The Effect of Preferred Cash Flow and Control Provisions on Venture’s Subsequent Alliance Formation

Abstract

Nascent ventures require resources for growth. Prior literature has focused on venture capitalists (VC) and alliances as the sources of these resources and has shown that VCs play a significant role in providing such resources. While VCs facilitate forming strategic alliances with incumbents, prior work has revolved around comparing VC-backed ventures to non-VC backed ventures. In this paper, we depart from this traditional comparison by acknowledging the heterogeneous nature of VCs. We explore how contracts design affect the post-investment behavior of the VCs, impacting the formation of strategic alliances. Through an analysis of 1,167 Series A contracts between the VC and the biotechnology ventures, we argue that preferred cash flow provision influences VC’s incentive and VC board representation impacts VC’s effectiveness and, consequently, show that both facet of contract design are positively related to the likelihood of forming an alliance. In addition, we investigate numerous boundary conditions to tease out our mechanisms. We discuss the theoretical implications of our study.