VC contracts closely reflect contractual theory as VCs have the power to separately allocate rights and because they have a variety of contractual tools to use in financing rounds. Staged financing, as well as performance-based incentives, non-compete agreements, and control rights are some examples
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VC contracts, contractual structures, legal structure and incentives
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How can theory explain the contractual and incentive structure of VC contracts?
- Summary bullet points
- VC financing approaches contractual theory because VCs can allocate different rights (voting, cash flow, board, liquidation, etc.) separately
- Allocation of these rights
- VCs tend to use different types of financial tools to invest
- Convertible securities are most often used
- VCs accomplish similar results in allocating rights using different classes of stock and other methods
- VCs can put milestones in place to which they can tie future outcomes in terms of rights and future financing rounds
- Control can depend on performance
- When the company’s performance is sub-par, the VCs can obtain more control. If it then improves, the founders can regain some control.
- Vice versa, if the company performs very well, investors lose control and liquidation rights but both investors and founders’ cash flow rights increase
- Non-compete clauses are often included in VC contracts to avoid conflict with founders
- Vesting provisions are also included in VC contracts to avoid conflict with founders but they are more used in early-stage financing because of the higher conflict risk
- Different contractual strategies are often used together to achieve goals
- Cash flow incentives
- Control rights,
- Contingencies
- VCs tend to use control rights tied to key performance indicators
- These contractual strategies are ways to discriminate good companies and founders from bad ones
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