The Role of Contracts in Venture Capital Returns

Abstract

During contract negotiations with startups, venture capitalists (VCs) can receive preferred stock with additional cash flow rights to yield a higher return than the common stock return. The common share price is currently used to calculate payoffs to limited partners (LPs), but incorporating contract terms can considerably change the payoff distribution. Realized proceeds to LPs reveal that VCs exercise all available cash flow rights. Such choices are most financially significant when startups have relatively low acquisition prices, which is also the most frequent outcome. Consequently, the current post-money valuation method is an overvaluation of the true price of all outstanding securities. <b>Key Findings</b> ▪ After constructing a novel dataset of realized proceeds to LPs, the author found that VCs exercise all the preferred stock cash flow rights available to them in their contracts. ▪ VCs invest relatively the same amount of money into startups that become failures, small acquisitions, large acquisitions, or IPOs. Because they are not able to accurately predict a startup’s exit outcome, the cash flow rights accumulate into a significant amount for a fund. ▪ The post-money valuation calculation assumes common stock, and it is an overvaluation of the startup’s true value that considers all outstanding securities.