The Importance of Geographical Location and Distance on Venture Capital Contracts

Abstract

This paper shows that geographical and cultural elements could form an essential component of contract design in addition to more traditional ingredients such as information and agency problems and the quality of legal institutions. Contracts between U.S. venture capitalists (VCs) and entrepreneurial companies include significantly fewer investor-friendly cash flow contingencies if the company is located in California and in particular in Silicon Valley. Contract solutions also carry over between markets, with contracts being less investor-friendly if a VC is located in California or if a non-California VC has had large exposure to investments in California. Although we find that a larger concentration of VCs and venture-backed companies in a region is associated with less investor-friendly contracts, this pattern alone cannot explain why California is different. We show that, after controlling for these important regional differences, contracts include fewer cash flow contingencies when the geographical distance between VC and company is shorter. This finding supports the view that that monitoring and soft information decrease with distance but can be substituted with high-powered incentive contracts.