Venture Capital Meets Contract Theory: Risky Claims or Formal Control?*

Abstract

This article develops a theory of the joint allocation of control and cash-flow rights in venture capital (VC) deals. When the need for VC advice and support calls for a high-powered outside claim, the entrepreneur should optimally retain control in order to avoid undue interference. Hence, I predict that more high-powered claims should be associated with fewer control rights. This challenges the idea that control should always be attached to equity-like claims and is in line with contractual terms used in venture capital, corporate venturing, and partnerships between biotech start-ups and large corporations. The article also rationalizes evidence that venture capital contracts include contingencies triggering both a reduction in VC control and the automatic conversion of VC’s preferred stock into common.