16 - Covenants in venture capital contracts: Theory and empirical evidence from the German capital market

Abstract

Young innovative firms operate in high-tech branches and their value is mainly determined by specific, non-transferable knowledge controlled by the entrepreneur and other important employees. The financing relationship between venture capitalists and entrepreneurs is burdened by severe agency and hold-up problems because of the special characteristics of growth companies. It discusses which specific forms of agency problems and hold-up conflicts arise from this particular situation. Moreover, it shows that typical characteristics of venture capital contracts, such as stage financing and vesting provisions, are utilized to mitigate these problems in certain ways that could not be accomplished by simple capital structure optimization or the sole establishment of monetary incentive contracts. Using a hand-collected sample of contracts from the German VC market, it analyzes whether there is empirical evidence for our hypotheses of the relevance of particular covenants in VC contracts. As a proxy for the factors in the environment of innovative firms that lead to certain conflict patterns, firm characteristics such as the affiliation to a high-tech industry or the existence of positive revenues of the growth company at the time of funding are used. Most of the resulting significant relations between indicators and contractual provisions can be explained by agency or hold-up theories, while insignificant coefficients might stem from substitution effects or complementary effects among provisions, costly contracting, or the application of indirect indicators.