Geography and Style in Private Equity Contracting: Evidence from the U.S. Venture Capital Market

Abstract

We present novel evidence that contracting style and geography matter in financial contracts, in addition to more traditional ingredients based upon financing frictions and formal institutions. We analyze cash flow contingencies included in 1,804 private equity contracts between U.S. venture capitalists (VCs) and U.S. startup companies. These contingencies affect both pricing and incentives. We document a pronounced “California effect”, namely, that California based entrepreneurs receive more lenient contract terms. We find a similar effect if the VC is located in California, or if a non-California VC had large exposure the California market. 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 can lower monitoring costs. However, the “California effect” remains large and significant even after we control for such explanations. Our findings cannot be explained by differences in state laws, bankruptcy and tax regimes. We also confirm that it is not that VCs substitute less harsh cash flow contingencies for harsher control rights or for more performance-based CEO compensation. In fact, California contracts are more entrepreneur-friendly in all these dimensions. Our findings suggest that in addition to traditional variables, behavioral norms can lead to a contracting equilibrium. In addition to the “California effect”, we present several other new findings on VC contract design.