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Different Problem, Same Solution: Contract-Specialization in Venture Capital

Bengtsson, Ola LU and Bernhardt, Dan (2014) In Journal of Economics & Management Strategy 23(2). p.396-426
Abstract
Real-world financial contracts vary greatly in the combinations of cash flow contingency terms and control rights used. Extant theoretical work explains such variation by arguing that each investor finely tailors contracts to mitigate investment-specific incentive problems. We provide overwhelming evidence from 4,561 venture capital (VC) contracts that this tailoring is overstated: even though there is broad variation in contracting across VCs, each individual VC tends to specialize, recycling familiar terms. In fact, a VC typically restricts contracting choices to a small set of alternatives: 46% of the time, a VC uses the same exact cash flow contingencies as in one of her previous five contracts. We document specialization in both... (More)
Real-world financial contracts vary greatly in the combinations of cash flow contingency terms and control rights used. Extant theoretical work explains such variation by arguing that each investor finely tailors contracts to mitigate investment-specific incentive problems. We provide overwhelming evidence from 4,561 venture capital (VC) contracts that this tailoring is overstated: even though there is broad variation in contracting across VCs, each individual VC tends to specialize, recycling familiar terms. In fact, a VC typically restricts contracting choices to a small set of alternatives: 46% of the time, a VC uses the same exact cash flow contingencies as in one of her previous five contracts. We document specialization in both aggregated downside protection, and in each individual cash flow contingency term. Such specialization remains economically and statistically significant even after controlling for VC and company characteristics. We also find that VCs learn to use new contractual solutions from other VCs in her syndication network. Our findings challenge the traditional premise that each investor selects from the universe of combinations of terms to match an investment's unique contracting problem. Rather, the cumulative evidence indicates that contract-specialization arises because investors better understand payoff consequences of familiar terms, and are reluctant to experiment with unknown combinations. (Less)
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author
organization
publishing date
type
Contribution to journal
publication status
published
subject
in
Journal of Economics & Management Strategy
volume
23
issue
2
pages
396 - 426
publisher
Wiley-Blackwell
external identifiers
  • wos:000333811500007
  • scopus:84897513506
ISSN
1058-6407
DOI
10.1111/jems.12055
language
English
LU publication?
yes
id
bb5a49b7-b117-416a-9c1c-f3dc729ef22b (old id 4559005)
date added to LUP
2014-07-17 13:55:09
date last changed
2017-10-01 04:06:02
@article{bb5a49b7-b117-416a-9c1c-f3dc729ef22b,
  abstract     = {Real-world financial contracts vary greatly in the combinations of cash flow contingency terms and control rights used. Extant theoretical work explains such variation by arguing that each investor finely tailors contracts to mitigate investment-specific incentive problems. We provide overwhelming evidence from 4,561 venture capital (VC) contracts that this tailoring is overstated: even though there is broad variation in contracting across VCs, each individual VC tends to specialize, recycling familiar terms. In fact, a VC typically restricts contracting choices to a small set of alternatives: 46% of the time, a VC uses the same exact cash flow contingencies as in one of her previous five contracts. We document specialization in both aggregated downside protection, and in each individual cash flow contingency term. Such specialization remains economically and statistically significant even after controlling for VC and company characteristics. We also find that VCs learn to use new contractual solutions from other VCs in her syndication network. Our findings challenge the traditional premise that each investor selects from the universe of combinations of terms to match an investment's unique contracting problem. Rather, the cumulative evidence indicates that contract-specialization arises because investors better understand payoff consequences of familiar terms, and are reluctant to experiment with unknown combinations.},
  author       = {Bengtsson, Ola and Bernhardt, Dan},
  issn         = {1058-6407},
  language     = {eng},
  number       = {2},
  pages        = {396--426},
  publisher    = {Wiley-Blackwell},
  series       = {Journal of Economics & Management Strategy},
  title        = {Different Problem, Same Solution: Contract-Specialization in Venture Capital},
  url          = {http://dx.doi.org/10.1111/jems.12055},
  volume       = {23},
  year         = {2014},
}