencies high-risk startups face is a difficult task. What is commonly understood in most VC financings is that the company receives a certain sum of money at a certain valuation from the investment fund and in return agrees to sell a certain portion of the firm at a certain price to the venture capitalist. Alas, it is far more complicated than this.
The first section proceeds as follows: I begin by reviewing the literature written on venture capital contracting theories. I acknowledge that financial contracts are inherently incomplete (Aghion and Bolton 1992) and that the ability to make decisions in situations where contracts do not specify what to do is determined by the holder of control rights (Kaplan and Strömberg 2002). I then mention the various contingencies and control mechanisms used by VCs to guide decision making in non-contractable scenarios (Gompers 1995). I move on to discuss the monitoring incentives in these contracts and how particular circumstances affect the intensity of monitoring (Gompers 1995 and Black and Gilson 1997). I briefly mention how VCs can adjust their contracts depending on the states of their prospective portfolio companies (Sonius et al. 2017). Next, I outline the importance of reputational capital in VC financings, paying particularly close attention to how reputation enhances an early-stage firm’s credibility with third parties (Black and Gilson 1997). I describe a parallel situation in which the VC must also utilize its reputation to gain credibility in its own dealings with third parties (Black and Gilson 1997). I contend that the staging of financings allows VCs to withhold not just financial capital, but reputational as well (Black and Gilson 1997). I end the section by discussing how the value of reputational assistance decreases over the lifespan of the portfolio company and how, in order for the venture capitalist to more efficiently allocate reputational capital, the VC firm must initiate exit opportunities for their portfolio firms so they can recycle both financial and nonfinancial capital back into a new set of early-stage ventures (Black and Gilson 1997).
In the second section of this paper, I introduce David Kreps’ trust game from his important work on corporate culture in order to build a novel framework around the importance of reputation in the allocation of control rights between VCs and entrepreneurs. I contend that entrepreneurs accept venture capital to establish a reputation. I then address potential occasions for opportunism in these arrangements, noting that a contract based on the exchange of reputational capital for control rights works well at mitigating these circumstances. I then move towards defining a principle on which contractual relations between VCs and founders can be built upon. I note that by agreeing to make decisions based on maximizing the viability of an exit through an IPO, entrepreneurs and investors satisfy the requirements for successful contracting outlined by Kreps and others. Finally, I end by outlining how such a principle-based contracting approach allows VCs to tweak the allocation of certain control rights to correct incentive asymmetries arising from different development states in a startup’s lifecycle.
It is my hope that with this work I can address the question of how reputation affects the flow of control rights between entrepreneurs and venture capitalists by conceptualizing of financings as the acquisition of reputational capital for control rights which leads to the most efficient and useful outcomes for all stakeholders.
Financial contracts are inherently incomplete (Aghion and Bolton 1992). Contracts between venture capitalists and entrepreneurs are no exception to this rule. The ability to implement future decisions in situations not provided for in the contract — unforeseen contingencies — is determined by which party holds control rights in a given state (Kaplan and Strömberg 2002). Contingent control is one of two forms of allocation; the other is unilateral, in which the entrepreneur or investor is the sole owner (Aghion and Bolton 1992). Venture capitalists write contracts in which control rights are contingent on financial performance, nonfinancial performance, and other observable actions (Kaplan and Strömberg 2002). Gompers notes three common control mechanisms VCs use in contracts with startup founders: the use of convertible securities, syndication, and the investment of financial capital in stages (1995). The staging of capital infusions is the most potent control mechanism because it allows VCs to gather information and monitor at multiple stages (Gompers 1995). Further, the need for additional funds gives the entrepreneur a performance incentive in the form of a hard constraint (Black and Gilson 1997). For the VC, the ability to withhold continuation funding provides a monitoring incentive and reduces agency costs between the founder and the venture capitalist (Black and Gilson 1997). The right to withhold funding is given to the VC as a response to adverse selection in early-stage financing, where information asymmetry is greatest (Gompers 1995). This asymmetry arises from the minimal information venture capitalists have about the future success of portfolio companies. VCs weigh potential agency and monitoring costs when determining how frequently they should reevaluate projects and supply capital (Gompers 1995). The duration of a particular round of financing (i.e. the period between Series A and Series B), the size of each investment, the total financing provided, and quantity of rounds are metrics for determining the intensity of VC monitoring of portfolio firms (Gompers 1995). The intensity of monitoring should be negatively related to expected agency costs (Gompers 1995). Agency costs increase as the tangibility of assets declines, the share of growth options in firm value rises, and asset specificity grows (Gompers 1995).
Sonius et al. argue that control rights in VC contracts are determined by the degree of bargaining power and the development state of startups (2017). The venture capitalist adjusts contract design for varying stages of development (Sonius et al. 2017). In addition, capital availability also impacts relative bargaining and contracting power (Sonius et al. 2017). Startups can be classified into four types based on their development state and relative bargaining power in their lifecycle. These types are seedling, for a firm with a low development state and low bargaining power, beacon of hope, for a firm with a low development state and high bargaining power, turtle, for a firm with a high state of development but low bargaining power, and finally, skyscraper, a startup with high states of development and bargaining power (Sonius et al. 2017). These types are adjusted for in contracts with VCs, in which liquidation preference, board rights, vesting clauses, and anti-dilution protection are tweaked according to type (Sonius et al. 2017). As one would expect, skyscraper and beacon of hope firms retain more control rights than turtle and seedling firms (Sonius et al. 2017). This is consistent with Kaplan and Strömberg, who argue that in bad states, VCs are allocated more control rights, and then, as performance improves, the entrepreneur obtains more control rights, although the VC does retain rights to cash flow throughout (2002).
Venture capitalists provide more than just financial capital to entrepreneurs (Black and Gilson 1997). They provide management assistance, mostly by utilizing their networks to help portfolio companies hire talented personnel (Black and Gilson 1997). As discussed earlier, VCs provide intensive monitoring and control, derived from equity ownership and voting rights allocated with convertible preferred stock (Black and Gilson 1997). Black and Gilson argue that VCs are given disproportionate board representation — often an absolute majority — relative to overall voting power (1997). This is contradicted by Kaplan and Strömberg, who find that VCs have majorities on startup boards only 25% of the time, in contrast to outsiders, who are mutually agreed upon by both founder and venture capitalist, who tend to hold majorities on 65% of company boards (2002). However, both papers do concur that VCs hold a significantly higher fraction of votes to cash flow rights compared to the founder (meaning closer to a 1:1 ratio) (Black and Gilson 1997 & Kaplan and Strömberg 2002). Board control allows the VC to remove the entrepreneur as CEO in bad states (Black and Gilson 1997).
Most relevant to this paper is the third type of nonfinancial assistance that Black and Gilson outline, reputational capital. The venture capitalist acts as a reputational intermediary between the firm and the market (Black and Gilson 1997). VC financing enhances a portfolio company’s credibility with third parties. That is: talented managers are more likely to join a firm backed by a respected VC because VC participation provides a credible signal of success, suppliers are more likely to commit capacity and extend trade credit, and customers will take the portfolio company more seriously when the venture capitalist vouches for and monitors it (Black and Gilson 1997). VC reputation is also important in securing a reputable investment bank to underwrite IPOs for portfolio firms (Black and Gilson 1997), which will be important to remember later in this paper. The signal of reputation to third parties is credible because a VC fund is a player in a repeated game and, as it were, must put their money where their mouth is (Black and Gilson 1997). The reputation of the VC fund is also crucial for its dealings with its investors in existing and future limited partnerships, with other VCs in syndicate investments, and in negotiating terms with prospective portfolio companies (Black and Gilson 1997). Adding to the contribution of Gompers, who revealed that the staged investment of financial capital is a common control mechanism used by VCs (1995), Black and Gilson contend that commitments of reputational capital can be staged too (1997). The venture capitalist can withhold management assistance and reputational capital, which reinforces its own incentive and power to monitor (Black and Gilson 1997). The venture capitalist’s role as a reputational intermediary shares an economy of scope with the provision of financial capital (Black and Gilson 1997). Potential employees, suppliers, and customers must evaluate the credibility of the VC’s explicit and implicit reputational commitments to its portfolio companies (Black and Gilson 1997). The combination of financial and nonfinancial contributions enhances the credibility of information provided by venture capitalists to third parties while simultaneously binding the VC to its promise to its portfolio firms of being a reputational intermediary (Black and Gilson 1997). This combination also allows LPs to evaluate the VC’s reputational contribution by measuring its return on overall investment (Black and Gilson 1997).
Reputation, monitoring, and management assistance are especially valuable to early-stage firms (Black and Gilson 1997). As a portfolio company’s management proves itself and establishes its own reputation, the relative value of the venture capitalist’s contribution declines (Black and Gilson 1997). Thus, by the time a portfolio company succeeds, the VC’s nonfinancial capital is best allocated in a new round of early-stage ventures (Black and Gilson 1997). However, due to the economy of scope discussed earlier which bonds financial and nonfinancial contributions, the venture capitalist must also exit from its investment in the firm, in order to recycle its financial capital (as well as its service as a reputational intermediary) from successful portfolio firms to its next batch of early-stage ventures, in which its nonfinancial contributions can be allocated with far greater efficiency and impact (Black and Gilson 1997).
Synthesis and New Ideas
Using the framework of David Kreps’ trust game, the importance of reputation on the flow of control rights between entrepreneurs and venture capitalists can be examined in a novel light.
Ronald Coase (pictured) was a huge influence on David Kreps. Where Coase initially said that a firm stops expanding when internal transaction costs equal market transaction costs, Kreps, in the paper cited, pushes the idea that a firm stops expanding once it is unable to enforce its cultural principles effectively across an org and must instead rely on market best practices.
Let us assign label “A” to the firm seeking financing and label “B” to the VC. In other words, the startup is the agent and the venture capitalist the principal. A firm enters into a hierarchical contract because they do not expect to be abused and seek to make gains impossible without coordination (Kreps 1984). The weak party — or perhaps better stated as the party with a weaker reputation — accepts authority because of the presence of the principal’s reputation (Kreps 1984). Kreps identifies the problem of entity “A” as needing many rounds and vast information in order to establish a reputation (1984). A shortcut to a solution is identified as purchasing access in another organization, in which reputation is given in exchange for some type of asset (Kreps 1984). Using the framework of Black and Gilson, we can understand this transaction in the context of venture capital financing as the exchange of control and cash flow rights, which are given to the VC, in exchange for the fund’s financial and nonfinancial capital, namely its reputational capital (1997). Thus, the company enters the “sacred hall” (Kreps 1984) by becoming a portfolio firm of the venture fund. Kreps notes that entity “B”, or the VC here, compete through their reputation for “A’s” (1984). This is consistent with Black and Gilson, who note that VCs are distinguished by their reputation with portfolio firm success when dealing with limited partners, syndicates, and with new entrepreneurs seeking financing (1997).
When the venture capitalist decides to contract with an early-stage company, they have a responsibility to not act opportunistically and renege on the promise of reputational assistance. Opportunistic behavior leads to a reputation loss, which negatively impacts the future transactions of the VC and excludes funds from the opportunity to invest in the best early-stage firms (Black and Gilson 1997). The circumstances for opportunistic behavior come from the ability of the venture capitalist to withhold continuation funding in subsequent rounds of fundraising (Gompers 1995 & Black and Gilson 1997). As Gompers notes, this is a response to the adverse selection inherent in early-stage financing, in which information asymmetry is significant (1995). Simultaneously, this provides the entrepreneur an incentive to perform (or “A” to trust “B”), the VC an incentive to monitor (or “B” to trust “A”) and reduces agency costs for all parties (Gompers 1995). Kreps notes that through repetition of informal arrangements, such as the agreement between VCs and firms, such trust-honor agreements are self-enforcing (1984). This is certainly the case, though there must be a principle put in place that is an intangible asset of the firm and, if not followed in non-contract specified contingencies, will lead to reputation loss for “B” (Kreps 1984).
This principle, using the framework of Black and Gilson, looks something like this: in the case of uncontracted upon contingencies, the VC (and the company) will make decisions that maximize the viability of an IPO exit. This scenario provides maximum benefit to both parties, because the VC will, more often than not, maximize their residual and their accountability to capital providers (LPs). An IPO triggers the full transfer of control rights from the VC to the entrepreneur, which is “a powerful incentive for the entrepreneur”, whereas a sale transfers cash flow rights but not control rights (1997). For a principle to work, it must satisfy three requirements. First, the VC fund (“B”) must promote its understanding to hierarchical inferiors (Kreps 1984). This is seen in the presence of the reputation market, which facilitates adherence to the principle and signals, to the intelligent entrepreneur, that the aforementioned principle is “how business is done around here”. Second, the firm must apply the principle even when it’s immediately costly (Kreps 1984). Again, through the presence of the reputation market, short-term benefits from opportunism are punished (Black and Gilson 1997), thus the principle will be upheld by the VC to protect its reputation. Third, stakeholders must be judged in their fidelity to the principle and the responsibilities which adherence to it entails (Kreps 1984). Given the repetitive nature of contracting between VCs and founders, neither party benefits by not applying the principle. However, additional safeguards exist, in the form of the control right held by the VC, which can be used to remove the CEO, and the termination of said ability upon IPO, which protects the founder (Black and Gilson 1997). In addition, the staging of capital infusions allows the VC to monitor the entrepreneur for non-adherence to the principle (Gompers 1995), and to a lesser extent, it allows the entrepreneur to hold the venture capitalist to account for non-compliance by seeking funding elsewhere. This presence of monitoring also encourages startup teams to develop their own reputation and expertise, because as Kaplan and Strömberg show, the entrepreneur obtains more control rights in good states (2002), which also aligns with the goals of the venture capitalist who wishes to more efficiently invest their nonfinancial assistance in early-stage firms in order to enhance their overall reputation (Black and Gilson 1997). Finally, this principle is flexible enough to allow VCs the opportunity to adjust contract design for information availability and varying stages of development of prospective portfolio firms (Sonius et al. 2017). This permits venture capitalists to adjust the allocation of certain rights (i.e. board rights and liquidation preferences) to correct asymmetries of incentives in different states of the world to increase the likelihood of the principle being followed. Bringing it all back to Kreps, at some point when the scope is widened, the VC will be unable to adhere to the principle without picking up significant inefficiencies (1984). This is where the venture capitalist passes on a deal because “it’s out of scope”, perhaps the most common reason given when VCs choose not to invest in a startup.
To conclude, I will summarize how the contributions of each of the sources of this paper has formed a greater understanding of the influence of reputation on the flow of control rights. First, Aghion and Bolton showed that financial contracts are inherently incomplete (1992). From there, Kaplan and Strömberg contributed the idea that the ability to make decisions in contingent conditions is held by the owner of the control rights and that the quantity of control rights changes in various states (2002). Thus, in order to protect reputation, VCs are incentivized to hold more control rights in adverse states. Gompers goes into greater detail about the contingencies and control mechanisms used by venture capitalists to retain control rights (1995). Incentives for monitoring and how they impact intensity is then discussed (Gompers 1995 & Black and Gilson 1997). Next, the ability of VCs to design contracts based on the states of prospective firms is mentioned (Sonius et al.). This is important because it allows investors to correct for information asymmetry and potential divergent incentives between entrepreneurs and venture capitalists. From there, how reputation enhances the credibility of early-stage firms is remarked upon (Black and Gilson 1997). Necessarily, the benefit of the VC’s reputation to the portfolio firm decreases over time, until it becomes more efficient to invest that reputation in another venture (Black and Gilson 1997). In parallel, VCs must leverage their own reputations when dealing with third parties, such as their limited partners (Black and Gilson 1997). This pushes the VC towards a principle-driven culture, for it allows the contribution of nonfinancial and financial capital to overall returns to be evaluated holistically. The staging of financing rounds allows venture capitalists to withhold not just financial capital but reputational capital as well (Black and Gilson 1997). This encourages the investor to monitor portfolio companies’ adherence to the principle periodically.
Through this synthesis of ideas and sources, it is my hope that I have explained, using David Kreps’ framework, the significance of reputation on the flow of control rights between entrepreneurs and venture capitalists. Future research on this topic could survey VCs about what their firm’s principles are and then empirically examine how their principles are enforced and the success of their adherence to them.
Aghion, Philippe, and Patrick Bolton. “An Incomplete Contracts Approach to Financial Contracting.” The Review of Economic Studies, vol. 59, no. 3, 1992, pp. 473–494.
Gilson, Ronald J. and Black, Bernard S., Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets (November 1997). Journal of Financial Economics, Vol. 47, pp. 243–277, 1998.
Gompers, Paul A. “Optimal Investment, Monitoring, and the Staging of Venture Capital.” The Journal of Finance, vol. 50, no. 5, 1995, pp. 1461–1489. JSTOR, www.jstor.org/stable/2329323.
Kaplan, Steven N, and Per Strömberg. “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts.” Review of Economic Studies, Mar. 2002, pp. 1–35., faculty.chicagobooth.edu/steven.kaplan/research/kaplanstromberg.pdf.
Kreps, David M. “Corporate Culture and Economic Theory.” Second Mitsubishi Bank Foundation Conference on Technology and Business Strategy, 1984, pp. 221–275.
Sonius, David, et al. “VC Contract Design: Development State, Bargaining Power, and the Classification of Early-Cycle Companies.” The Journal of Private Equity, vol. 20, no. 4, 2017, pp. 36–46. JSTOR, www.jstor.org/stable/44397535.