Geography and Financial Contracts

Abstract

This paper shows that geographical elements can form an essential component of contract design in addition to more traditional ingredients such as information problems, moral hazard and legal institutions. We analyze cash flow contingencies included in 1,804 contracts between U.S. venture capitalists (VCs) and U.S. startup companies. These contingencies affect both the pricing of the VC investment and the entrepreneur’s monetary incentives. We construct an index of “contract harshness”. Consistent with theoretical arguments, we show that contracts include fewer harsh contingencies for younger companies and companies that raise larger amounts of VC financing. However, we find that geography plays a crucial role in VC contract design. Our main result is that contracts are considerably less harsh if the startup is located in California, and in particular in Silicon Valley. The effect also carries over between markets: contracts are less harsh for entrepreneurs if a VC is located in California or if a non-California VC has had large exposure to investments in California. We further show that contracts are less harsh if the startup is located in a region with a larger VC market, or if the geographical distance between the VC and the company is shorter. This latter finding supports the view that geographical proximity lowers monitoring costs. However, the “California effect” remains large and significant even after we control for all other factors. Finally, we present evidence that the effect cannot be explained by a substitution between control rights and cash flow contingencies. In fact, California contracts are less investor-friendly on both counts.