Venture Capital and Private Equity Contracting: An International Perspective [NOOK Book]

Overview

Other books present corporate finance approaches to the VC/PE industry, but many key decisions require an understanding of the ways that law and economics work together. This book is better than straight corporate finance textbooks because it offers broad perspectives and principles that enable readers to deduce the economic implications of specific contract terms. This approach avoids the common pitfalls of implying that contractual terms ...
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Venture Capital and Private Equity Contracting: An International Perspective

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Overview

Other books present corporate finance approaches to the VC/PE industry, but many key decisions require an understanding of the ways that law and economics work together. This book is better than straight corporate finance textbooks because it offers broad perspectives and principles that enable readers to deduce the economic implications of specific contract terms. This approach avoids the common pitfalls of implying that contractual terms apply equally to firms in any industry anywhere in the world.

• Explores the economic implications of contract terms for start-up firms in various industries
• Pairs international data with explanations and examples about differences in VC and PE national and regional markets
• Contains sample contracts, including limited partnership agreements, term sheets, shareholder agreements, and subscription agreements
• Presents international datasets on limited partnership agreements between institutional investors and VC and PE funds
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Editorial Reviews

From the Publisher
"This volume complements existing books on the venture capital and private equity industry by focusing on financial contracting, and hence around the crucial aspect of the private equity industry."
--Uwe Walz, Goethe Universität Frankfurt/Main

"The book covers many facets of venture capital and private equity contracting, from the birth of a venture capital fund to its exit, giving readers a complete and comprehensive picture about the venture capital and private equity industry."
--Xuan Tian, Indiana University

"Cumming and Johan examine the important topics not covered by existing books."
--Masako Ueda, University of Wisconsin-Madison

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Product Details

  • ISBN-13: 9780080917542
  • Publisher: Elsevier Science
  • Publication date: 4/2/2009
  • Sold by: Barnes & Noble
  • Format: eBook
  • Edition number: 1
  • Pages: 792
  • File size: 4 MB

Meet the Author

Douglas Cumming, J.D., Ph.D., CFA, is a Professor of Finance and Entrepreneurship and the Ontario Research Chair at the Schulich School of Business, York University. His research interests include venture capital, private equity, hedge funds, entrepreneurship, and law and finance. He is a Co-Editor of Entrepreneurship Theory and Practice, and has been a guest editor for 12 special issues of top journals. He has published over 90 articles in leading refereed academic journals in finance, management, and law and economics, such as the Journal of Financial Economics, Review of Financial Studies, Journal of International Business Studies and the Journal of Empirical Legal Studies. He is the coauthor of Venture Capital and Private Equity Contracting (Elsevier Academic Press, 2009), and Hedge Fund Structure, Regulation and Performance around the World (Oxford University Press, 2013). He is the Editor of the Oxford Handbook of Entrepreneurial Finance (Oxford University Press, 2012), the Oxford Handbook of Private Equity (Oxford University Press, 2012), and the Oxford Handbook of Venture Capital (Oxford University Press, 2012). His work has been reviewed in numerous media outlets, including The Economist, Canadian Business, the National Post, and The New Yorker. He is a research associate with the Bocconi University Paolo Baffi Center for Central Banking and Financial Regulation (Milan), Groupe d'Economie Mondiale at Sciences Po (Paris), Capital Markets CRC (Sydney), Venture Capital Experts (New York), Cambridge University ESRC Center for Business Research (Cambridge UK), Center for Financial Studies (Frankfurt), Amsterdam Center for Research in International Finance, and the University of Calgary Van Horne Institute. He has also consulted for a variety of governmental and private organizations in Australasia, Europe and North America. Much of Douglas Cumming’s work is online at SSRN: http://ssrn.com/author=75390

Sofia Johan, LL.B (Liverpool), LL.M. in International Economic Law (Warwick), Ph.D. in Law and Economics (Tilburg), is the AFM Senior Research Fellow at the Tilburg Law and Economics Centre (TILEC) in The Netherlands and Adjunct Professor of Law and Finance at the Schulich School of Business, York University. Her research is primarily focused on law and finance, market surveillance, hedge funds, venture capital, private equity and IPOs. Her work has been presented at the American Law and Economics Association, the American Economics Association, European Law and Economics Association, the European Financial Management Association, and other leading international conferences. Her recent publications have appeared in numerous journals including the Journal of Financial Economics, Journal of International Business Studies, American Law and Economics Review, International Review of Law and Economics, Journal of Banking and Finance, European Financial Management, European Economic Review, and Entrepreneurship Theory and Practice, among numerous other journals. She is the coauthor of Venture Capital and Private Equity Contracting: An International Perspective (Elsevier Science Academic Press, 2009, 770pp) and Hedge Fund Structure, Regulation and Performance around the World (Oxford University Press, 2013, 300pp). . Prior to her Ph.D., she was the head legal counsel at the largest government owned venture capital fund in Malaysia. She has also consulted for a variety of governmental and private organizations in Australasia and Europe. http://ssrn.com/author=370203

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Read an Excerpt

Venture Capital and Private Equity Contracting

An International Perspective
By Douglas J. Cumming Sofia A. Johan

Academic Press

Copyright © 2009 Elsevier Inc.
All right reserved.

ISBN: 978-0-08-091754-2


Chapter One

Introduction and Overview

These days almost everyone has heard of the terms venture capital and private equity. The venture capital and private equity markets are frequently discussed in popular media and are often described as "scorching" in the popular press, at least in boom times. The market has direct relevance for entrepreneurs who want to raise money, investors who want to make money from financing entrepreneurs, and individuals who want to work for a fund or set up their own fund. Also, venture capital and private equity are of significant interest to the public sector, as government bodies around the world strive to find ways to promote entrepreneurship and entrepreneurial finance. It is widely believed that venture capital and private equity funds facilitate more innovative activities and thereby improve the well-being of nations. It is thought of as a critical aspect of national growth in the twenty-first century.

The 23 chapters of this book provide an analysis of the issues that venture capital and private equity market participants face during the fundraising process (Part II), investment process (Part III), and divestment process (Part IV). A common theme across all of these issues is agency costs, so agency theory is reviewed in Chapter 2. All of the issues addressed in this book are analyzed from an empirical law and finance perspective, with a focus on financial contracting. Financial contracts are central to the establishment of the relationship between venture capital and private equity funds and their investors. Financial contracts also govern the relationship between venture capital and private equity funds and their investee entrepreneurial firms, as well as determine the efficacy of the divestment process. In most chapters we refer to datasets to grasp the real-world aspects of the venture capital and private equity process. Further, it is important to consider international evidence to grasp the impact of laws and institutions on the respective venture capital and private equity markets. The empirical methods and legal and institutional settings in this book are overviewed in Chapter 3.

1.1 What Are Venture Capital and Private Equity?

At the outset, it is important to discuss the definitions of the terms venture capital and private equity. Venture capital and private equity funds are financial intermediaries between sources of funds (typically institutional investors) and high-growth and high-tech entrepreneurial firms. Funds are typically established as limited partnerships, but, as we will see, there are other types of funds. A limited partnership is in essence a contract between institutional investors who become limited partners (pension funds, banks, life insurance companies, and endowments who have rights as partners but trade "management" rights over the fund for limited liability) and the fund manager, who is designated the general partner (the partner that takes on the responsibility of the day-to-day operations and management of the fund and assumes total liability in return for negligible buy-in). Chapter 5 examines in detail the structure of limited partnerships and limited partnership contracts. The basic intermediation structure of venture capital and private equity funds is graphically summarized in Figure 1.1.

Venture capital funds are typically set up with at least US$50 million in capital committed from institutional investors and often exceed US$100 million. Some of the larger private equity funds raised more than US$10 billion in 2006. Fund managers typically receive compensation in the form of a management fee (often 1 to 2% of committed capital, depending on the fund size) and a performance fee or carried interest (20% of capital gains). Chapter 6 discusses factors related to fund manager compensation. Venture capital funds invest in start-up entrepreneurial firms that typically require at least US$1 million and up to US$20 million in capital. Private equity funds invest in more established firms, as discussed further below.

Venture capital is often referred to as the money of invention (see, e.g., Black and Gilson, 1998; Gompers and Lerner, 1999a,b,c, 2001a,b; Kortum and Lerner, 2000) and venture capital fund managers as those who provide value-added resources to entrepreneurial firms. Venture capital fund managers play a significant role in enhancing the value of their entrepreneurial investments as they provide financial, administrative, marketing, and strategic advice to entrepreneurial firms, as well as facilitate a network of support for an entrepreneurial firm with access to accountants, lawyers, investment bankers, and organizations specific to the industry in which the entrepreneurial firm operates (Gompers and Lerner, 1999a,b,c; Leleux and Surlemount, 2003; Manigart, Korsgaard et al., 2002; Manigart, Lockett et al., 2002; Sahlman, 1990; Sapienza et al., 1996; Wright and Lockett, 2003). Academic studies have shown that venture capital–backed entrepreneurial firms are on average significantly more successful than non–venture capital–backed entrepreneurial firms in terms of innovativeness (Kortum and Lerner, 2000), profitability, and share price performance upon going public (Gompers and Lerner, 1999a,b,c, 2001a,b).

Venture capital and private equity investments carried out by a fund typically last over a period of 2 to 6 years. A venture capital limited partnership envisages this extended investment horizon and thus is structured over a 10-year horizon (with an option to continue for an additional 3 years) so the fund manager can select investments over the first few years and then bring those investments to fruition over the remaining life of the fund. Investments are made with a view toward capital gains upon an exit event (a sale transaction), since entrepreneurial firms typically cannot pay interest on debt or dividends on equity. The terms of the investment often give the venture capital fund significant cash flow rights in the form of equity and priority in the event of liquidation. As well, the venture capital fund typically receives significant veto and control rights over decisions made by the management of the entrepreneurial firm.

The terms venture capital and private equity differ primarily with respect to the stage of development of the entrepreneurial firm in which they invest. Venture capital refers to investments in earlier-stage firms (seed or start-up firms), whereas private equity is a broader term that also encompasses later-stage investments as well as buyouts and turnaround investments. In this book, unless explicitly stated otherwise, for ease of exposition we use the term private equity to encompass all private investment stages, including venture capital. The various financing stages are defined as follows.

Seed: Financing provided to research, assess, and develop an initial concept before a business has reached the start-up phase.

Start-up: Financing provided to firms for product development and initial marketing. Firms may be in the process of being set up or may have been in business for a short time but have not sold their product commercially.

Other early stage: Financing to firms that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit.

Expansion: Financing provided for the growth and expansion of a firm that is breaking even or trading profitably. Capital may be used to finance increased production capacity or market or product development and/or to provide additional working capital.

Bridge financing: Financing made available to a firm in the period of transition from being privately owned to being publicly quoted.

Secondary purchase/replacement capital: Purchase of existing shares in a firm from another private equity investment organization or from another shareholder or shareholders.

Rescue/turnaround: Financing made available to an existing firm that has experienced trading difficulties—for example, the firm is not earning its weighted average cost of capital (WACC)—with a view to reestablishing prosperity.

Refinancing bank debt: To reduce a firm's level of gearing.

Management buyout: Financing provided to enable current operating management and investors to acquire an existing product line or business.

Management buy in: Financing provided to enable a manager or group of managers from outside the firm to buy in to the firm with the support of private equity investors.

Venture purchase of quoted shares: Purchase of quoted shares with the purpose of delisting the firm.

Other purchase of quoted shares: Purchase of shares on a public stock market.

In practice, sometimes broader categories are used:

Start-up: Sometimes used in practice to refer to start-up and other early stage.

Expansion: Sometimes used in practice to refer to expansion, bridge financing, or rescue/turnaround.

Replacement capital: Sometimes used in practice to refer to secondary purchase/ replacement capital or refinancing bank debt.

Buyouts: Sometimes used in practice to refer to management buyout, management buyin, or venture purchase of quoted shares.

Precise definitions of terms vary somewhat depending on the norms in a particular country and the specific individuals surveyed. Because this book uses data from different countries, these terms are defined and explained, along with others, in their specific contexts in each chapter.

Definitions of stages of development in venture capital and private equity are perhaps usefully viewed in the context of a diagram. A common picture used in practice is shown in Figure 1.2. In this picture, venture capital finance is placed in a broader context of other sources of finance. Prior to seeking and obtaining venture capital finance, entrepreneurs who are just starting their venture often obtain capital from friends, family, and "fools" (also known as the 3 Fs or FFF). Fools refers to the high risk associated with investment in nascent stage firms, and the "valley of death" depicted in Figure 1.2 is where firms require significant capital inflows but show little or no revenues until subsequent years. Professional individual investors, known as angel investors, are a common source of capital for entrepreneurs prior to obtaining more formal institutionalized venture capital finance (Wong, 2002). Many angel investors are successful entrepreneurs who have, through experience, specialized abilities to recognize talent in other entrepreneurs and their new ventures. A classic example is Andy Bechtolsheim who cofounded Sun Microsystems. He gave $100,000 to the founders of Google, who could not even cash the check because they had not yet established Google as a legal entity. A limitation in the study of the market for angel investment, however, is the lack of systematic data. This book will not be considering angel investment.

In Figure 1.2 the term mezzanine refers to investment in late-stage firms that are close to an initial public offering (IPO). An IPO is the first time a firm sells its shares for sale in the public market (i.e., lists or floats on a stock exchange). A seasoned equity offering involves additional capital-raising efforts by firms that are already trading on a stock exchange. Chapters 19 to 21 address the issues involved with the exit of venture capital investments through IPOs, mergers and acquisitions, and other exit vehicles.

(Continues...)



Excerpted from Venture Capital and Private Equity Contracting by Douglas J. Cumming Sofia A. Johan Copyright © 2009 by Elsevier Inc.. Excerpted by permission of Academic Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Part I. Introduction
Part II. Fund Structure and Governance
Part III. Financial Contracting between Funds and Entrepreneurs
Part IV. Investor Effort
Part V. Divestment
Part VI. Conclusion and Appendices
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