Aspects of Financial Contracting in Venture Capital

ASPECTS OF FINANCIAL by William A. Sahlman,

CONTRACTING IN Harvard Business School

VENTURE CAPITAL

INTRODUCTION

During much of the 1960s and 1970s, academic discussions of corporate capital

structure routinely began with the assumption that a firm’s financing decisions

had no material effect on its intrinsic economic value. Setting aside tax consequences

and the possibility of a costly bankruptcy, the value of the firm was assumed

to depend solely on the level and risk of a firm’s operating cash flows. And

operating profitability in turn was assumed to depend entirely on corporate investment

decisions that are made prior to, and completely independently of, financing

choices.1 In the last ten years or so, however, finance scholarship has progressively

reversed this assumption while entertaining the possibility that the way a transaction

is financed can influence operating outcomes in predictable, systematic ways2

And the results of this new thinking–especially the contribution of the “agency

cost” literature to our understanding of the current wave of financial restructurings

– have been interesting.3

Further support for this relatively new direction in finance may also come

from an area of study beyond the usual academic focus on public corporations:

namely, the venture capital markets. For, the interaction of entrepreneur and venture

capitalist has resulted in the evolution of a unique set of financial contracts.

And in no other kind of transaction does the implied link between value and financial

structure appear so strong and direct as in the typical venture capital deal. As I

hope to show in this article, an effective financial design may well be the difference

between a flourishing and a failed (if not a still-born) enterprise.

1. The original formulation of the capital structure “irrelevance” argument was by Franco Modigliani and Merton Miller, “The

Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 53 (June 1958).

2. The first major theoretical departure from the capital structure “irrelevance” argument came with the formulation of the

“agency cost theory” by Michael C. Jensen and William Meckling, “Theory of the Firm: Mangerial Behavior, Agency Costs and

Capital Structure,” Journal of Financial Economics, 3 (October 1976).

3. I am thinking, especially, of Michael Jensen’s article, “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers,”

American Economic Review (May 1986). For an extended elaboration of Jensen’s arguments, see also Vol. 1 No. 1 of this journal.

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JOURNAL OF APPLIED CORPORATE FINANCE

FIRST PRINCIPLES

As is true of all financial transactions, structuring

a venture capital deal involves the allocation of economic

value. Value, in turn, is determined by the interaction

of three major ingredients: cash, risk, and time.

My colleague Bill Fruhan argues that all financial

transactions can be classified into three categories:

those that create value, those that destroy value,

and those that transfer value between two or more

parties. 4 This taxonomy can be readily transferred to

venture capital because almost all venture capital

deals either create, destroy, or transfer value.