[go: up one dir, main page]
IDEAS home Printed from https://ideas.repec.org/p/chf/rpseri/rp63.html
   My bibliography  Save this paper

Understanding the Economic Value of Legal Covenants in Investment Contracts: A Real-Options Approach to Venture Equity Contracts

Author

Listed:
  • Didier Cossin

    (HEC-University of Lausanne, FAME and IMD)

  • Benoît Leleux

    (IMD)

  • Entela Saliasi

    (HEC-University of Lausanne and FAME)

Abstract
Valuing early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies. This inability to come up with robust point estimates of value should not and does not lead to a breakdown of market liquidity: instead, efforts are redirected towards the design of investment contracts which materially skew the distribution of payoffs in favor of the venture investors. In effect, limitations in valuation abilities are addressed by designing the investment contracts as baskets of real options instead of linear payoff functions. This paper investigates four common features (covenants) of venture capital investment contracts from a real option perspective, using both analytical solutions and numerical analyis to draw inferences for a better understanding of contract features. The impact of the concept for pricing issues, valuation negotiation and for contract design are considered. It is shown, for example, how "contingent pre-contracting" for follow-up rounds is theoretically a better proposition than the simple "rights of first refusal" commonly found in many contracts. We also provide for results (such as timing of investments, lengths of rounds, choices of liquidation levels, conversion levels) that take into account full interaction of the different features considered. We document some complex facts, such as the concavity of the VC contract value depending on the amount invested at the different stages, the actual share impact of the most common anti-dilution feature, some endogenous motivation for early VC exits from otherwise performing companies and stress overall the importance of a full analysis for efficient contract negotiations and understanding.

Suggested Citation

  • Didier Cossin & Benoît Leleux & Entela Saliasi, 2002. "Understanding the Economic Value of Legal Covenants in Investment Contracts: A Real-Options Approach to Venture Equity Contracts," Swiss Finance Institute Research Paper Series rp63, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp63
    as

    Download full text from publisher

    File URL: http://www.swissfinanceinstitute.ch/rp63.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Jonathan B. Berk Richard C. Green and Vasant Naik., 1998. "Valuation and Return Dynamics of New Ventures," Research Program in Finance Working Papers RPF-284, University of California at Berkeley.
    2. Black, Bernard S. & Gilson, Ronald J., 1998. "Venture capital and the structure of capital markets: banks versus stock markets," Journal of Financial Economics, Elsevier, vol. 47(3), pages 243-277, March.
    3. Laura Casares Field & Gordon Hanka, 2001. "The Expiration of IPO Share Lockups," Journal of Finance, American Finance Association, vol. 56(2), pages 471-500, April.
    4. Georg Noeldeke & Klaus Schmidt, 1998. "Sequential Investments and Options to Own," RAND Journal of Economics, The RAND Corporation, vol. 29(4), pages 633-653, Winter.
    5. Bergemann, Dirk & Hege, Ulrich, 1998. "Venture capital financing, moral hazard, and learning," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 703-735, August.
    6. Kaplan, Steven & Strömberg, Per, 2002. "Characteristics, Contracts and Actions: Evidence from Venture Capitalist Analyses," CEPR Discussion Papers 3243, C.E.P.R. Discussion Papers.
    7. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-367, May.
    8. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    9. Admati, Anat R & Pfleiderer, Paul, 1994. "Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, vol. 49(2), pages 371-402, June.
    10. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. "Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-320, June.
    11. Schwartz, Eduardo S. & Zozaya-Gorostiza, Carlos, 2000. "Valuation of Information Technology Investments as Real Options," University of California at Los Angeles, Anderson Graduate School of Management qt4dv270zv, Anderson Graduate School of Management, UCLA.
    12. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, vol. 27(2), pages 473-521, October.
    13. Michel Benaroch & Robert J. Kauffman, 1999. "A Case for Using Real Options Pricing Analysis to Evaluate Information Technology Project Investments," Information Systems Research, INFORMS, vol. 10(1), pages 70-86, March.
    14. Gompers, Paul A, 1995. "Optimal Investment, Monitoring, and the Staging of Venture Capital," Journal of Finance, American Finance Association, vol. 50(5), pages 1461-1489, December.
    15. Gompers, Paul & Lerner, Josh, 1996. "The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements," Journal of Law and Economics, University of Chicago Press, vol. 39(2), pages 463-498, October.
    16. Steven N. Kaplan & Per Strömberg, 2003. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 70(2), pages 281-315.
    17. Grenadier, Steven R. & Weiss, Allen M., 1997. "Investment in technological innovations: An option pricing approach," Journal of Financial Economics, Elsevier, vol. 44(3), pages 397-416, June.
    18. Bernardo, Antonio E. & Chowdhry, Bhagwan, 2002. "Resources, real options, and corporate strategy," Journal of Financial Economics, Elsevier, vol. 63(2), pages 211-234, February.
    19. Daniel J. Bradley & Bradford D. Jordan & Ha-Chin Yi & Ivan C. Roten, 2001. "Venture Capital And Ipo Lockup Expiration: An Empirical Analysis," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 24(4), pages 465-493, December.
    20. K. G. Nyborg, 1996. "The use and pricing of convertible bonds," Applied Mathematical Finance, Taylor & Francis Journals, vol. 3(3), pages 167-190.
    21. Panayi, Sylvia & Trigeorgis, Lenos, 1998. "Multi-stage Real Options: The Cases of Information Technology Infrastructure and International Bank Expansion," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 675-692.
    22. Ingersoll, Jonathan Jr., 1977. "A contingent-claims valuation of convertible securities," Journal of Financial Economics, Elsevier, vol. 4(3), pages 289-321, May.
    23. Cochrane, John H., 2005. "The risk and return of venture capital," Journal of Financial Economics, Elsevier, vol. 75(1), pages 3-52, January.
    24. Bradley, Daniel J & et al, 2001. "Venture Capital and IPO Lockup Expiration: An Empirical Analysis," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 24(4), pages 465-493, Winter.
    25. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," The Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 37-68.
    26. Joshua Lerner, 1994. "The Syndication of Venture Capital Investments," Financial Management, Financial Management Association, vol. 23(3), Fall.
    27. Barraquand, Jérôme & Martineau, Didier, 1995. "Numerical Valuation of High Dimensional Multivariate American Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(3), pages 383-405, September.
    28. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
    29. Gompers, Paul A., 1996. "Grandstanding in the venture capital industry," Journal of Financial Economics, Elsevier, vol. 42(1), pages 133-156, September.
    30. Bascha, Andreas & Walz, Uwe, 2001. "Convertible securities and optimal exit decisions in venture capital finance," Journal of Corporate Finance, Elsevier, vol. 7(3), pages 285-306, September.
    31. Kumar, Ram L., 1999. "Understanding DSS value: an options perspective," Omega, Elsevier, vol. 27(3), pages 295-304, June.
    32. Allen, Franklin & Faulhaber, Gerald R., 1989. "Signalling by underpricing in the IPO market," Journal of Financial Economics, Elsevier, vol. 23(2), pages 303-323, August.
    33. Geske, Robert & Johnson, Herb E, 1984. "The American Put Option Valued Analytically," Journal of Finance, American Finance Association, vol. 39(5), pages 1511-1524, December.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Julian Kaboth & Arnd Lodowicks & Maximilian Schreiter & Bernhard Schwetzler, 2023. "Same same but different: how preferential claims trigger valuation discounts in equity tranches of VC-backed firms," Review of Quantitative Finance and Accounting, Springer, vol. 60(3), pages 877-914, April.
    2. Elisabete Gomes Santana F�lix & Cesaltina Pacheco Pires & Mohamed Azzim Gulamhussen, 2014. "The exit decision in the European venture capital market," Quantitative Finance, Taylor & Francis Journals, vol. 14(6), pages 1115-1130, June.
    3. Dietmar P.J. Leisen, 2012. "Staged venture capital contracting with ratchets and liquidation rights," Review of Financial Economics, John Wiley & Sons, vol. 21(1), pages 21-30, January.
    4. Tony W. Tong & Yong Li, 2011. "Real Options and Investment Mode: Evidence from Corporate Venture Capital and Acquisition," Organization Science, INFORMS, vol. 22(3), pages 659-674, June.
    5. Li, Yong, 2008. "Duration analysis of venture capital staging: A real options perspective," Journal of Business Venturing, Elsevier, vol. 23(5), pages 497-512, September.
    6. Tyrone Lin & Chuan-Chuan Ko & Chia-Wen Chang, 2010. "Applying jump-diffusion processes to liquidate and convert venture capital," Quality & Quantity: International Journal of Methodology, Springer, vol. 44(5), pages 817-832, August.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Rin, Marco Da & Hellmann, Thomas & Puri, Manju, 2013. "A Survey of Venture Capital Research," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 573-648, Elsevier.
    2. Andrew Metrick & Ayako Yasuda, 2011. "Venture Capital and Other Private Equity: a Survey," European Financial Management, European Financial Management Association, vol. 17(4), pages 619-654, September.
    3. Hall, Bronwyn H. & Lerner, Josh, 2010. "The Financing of R&D and Innovation," Handbook of the Economics of Innovation, in: Bronwyn H. Hall & Nathan Rosenberg (ed.), Handbook of the Economics of Innovation, edition 1, volume 1, chapter 0, pages 609-639, Elsevier.
    4. Tereza Tykvová, 2007. "What Do Economists Tell Us About Venture Capital Contracts?," Journal of Economic Surveys, Wiley Blackwell, vol. 21(1), pages 65-89, February.
    5. Cumming, Douglas J., 2005. "Capital structure in venture finance," Journal of Corporate Finance, Elsevier, vol. 11(3), pages 550-585, June.
    6. Cumming, Douglas & Fleming, Grant & Suchard, Jo-Ann, 2005. "Venture capitalist value-added activities, fundraising and drawdowns," Journal of Banking & Finance, Elsevier, vol. 29(2), pages 295-331, February.
    7. Cumming, Douglas J. & MacIntosh, Jeffrey G., 2003. "A cross-country comparison of full and partial venture capital exits," Journal of Banking & Finance, Elsevier, vol. 27(3), pages 511-548, March.
    8. Yao-Wen Hsu, 2010. "Staging of venture capital investment: a real options analysis," Small Business Economics, Springer, vol. 35(3), pages 265-281, October.
    9. Giot, Pierre & Schwienbacher, Armin, 2007. "IPOs, trade sales and liquidations: Modelling venture capital exits using survival analysis," Journal of Banking & Finance, Elsevier, vol. 31(3), pages 679-702, March.
    10. Cumming, Douglas & Fleming, Grant & Schwienbacher, Armin, 2006. "Legality and venture capital exits," Journal of Corporate Finance, Elsevier, vol. 12(2), pages 214-245, January.
    11. Jens Burchardt & Ulrich Hommel & Dzidziso Samuel Kamuriwo & Carolina Billitteri, 2016. "Venture Capital Contracting in Theory and Practice: Implications for Entrepreneurship Research," Entrepreneurship Theory and Practice, , vol. 40(1), pages 25-48, January.
    12. Paul Gompers & Josh Lerner, 2001. "The Venture Capital Revolution," Journal of Economic Perspectives, American Economic Association, vol. 15(2), pages 145-168, Spring.
    13. Cumming, Douglas & Schmidt, Daniel & Walz, Uwe, 2004. "Legality and venture governance around the world," CFS Working Paper Series 2004/17, Center for Financial Studies (CFS).
    14. Kanniainen, Vesa & Keuschnigg, Christian, 2004. "Start-up investment with scarce venture capital support," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1935-1959, August.
    15. Krohmer, Philipp & Lauterbach, Rainer & Calanog, Victor, 2009. "The bright and dark side of staging: Investment performance and the varying motivations of private equity firms," Journal of Banking & Finance, Elsevier, vol. 33(9), pages 1597-1609, September.
    16. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    17. Espenlaub, Susanne & Khurshed, Arif & Mohamed, Abdulkadir, 2014. "Does cross-border syndication affect venture capital risk and return?," International Review of Financial Analysis, Elsevier, vol. 31(C), pages 13-24.
    18. Suresh M. Sundaresan, 2000. "Continuous‐Time Methods in Finance: A Review and an Assessment," Journal of Finance, American Finance Association, vol. 55(4), pages 1569-1622, August.
    19. Cumming, D. & Johan, S.A., 2005. "Is it the law or the lawyers? Investment fund covenants," Discussion Paper 2005-005, Tilburg University, Tilburg Law and Economic Center.
    20. Ulrich Hege & Frédéric Palomino & Armin Schwienbacher, 2009. "Venture Capital Performance: The Disparity Between Europe and the United States," Finance, Presses universitaires de Grenoble, vol. 30(1), pages 7-50.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:chf:rpseri:rp63. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Ridima Mittal (email available below). General contact details of provider: https://edirc.repec.org/data/fameech.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.