Another important aspect of both venture capital and angel investments is the terms of the investment contract. A large portion of corporate law, and decisions made regarding corporate law, revolve around the “fiduciary duties” that management, in this case the entrepreneur, owes to shareholders and debt holders. Realistically however, these groups often have conflicting interests, so that contract terms and covenants are vitally important (Baird & Henderson, 2008). Potential conflicts are exacerbated by the volatility and conflicting interests present in nascent or early stage firms. In risky environments the contracts between entrepreneurs and their venture capital financiers become longer and more complex, as the venture capitalists try to protect the capital they supply from the inherent risk involved (Emert, 2001).
Venture capital contracts, commonly known as “term sheets,” outline the relationship and rights of the investors and founders in the venture or firm. These term sheets seek to minimize the “moral hazard problem” associated with investing in new or small firms. The moral hazard problem is the name given to the problem of opportunism when the parties involved in the investment begin acting solely in their personal interests without regard for the effect on the other party (Elitzur & Gavious, 2002). This can create a situation where the venture capitalist pays less, relying on others to pick up the slack, and the entrepreneur gives less effort because he/she does not want to exert more than his/her fair share of effort and so rely on the other parties. This leads to an unproductive situation for both the entrepreneur and the venture capitalist. To avoid this dilemma, venture capitalists first seek entrepreneurs who have invested significant equity in their firms, and so have a vested interest in its success (Elitzur & Gavious, 2002). Then the VCs rely on provisions in the term sheet to maintain control and manage incentives.
A very common strategy to achieve these objectives is staged financing. Staged financing involves the venture firm spreading the investment over several stages as opposed to supplying the entire financing up front. Through staged investment planning the venture capitalist may maintain greater control of his/her investment in the firm – through monitoring, maintaining an exit from the investment, and controlling the risk of the moral hazard problem thereby reducing agency costs (Wang & Zhou, 2002). The staged format allows monitoring of the investment by pre-established milestones which must be met. These milestones give the entrepreneur incentives to maintain a high level of performance and make it difficult for the entrepreneur to abscond with the venture capitalist’s investment.
Through staging the venture capitalist also maintains an exit. This exit gives the venture capitalist a real option perspective on future investments, in which the existing investment may be maintained as the venture capitalists waits for further information, or increased to gain the option to invest again in the future (Li, 2007). This has benefits to the venture capitalist as well as to the entrepreneur, as subsequent financing is often as critical to firm survival as initial financing.
The type of equity to be purchased by the investors is one of the first considerations in a start-up equity investment decision. A venture capitalist usually invests in a preferred asset class to maintain a level of control over the investment (BVCA, 2004). Venture financing in the United States is predominantly in the form of convertible preferred equity.
The fact that this one form of financing is used in the majority of venture capital financing deals was examined by Douglas Cumming (2004). Cumming’s findings attributed the use in the United States of convertible preferred equity to the influence of tax law. In comparing US to Canadian venture capital, Cumming found that in the absence of tax law influence, venture capital funding was much more flexible and changed based on individual deal factors such as the industry and the counter party in the funding deal. Canadian firms used common equity in more than a third of their deals and straight, nonconvertible debt in more than one out of seven. Cumming concluded that the capital structure of these venture capital deals was probably adapted to expected agency problems in accordance with the majority of financial literature outside of the venture capital specific literature.
Before each new investment round the investors and the entrepreneur generally explicitly agree on a valuation of the firm (BVCA, 2004). The process of valuing a new firm is not exact. There exist several methods and theories of valuation. The results of the valuation may vary greatly depending on the method used and often vary greatly from one evaluator to the next, even using the same methods. The subject of valuation is covered in depth in a later section.
Other issues addressed by the term sheet, as per the National Venture Capital Association and the British Venture Capital Association, include dividends, liquidation preferences, voting and control rights, protective provisions, both mandatory and optional conversion clauses, anti-dilution clauses, pay-to-play, and redemption rights (BVCA, 2004). Investors, such as venture capitalists and angels, and the founder draw up investor rights agreements which include agreements about the registration of securities, management and information rights, rights to maintain proportionate ownership, non-disclosure agreements, board agreements, stock option agreements, voting agreements and future preferred stock agreements.
These terms of various investor and founder agreements are variable and negotiable between the entrepreneur and the investors. These extensive contracting agreements (both their content and the effort and ability to negotiate them) are a key factor an entrepreneur must consider when choosing funding sources. The alignment of the funding source with the entrepreneur’s strategy and goals is even more critical to success when the effects of term sheets are considered. Entrepreneurs must keep their best interests in mind when negotiating terms, as it is sure that their funding sources, whether venture capital or angel, will be watching out for themselves.