© Cumming & Johan (2013)Forms of VC Finance Security Design Cumming & Johan (2013, Chapter 11) 1

© Cumming & Johan (2013)Forms of VC Finance Forms of Finance Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary Debt  1 st priority in bankruptcy  Stipulated interest payments  Non-payment of interest  can force bankruptcy Preferred Equity  2 nd priority in bankruptcy  Stipulated preferred dividend payments  Non-payment of dividends  cannot force bankruptcy 2

© Cumming & Johan (2013)Forms of VC Finance Forms of Finance (Con’t) Common Equity  Last priority in bankruptcy  Dividends may or may not be forthcoming  Residual claimants  upside potential  capital gains! Warrants  Option to purchase common equity  Like an American call option to purchase the firm (but different because increases # securities when exercised) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 3

© Cumming & Johan (2013)Forms of VC Finance Forms of Finance (Con’t) Convertible debt  Debt + option to convert from debt to common equity  Similar to debt + warrants Convertible preferred equity  Preferred equity + option to convert from preferred equity to common equity  Similar to preferred equity + warrants Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 4

© Cumming & Johan (2013)Forms of VC Finance 5 Figure 2.1. Payoff Functions $ Value of Entrepreneurial Firm Payoff to Common Equity Payoff to Debt Payoff to Preferred Equity 45 o Present Value of Interest + Principal on Debt Present Value of Pre-Specified Preferred Dividends Slope is 45 o for 100% of the common shares (45 o * X/100 for X% of the common shares) 5

© Cumming & Johan (2013)Forms of VC Finance The Conventional Wisdom “Convertible preferred equity is optimal”  No threat of bankruptcy for entrepreneurial firm (contrast to debt & interest payments)  Priority for the VC in the event of bankruptcy  Upside potential for the VC  Entrepreneur would not agree unless truly committed to the venture – mitigates adverse selection problems  Provides incentives for the VC to help the firm in bad times (VC a residual claimant in bankruptcy)  Pricing of securities is robust to errors in firm valuation Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 6

© Cumming & Johan (2013)Forms of VC Finance The Conventional Wisdom (Con’t) “Convertible preferred equity is optimal”  Mitigates ‘window-dressing’ problems in staged financing arrangements  Mitigates ‘risk-shifting’ problems  Terms of the contract can be flexible  Incentives for the entrepreneur (terms of conversion less favorable for VC the more successful the firm)  Incentives for the VC (ensure worth converting the securities) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 7

© Cumming & Johan (2013)Forms of VC Finance Detailed Intuition on why Convertible Preferred Equity might be ‘Optimal’ 1.Incentives for investor to add value  Share in profit potential of company  Downside protection for investor in case of bankruptcy 2.Incentives for entrepreneur to work hard  Also share in profit potential  Ownership provided to investor not as great as with common equity  Terms of conversion are graduated, such that conversion for investor worse the better off the performance  E.g., value < 10,000,000  convert 2 preferred for 1 common  E.g., value > 10,000,000  convert 3 preferred for 1 common (better for entrepreneur in this second case) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 8

© Cumming & Johan (2013)Forms of VC Finance Empirical Evidence in U.S. Research Gompers (1998) Harvard University Working Paper  50 venture capital investments from limited partnership funds in US Kaplan and Stromberg (2003) Review of Economic Studies  213 investments from 14 venture capital funds (limited partnerships) in US No industry-wide evidence from the United States Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 9

© Cumming & Johan (2013)Forms of VC Finance Question Does it make sense to use the same form of finance for all different possible types of entrepreneurial firms?! Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 10

© Cumming & Johan (2013)Forms of VC Finance All of these countries show VCs using a variety of forms of finance, not just convertibles Canada – Cumming (2005 Journal of Corporate Finance; 2005 Journal of Business Venturing) Australia – Cumming et al. (2005 Journal of Banking and Finance) Europe – Schwienbacher (2008 Financial Markets and Portfolio Management); Cumming (2008 Review of Financial Studies); Cumming and Johan (2008 European Economic Review), Bascha and Walz (2008 Chapter in Venture Capital in Europe); Parhangkas and Smith (2000 Working Paper) Taiwan – Songtao (2000 Asia & Pacific Finance) Developing Countries – Lerner and Schoar (2005 Quarterly Journal of Economics); Cumming Schmidt and Walz (2013 Journal of Business Venturing) To the best of our knowledge, every country outside the US where data have been collected up to January 2013 shows patterns that are consistent with the Canadian data, not the US data. In no country is convertible preferred equity used most frequently except in the US!!! Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 11

© Cumming & Johan (2013)Forms of VC Finance Empirical Evidence from Canada 12,343 transactions! Source: Macdonald & Associates, Ltd. Observations from all types of venture capital funds (private independent LPs, corporate, government, LSVCC, US VCs financing Canadian entrepreneurs) This is by far the largest and most comprehensive data on security design in VC and PE of any country worldwide where VC or PE data have been collected Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 12

© Cumming & Johan (2013)Forms of VC Finance 13

© Cumming & Johan (2013)Forms of VC Finance 14

© Cumming & Johan (2013)Forms of VC Finance Table Panel A. Private Independent Limited Partnership Venture Capitalists (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)(14) Average Average Year Total ## Inv. Average$Can Invested$ Invested /AverageCapitalNumber Trend Forms of FinanceInvestmentsStart-upExpansionBuyoutTurnaroundHigh-TechSyndicationNewRound #Real 1992 ('000)$ Deal SizeTSX IndexGains Tax(1991=1) Common Preferred Convertible Preferred Preferred and Warrants Convertible Debt Straight Debt and Warrants Straight Debt Warrants Common and Straight Debt Common and Preferred and Debt Preferred and Debt Preferred and Common Common and Warrants Other Combinations Total This table continues on the following page…

© Cumming & Johan (2013)Forms of VC Finance Table (Continued) Panel B. Corporate Venture Capitalists (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)(14) Average Average Year Total ## Inv. Average$Can Invested$ Invested /AverageCapitalNumber Trend Forms of FinanceInvestmentsStart-upExpansionBuyoutTurnaroundHigh-TechSyndicationNewRound #Real 1992 ('000)$ Deal SizeTSX IndexGains Tax(1991=1) Common Preferred Convertible Preferred Preferred and Warrants Convertible Debt Straight Debt and Warrants Straight Debt Warrants Common and Straight Debt Common and Preferred and Debt Preferred and Debt Preferred and Common Common and Warrants Other Combinations Total This table continues on the following page…

© Cumming & Johan (2013)Forms of VC Finance Table (Continued) Panel C. Labour Sponsored Venture Capitalists (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)(14) Average Average Year Total ## Inv. Average$Can Invested$ Invested /AverageCapitalNumber Trend Forms of FinanceInvestmentsStart-upExpansionBuyoutTurnaroundHigh-TechSyndicationNewRound #Real 1992 ('000)$ Deal SizeTSX IndexGains Tax(1991=1) Common Preferred Convertible Preferred Preferred and Warrants Convertible Debt Straight Debt and Warrants Straight Debt Warrants Common and Straight Debt Common and Preferred and Debt Preferred and Debt Preferred and Common Common and Warrants Other Combinations Total This table continues on the following page…

© Cumming & Johan (2013)Forms of VC Finance Table (Continued) Panel D. Government Venture Capitalists (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)(14) Average Average Year Total ## Inv. Average$Can Invested$ Invested /AverageCapitalNumber Trend Forms of FinanceInvestmentsStart-upExpansionBuyoutTurnaroundHigh-TechSyndicationNewRound #Real 1992 ('000)$ Deal SizeTSX IndexGains Tax(1991=1) Common Preferred Convertible Preferred Preferred and Warrants Convertible Debt Straight Debt and Warrants Straight Debt Warrants Common and Straight Debt Common and Preferred and Debt Preferred and Debt Preferred and Common Common and Warrants Other Combinations Total This table continues on the following page…

© Cumming & Johan (2013)Forms of VC Finance Table (Continued) Panel E. US Venture Capitalists (financing Canadian entrepreneurial firms) (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)(14) Average Average Year Total ## Inv. Average$Can Invested$ Invested /AverageCapitalNumber Trend Forms of FinanceInvestmentsStart-upExpansionBuyoutTurnaroundHigh-TechSyndicationNewRound #Real 1992 ('000)$ Deal SizeTSX IndexGains Tax(1991=1) Common Preferred Convertible Preferred Preferred and Warrants Convertible Debt Straight Debt and Warrants Straight Debt Warrants Common and Straight Debt Common and Preferred and Debt Preferred and Debt Preferred and Common Common and Warrants Other Combinations Total This table continues on the following page…

© Cumming & Johan (2013)Forms of VC Finance Table (Continued) Panel F. Institutional Investors (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)(14) Average Average Year Total ## Inv. Average$Can Invested$ Invested /AverageCapitalNumber Trend Forms of FinanceInvestmentsStart-upExpansionBuyoutTurnaroundHigh-TechSyndicationNewRound #Real 1992 ('000)$ Deal SizeTSX IndexGains Tax(1991=1) Common Preferred Convertible Preferred Preferred and Warrants Convertible Debt Straight Debt and Warrants Straight Debt Warrants Common and Straight Debt Common and Preferred and Debt Preferred and Debt Preferred and Common Common and Warrants Other Combinations Total

© Cumming & Johan (2013)Forms of VC Finance Data Summary: Major Puzzles Mix of forms of finance observed is NOT explained by: 1.Type of VC fund 2.Type of entrepreneurial firm 3.Amount invested 4.When invested 5.United States versus Canadian VC funds for Canadian entrepreneurial firms Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 21

© Cumming & Johan (2013)Forms of VC Finance Explanations 1.Not enough U.S. data 2.U.S. venture capitalists are more sophisticated 3.Restrictive covenants on venture capital funds 4.Exit more difficult in Canada 5.U.S. Tax Laws(!) 6.Differences in types of firms financed – agency costs differ by transaction type Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 22

© Cumming & Johan (2013)Forms of VC Finance 1. Enough U.S. Data? Gompers (1998) 50 observations Kaplan and Stromberg (2003) 213 observations Unavailable data on security design from the population of US investments Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 23

© Cumming & Johan (2013)Forms of VC Finance 2. Sophistication? That forms of finance other than convertible preferred equity is used is not de facto evidence of a lack of sophistication Some ‘sophisticated’ U.S. VCs use other forms of finance (based on casual search of U.S. VC web pages) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 24

© Cumming & Johan (2013)Forms of VC Finance Sophistication (Continued) The PricewaterhouseCoopers MoneyTree TM Survey ( of U.S. venture capital financings indicates: “ Debt is very often part of a venture capital deal ” Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 25

© Cumming & Johan (2013)Forms of VC Finance Sophistication (Continued) Benchmark Capital states (see “ At Benchmark Capital, we're focused on one, and only one, mission: to help talented entrepreneurs build great technology companies. That's what drives us and everything we do - from how we organize our firm to our investment strategy Our investment strategy is simple: be the first venture investor in technology companies that seek to create new markets. We focus on early-stage investing and take a labor-intensive, service-oriented approach in markets where we have direct experience. These markets include application services, infrastructure services, Internet retail, Internet services - business, Internet services - consumer, mobile Internet, networking equipment, semiconductor, and software. Minimum investment: $500,000; Maximum investment: $5,000,000 … “ Raising debt funding is a recent phenomenon for venture-backed start-ups and such funding can be a valuable source of capital. To help companies evaluate debt terms, we recently conducted an informal survey of our portfolio companies that summarizes the terms and conditions being offered to venture-backed start-ups. The spreadsheet below [see contains a summary of our findings. ” [Emphasis added.] Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 26

© Cumming & Johan (2013)Forms of VC Finance Sophistication (Continued) St. Paul Venture Capital states ( “ With annual investments placing us among the top 10 venture capital firms in the United States, we have committed more than $1.5 billion to venture capital investments since our founding in 1998 … While the dominant portion of our investing is in early-stage companies, we also invest in more established companies which are showing excellent progress and could benefit from an additional round of private financing. These are often companies with proven business models that are raising funds to finance rapid growth. Or they may be pursuing an acquisition-and-consolidation strategy in an industry burdened with inefficiencies. We also invest selectively in equity securities of middle-market management buyouts. As with our early-stage investments, we bring strategic thinking and financial engineering skills to the relationship, as well as capital. Our involvement is frequently weighted toward the front end in our later stage deals, structuring mutually beneficial multi-party financings and developing equity and debt structures to fit a company's unique circumstances. ” [Emphasis added.] Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 27

© Cumming & Johan (2013)Forms of VC Finance Sophistication (Continued) Northwest Venture Associates states ( “ Northwest Venture Associates ("NWVA") has $190 million under management and is the largest venture capital fund manager focused exclusively on companies headquartered in the Pacific Northwest. The funds were established to provide equity capital and financial guidance to successful, rapidly growing Northwest businesses managed by entrepreneurial, creative and ethical individuals … The preferred size of our investment ranges from $250,000 to $7,500,000, in the form of common or convertible preferred stock. In many cases, we can arrange the balance of your capital needs with investors whose objectives are similar to yours and to ours. We have extensive contacts with other equity funds and syndicates of high net worth individuals. In addition, we can facilitate investments from strategic partners. Our ultimate objective is to earn a rate of return commensurate with the risk we are assuming. Our time frame is roughly five years from the date of our investment in a company. The mechanism for realizing our return may include an initial public offering (IPO), sale or stock repurchase. ” [Emphasis added.] Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 28

© Cumming & Johan (2013)Forms of VC Finance 3. Restrictive Covenants Most U.S. venture capital limited partnerships face restrictive covenants on the types of forms of finance they may use E.g., many are restricted against using debt (e.g., from leveraging up the fund) (see Chapter 5) – The frequency of use of this restriction changes over time, etc. Less of an incentive to use debt when financing entrepreneurs to match the timing of cash flows into and out of a VC or PE fund when the fund itself does not use debt Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 29

© Cumming & Johan (2013)Forms of VC Finance Restrictive Covenants (continued) Canadian data: not just limited partnerships, but also government, hybrid, LSVCCs and corporate VC funds Each faces different types of constraints Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 30

© Cumming & Johan (2013)Forms of VC Finance 4. Exit More Difficult in Canada? Securities regulation: IPOs more costly Fewer strategic acquirers Lots of buybacks Possibly less of a need for equity-type securities(?) **Later on we relate contract choice to exit outcome (Chapters 14, 20 and 21) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 31

© Cumming & Johan (2013)Forms of VC Finance 5. TAX U.S. Tax Law biases the selected form of VC finance in the U.S. (Gilson and Schizer, 2003 Harvard Law Review) These tax biases do not exist in Canada (Sandler, Canadian Tax Journal, 2001) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 32

© Cumming & Johan (2013)Forms of VC Finance Taxation in the US Gilson & Schizer (2003 Harvard Law Review) US VCs + US Entrepreneurs: tax bias Convertible Preferred Equity lowers the value of Entrepreneur’s common shares  lowers the strike price for employee stock options. Tax is deferred until the incentive compensation is sold “Eat em up Preferreds” [!] Suggest (note 51) adverse tax consequences in Canada with preferred dividends, but VC backed entrepreneurial firms typically do not pay significant dividends ($ comes from capital gain upon exit) If adverse tax consequences with preferred dividends, would never expect straight (non-convertible) preferred equity in Canada Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 33

© Cumming & Johan (2013)Forms of VC Finance Taxation in Canada Sandler (2001 Can Tax Journal) No clear perception on how Revenue Canada (IRS equivalent) would treat US Style “Eat em up preferreds” BUT: No Canadian VC uses ConvPrefs more than 50% of the time (Cumming, 2005) Would US VCs try “Eat em up preferreds” in Canada? No pertinent change in tax code in years covered by the data Significant changes in intensity of use of different forms of finance over time  Suggestive that factors other than tax are determinative of capital structure Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 34

© Cumming & Johan (2013)Forms of VC Finance 6. Types of Transactions Different transactions are, yes, different E.g., moral hazard costs may be more problematic among different types of firms E.g., adverse selection problems may be different for other types of firms Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 35

© Cumming & Johan (2013)Forms of VC Finance Agency Problems The degree to which agency costs are pronounced (and therefore the choice of security) depends on: (i.e., NOT the same for every financing transaction!!!)  Entrepreneurial firm development stages  start-up, expansion, buyout, turnaround  Other non-mutually exclusive entrepreneurial firm characteristics  high-tech, # employees, etc.  Type of transaction  staging and/or syndication, capital contribution Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 36

© Cumming & Johan (2013)Forms of VC Finance Principal  Agent Venture Capitalist 1Venture Capitalist 2 Entrepreneur Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 37

© Cumming & Johan (2013)Forms of VC Finance Objective Determine which form of finance may be optimal depending on:  Characteristics of entrepreneurial firm  Characteristics of VC firm(s)  Regulatory environment Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 38

© Cumming & Johan (2013)Forms of VC Finance 1. Buyout Stage Firms The operating management of the entrepreneurial firm acquires a product line, a division, or a company Established firms  Adverse selection costs of debt are less significant relative to earlier stage firms  Syndication unnecessary Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 39

© Cumming & Johan (2013)Forms of VC Finance Buyout (Con’t) Moral Hazard  Effort of entrepreneur is important  Effort of venture capitalist is less important Transparent type of transaction  Staging re monitoring is unnecessary Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 40

© Cumming & Johan (2013)Forms of VC Finance Buyout (Con’t) What form(s) of finance would you expect? Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 41

© Cumming & Johan (2013)Forms of VC Finance 2. Turnaround Stage The entrepreneurial firm is earning less than its cost of capital Established Firm  But risk of a ‘lemon’ is significant (significant adverse selection problems) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 42

© Cumming & Johan (2013)Forms of VC Finance Turnaround (Con’t) Moral Hazard  Effort of both VC and entrepreneur significant Trilateral Bargaining  Risk entrepreneur may give up control of the firm (after contracting with the VC) to an outside third party to lower the firm’s cost of capital Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 43

© Cumming & Johan (2013)Forms of VC Finance Turnaround (Con’t) Which form(s) of finance does this suggest? Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 44

© Cumming & Johan (2013)Forms of VC Finance 3. Start-up Stage The firm may be based on a concept without a product or any marketing, or it may have a product being developed, but not yet sold commercially No track record  Adverse selection problems are significant Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 45

© Cumming & Johan (2013)Forms of VC Finance 4. Expansion Stage The entrepreneurial firm requires significant capital for plant expansion, marketing, and to initiate full commercial production and sales Short track record  Adverse selection significant Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 46

© Cumming & Johan (2013)Forms of VC Finance Start up and Expansion (Con’t) Moral hazard  Effort of both entrepreneur and VC(s) significant  Staging Need for Syndication  Prevent hold-up problems and renegotiation  Maximize growth options with a greater number of suppliers of capital Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 47

© Cumming & Johan (2013)Forms of VC Finance Staged Round 1: VC1 invests in Entrepreneur Staged Round 2: VC1 and VC2 invest in Entrepreneur VC2 invests based on recommendation of VC1 VC1 may “trick” VC2 to invest How to contracts to mitigate this problem?! Consider Agency Problems Among Syndicated VCs: Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 48

© Cumming & Johan (2013)Forms of VC Finance Changing equity ownership percentages and the value of the entrepreneurial firm VC1 50% ENT 25% VC2 25% VC1 50% ENT 45% VC2 5% VC1 increases price paid by VC2,  Decrease ownership of VC2  Increase ownership of ENT  Increase value of Firm  Increase payoff to VC1 !!! Case 1Case 2 Low firm value High firm value, high ENT share 49

© Cumming & Johan (2013)Forms of VC Finance Agency Problems (Continued) Start-up and Expansion VC Contracting objectives: 1.Continue financing positive expected NPV projects after each performance review 2.Limit mispricing of securities between lead (inside) and follow- on (outside) investors 3.Limit misstatement of capital requirements Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 50

© Cumming & Johan (2013)Forms of VC Finance Agency Problems (Continued) Competing explanations for start-up and expansion stage firms: 1.Convertible securities (almost all papers)  Problem: interdependent payoffs may lead inside VC to misstate capital requirements and misprice securities sold to outside VC 2.Fixed-fraction contracts (Admati & Pflederer, 1994 JF)  Problem: not robust to moral hazard costs and/or bankruptcy states 3.Straight Preferred Equity (Cumming, 2005 JBV, 2005 JCF)  “Inside VC” uses straight preferred equity to act as an unbiased intermediary between “outside VC” and the entrepreneurial firm Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 51

© Cumming & Johan (2013)Forms of VC Finance Figure 11.A1 Payoffs to Debt, Preferred Equity and Common Equity* * The relative magnitudes of P (prespecified preferred equity dividends) and D (interest and principal on debt) are arbitrary and may be reversed. Payoff Value of Entrepreneurial Firm Common Equity Debt Preferred Equity D P 52

© Cumming & Johan (2013)Forms of VC Finance Table 11.A1. Syndication Example This table presents a syndication example to highlight the non-robustness of the optimal contract derived by Admati and Pfleiderer (1994). Suppose there are two financing rounds. The first part of the Table provides the amounts invested. The second part of the Table outlines three cases (A – C). For each case, the inside VC 1 knows the salvage value of the firm if there is second-round financing. The outside VC 2 relies on the information provided by VC 1. If second-round investment does not happen then the salvage value of the firm is equal to $10. First-Round FinancingSecond-Round FinancingTotal Amount Invested Amounts invested by the threeVC 1 $50VC 1 $50VC 1 $100 parties for Cases A, B and C.Entrepreneur$50Entrepreneur$0Entrepreneur$50 VC 2 $0VC 2 $50VC 2 $50 Total$100Total$100Total$200 SalvageNet PayoffsSecond-round financing CaseValueVC 1 VC 2 EntrepreneurShould happen?Will happen? A. Fixed-fraction contract with equal priority and no effort-related moral$140($30)$0+ 1 ($30)- 1 Yes hazard costs B. Fixed-fraction contract with equal priority and effort-related moral hazard$120+40ß 2 -$100+.5(120+40ß)-$50+(.5-ß)(120+40ß)-$50+ß(120+40ß)YesNo 3 costs C. Proposed contract with moral hazard VC 1 : Straight Preferred Equity$120+40ß 4 ($30)0($50)Yes VC 2 : Convertible Debt Entrepreneur: Common Equity Notes: 1. The price of second-stage securities must be low enough to provide (a risk neutral) VC 2 with at least 35.7% (50/140) of the firm's equity. 2. Value of the firm itself depends on the entrepreneur's residual claim (ß), and therefore also depends the price of securities issued at the second stage. 3. VC 1 overstates the value of second-stage securities to minimize moral hazard (and VC 2 's share, 1-ß) and maximize the value of the firm. VC 2 will not participate. 4. Moral hazard costs could be normalized to 0 without loss of generality with respect to optimal continuation in case D. The entrepreneur's equity share does not affect VC 1 's payoff in non-bankruptcy states. In bankruptcy states, trilateral bargaining dissuades VC 1 from seeking outside VC 2 participation.

© Cumming & Johan (2013)Forms of VC Finance 5. Other Factors Learning (changes over time) Market conditions (pre- and post-Internet bubble) Sophistication (differences among VCs): Canadian VCs versus US VCs investing in Canadian entrepreneurial firms Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 54

© Cumming & Johan (2013)Forms of VC Finance 6. LSVCC: Canadian Government Funds Registered Retirement Savings Plan eligible investments  Tax incentive for using debt LSVCC Funds worried about the book value of their investments  Debt pays interest Economic issues  Moral hazard  Adverse selection Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 1. Enough US Data? 2. Sophistication 3. Restrictive Covenants 4. Difficulty in Exit 5. Tax 6. Agency Problems 55

© Cumming & Johan (2013)Forms of VC Finance Table Summary of Testable Hypotheses Hypothesis #Explanatory Variables Dominant Expected Agency Problem(s) Predicted Security Alternative or secondary prediction Entrepreneurial Firm Characteristics 11.1BuyoutEntrepreneur as agentDebt VC may have equity stake if expected to provide value-added 11.2TurnaroundTrilateral bargaining Convertible Preferred Equity 11.3, 11.4Start-up (1) Entrepreneur as agent; (2) VC as agent; (3) Agency Problems Between Investors Convertible Preferred Equity for Agency Problems (1) and (2) Straight Preferred Equity for Agency Problem (3) for Start-up 11.3, 11.4Expansion 11.7High-Tech (1) Window dressing (2) Trilateral bargaining Convertible Preferred Equity Less likely to use any form of debt; check robustness with Life Sciences Deal Characteristics 11.5$ Invested / $ Deal Size VC better negotiation position for more equity when larger $ Invested / Deal Size Less Debt for Higher Values Correlated with the syndication; See Hypotheses 11.3,11.4 for Agency Problems Between Investors 11.6Round Number Adverse selection and window dressing problems in earlier rounds Convertible Preferred Equity for Earlier Rounds First round (new) financing: alternative variable used to check robustness 56

© Cumming & Johan (2013)Forms of VC Finance Table Summary of Testable Hypotheses (Continued) Hypothesis #Explanatory Variables Dominant Expected Agency Problem(s) Predicted Security Alternative or secondary prediction VC Characteristics 11.8Limited Partnership VC Greater VC value added; more likely to have at least some equity share Convertible Preferred EquityCommon Equity 11.8Corporate VC Greater VC value added; more likely to have at least some equity share Convertible Preferred Equity Some use of debt, if add less value relative to other VCs 11.8Government VC Less incentive to take equity stakes with upside (ownership) Less ownership equity 11.9LSVCC Incentives to use at least some debt to show book value returns At least some debt 11.11VC Experience using convertible preferred equity as for domestic financings Convertible Preferred Equity Institutional and Market Factors 11.10Capital Gains Tax Rate Higher capital gains tax lowers likelihood of convertible preferred equity (Gilson and Schizer, 2003) Higher values make equity less valuable 11.11Trend (Learning Variable) Expect to converge to convertible preferred equity, as in the 11.12TSX Index Lower index more debt and preferred (downside protection) 57

© Cumming & Johan (2013)Forms of VC Finance Table Multinomial Logit Analyses of Security Choices Panel A. Base Model Regression Estimates Explanatory Variables From Table 11.1: (Hypothesis #): Dominant Predicted Security Straight Preferred Equity Common Equity and/or Warrants Convertible Preferred Equity and/or Preferred and WarrantsStraight Debt Convertible Debt and/or Debt and Warrants Mixes of Debt and Common Mixes of Preferred and Common Other Combinations Constant 0.153***0.387*** **-0.079***-0.051***-0.321*** Entrepreneurial Firm Characteristics Start-up (11.3, 11.4): Convertible Preferred; Straight Preferred 0.024***0.040*** ***-0.029***-0.013*** Buyout(11.1): Debt *-0.054**0.016***0.011** Turnaround (11.2): Convertible Preferred Equity ***0.058*** *** High-Tech (11.7): Convertible Preferred Equity 0.037*** ***-0.079***0.025***-0.024***-0.005*-0.015* Deal Characteristics Round Number (11.6): Convertible Preferred Equity for Earlier Rounds *** ***0.009***-0.004*** *** $ Invested / $ Deal Size (11.5): Less Debt for Higher Values ***0.038***-0.099***0.131***0.021**0.020*** *** VC Characteristics Government VC (11.8): Less ownership equity **0.017*-0.082***0.030***-0.011** LSVCC (11.9): At least some debt *** ** Limited Partnership VC (11.8): Convertible Preferred Equity 0.023***0.029**0.037***-0.083***0.023**-0.020*** Corporate VC (11.8): Convertible Preferred Equity 0.023**-0.084***0.028*** *** VC (11.11): Convertible Preferred Equity 0.055***0.101***0.043***-0.176***-0.122***-0.032** *** Institutional and Market Factors TSX Index (11.12): Lower index, more debt and preferred equity *** ** * *** ** *** Capital Gains Tax Rate (11.10): Lower rate, more convertible preferred *** *** ***0.075**0.315*** Trend (11.11): Higher numbers (later years) more convertible preferred equity ***-0.036*** ***0.009***0.002* *** 58

© Cumming & Johan (2013)Forms of VC Finance Conclusions / Summary Unlike US VCs financing US entrepreneurs, no single unique ‘optimal’ security for Canadian VCs and US VCs financing Canada entrepreneurs Canadian evidence is remarkably similar to the rest of world Possible explanations – Tax bias in US in favor of using convertibles, unlike Canada / elsewhere – Agency problems differ across different transactions  different securities – Market conditions – Learning / Institutional Factors Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 59

© Cumming & Johan (2013)Forms of VC Finance Conclusions / Summary Agency costs differ according to the characteristics of the entrepreneurial firm and the characteristics of the VC(s) From corporate finance we know (review Chapter 2):  Optimal forms of finance depend on agency costs Therefore optimal forms of finance depend on the characteristics of the entrepreneurial firm and the characteristics of the VC(s) Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 60

© Cumming & Johan (2013)Forms of VC Finance Note The form of finance is not the only way to alleviate informational asymmetries and agency problems (moral hazard and adverse selection) across different types of entrepreneurial financing transactions Chapter 12 looks at other contractual terms used in actual venture capital deals in Europe (not US due to tax bias), albeit not as many deals as in the Canadian financing data presented in this Chapter Review of Different Security Properties The Conventional Wisdom Data Explanations for the Data Summary 61