1. © Cumming & Johan (2013)Forms of VC Finance Venture Capital Contracts in Detail Cumming & Johan (2013, Chapter 12) 1

2. © Cumming & Johan (2013)Forms of VC Finance Evidence on Terms Used in US Venture Capital Contracts Review of US VC Contracts Preplanned Exits Data Summary Kaplan and Stromberg (2003 Review of Economic Studies) “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Financial Contracts” 2

3. © Cumming & Johan (2013)Forms of VC Finance Contingencies in Contracts Review of US VC Contracts Preplanned Exits Data Summary 4 main types: 1.Contract contingent on financial measures of performance 2.Contract contingent on non-financial measures of performance 3.Contract contingent on certain actions taken 4.Contract contingent on sale of securities 3

4. © Cumming & Johan (2013)Forms of VC Finance 1. Financial Measures Review of US VC Contracts Preplanned Exits Data Summary Examples: Employee shares vest if revenue goal attained VC can only vote for all owned shares if realized EBIT below threshold value, in which case VC gets voting control VC dividend on preferred shares, payable in common stock, is suspended if revenue and operating profit goals attained If net worth below threshold, VC will get 3 more board seats Exercise price on warrants is fraction of net worth: 50% of net worth/share for first 3 years, then 100% of net worth/share VC warrants expire if revenue goal attained Committed round of financing contingent on no material deviation from business plan 4

5. © Cumming & Johan (2013)Forms of VC Finance 2. Non-Financial Measures Review of US VC Contracts Preplanned Exits Data Summary Examples: Committed round of financing contingent on no material deviation from non- financial aspects of business plan Employee shares vest when company secures threshold number of customers who have purchased the product and give positive feedback Employee shares vest with release of second major version of the product that incorporates significant new functionality Founder shares vest contingent on FDA approval of new drug Founder shares vest contingent on new corporate partnership found Founder shares vest contingent on approved patents Founder loses voting rights for shares if terminated for cause Committed funding paid out when new clinical tests completed Committed funding paid out when new strategic partnership found 5

6. © Cumming & Johan (2013)Forms of VC Finance 3. Certain Actions Taken Review of US VC Contracts Preplanned Exits Data Summary Examples: Committed funding paid out subject to new business plan for entering new markets completed and approved by board Vesting of shares contingent on hiring new key executives Committed funding paid out subject to hiring new key executives or CEO Committed funding paid out subject to developing new facilities 6

7. © Cumming & Johan (2013)Forms of VC Finance 4. Sale of Securities Review of US VC Contracts Preplanned Exits Data Summary Examples: Founder ownership increasing non-linear function of share price obtained in sale or IPO Founder vesting accelerates upon sale or IPO of certain minimum value Cumulative dividend (in cash or stock) suspended upon sale or IPO of certain minimum value Conversion price of VC convertibles higher if company completes sale of new securities where proceeds exceed minimum amount VC warrants expire if company manages to raise alternative funds where proceeds and price of securities exceed threshold VC warrants expire upon IPO of minimum value Committed funding paid out when vendor financing agreements secured Committed funding paid out when new construction loans are secured VC dividend on preferred shares, payable in common stock, is suspended if company manages to raise certain amount of new funding above minimum price per share 7

8. © Cumming & Johan (2013)Forms of VC Finance US Data Review of US VC Contracts Preplanned Exits Data Summary 213 observations from U.S. limited partnerships Specific contractual details introduced here that have previously been ‘unknown’ outside the venture capital funds themselves 8

9. © Cumming & Johan (2013)Forms of VC Finance Main Results in US data Review of US VC Contracts Preplanned Exits Data Summary 1.VCs separately allocate cash flow rights, voting rights, board rights, liquidation rights, and other control rights 2.Convertible preferred equity is used ** and remember the US tax bias (Gilson and Schizer 2003 Harvard Law Review) and the fact that convertibles are not used most frequently in any other country where data have been collected (Chapter 11) 9

10. © Cumming & Johan (2013)Forms of VC Finance Main Results in US data (Continued) Review of US VC Contracts Preplanned Exits Data Summary 3. Cash flow rights, voting rights, control rights, and future financings are frequently contingent on observable measures of financial and non-financial performance 10

11. © Cumming & Johan (2013)Forms of VC Finance Main Results in US data (Continued) Review of US VC Contracts Preplanned Exits Data Summary 4. If the company performs poorly, the VCs retain control. As the company performance improves, the entrepreneur retains / obtains more control rights. If the company performs very well, the VCs retain their their cash flow rights, but relinquish their control and liquidation rights. The entrepreneurs cash flow rights increase with firm performance. 11

12. © Cumming & Johan (2013)Forms of VC Finance Main Results in US data (Continued) Review of US VC Contracts Preplanned Exits Data Summary 5. It is common for VCs to include non- compete and vesting provisions aimed at mitigating the potential hold-up problem between the entrepreneur and the investor 12

13. © Cumming & Johan (2013)Forms of VC Finance Preplanned Exits Review of US VC Contracts Preplanned Exits Data Summary What is a preplanned exit? Focus of Chapter 12 13

14. © Cumming & Johan (2013)Forms of VC Finance Why might preplanned exits affect contracts? Review of US VC Contracts Preplanned Exits Data Summary Entrepreneurs have a non-pecuniary preference for IPO over acquisition VCs only care about $ 14

15. © Cumming & Johan (2013)Forms of VC Finance Prediction Review of US VC Contracts Preplanned Exits Data Summary Preplanned acquisition  greater VC control at time of contract Chapter 21 considers a similar prediction – Greater VC control  actual acquisition 3-4 years later – Weak VC control  IPO or write-off? 15

16. © Cumming & Johan (2013)Forms of VC Finance Bargaining Power and VC Contracts Review of US VC Contracts Preplanned Exits Data Summary VCs with bargaining power – Convertibles and strong VC control rights Entrepreneurs with bargaining power – Common equity and weak VC control rights 16

17. © Cumming & Johan (2013)Forms of VC Finance Law Quality and VC Contracts Review of US VC Contracts Preplanned Exits Data Summary Law substitute or complement? Some conflicting evidence depends on dataset used – Lerner and Schoar (2005 QJE) – Kaplan et al. (2007 JFI) – More on this issue in Chapter 13 17

18. © Cumming & Johan (2013)Forms of VC Finance Data in Chapter 12 Review of US VC Contracts Preplanned Exits Data Summary 35 VC funds 11 European countries 223 Investee firms 1995-2002 investments 1996-2005 exits 18

19. © Cumming & Johan (2013)Forms of VC Finance 19

20. © Cumming & Johan (2013)Forms of VC Finance Figure 12.2. Preplanned IPOs and Acquisitions by Year of Investment 0 2 4 6 8 10 12 14 16 19951996199719981999200020012002 Year Number of Entrepreneurial Firms Preplanned IPOsPreplanned Acquisitions 20

21. © Cumming & Johan (2013)Forms of VC Finance Table 12.3. Relationships between Preplanned Exits and Actual Exits This table presents the relationship between preplanned exits at the time of first investment (including investments for which there was no clearly defined exit strategy in terms of seeking an IPO or acquisition at the time of first investment), and the actual exit as at 2005. Preplanned Exits Preplaned IPO Preplanned Acquisition No Preplanned Exit at Time of First Investment Total Actual Exits IPO612532 Acquisition5274274 Buyback021517 Write-off595064 No Exit962136 Total2545153223 21

22. Table 12.6. Regression Analyses of Sum of Veto and Control Rights For full table, see Cumming and Johan 2013 Chapter 12 LHS Variable = Sum of Veto RightsLHS Variable = Sum of Control Rights Model 1Model 2Model 3Model 4Model 5Model 6Model 7Model 8Model 9Model 10 Constant - 7.578*** -7.530* - 10.018** -9.148* - 12.600** - 5.703*** -2.5740.5492.0734.365 Preplanned Exit Strategy Preplanned Acquisition0.522**0.681***0.555**0.689***0.974***0.662***0.877***0.884***1.083***1.282*** Preplanned IPO -0.219-0.208-0.451 0.1350.2100.053 Legal and Economic Environment Log (Legality)2.787*** 2.265*** Log (GNP Per Capita) 0.850**1.147**1.055*1.294** 0.3810.3650.211-0.098 German Legal Origin -0.393*-0.040-0.0740.246 - 0.501*** -0.503**-0.566**-0.112 Socialist Legal Origin 0.2871.481**1.556**2.788*** -0.016-0.146-0.1600.229 Scandinavian Legal Origin -0.989**-1.141** - 1.252*** -0.622 -0.1380.1920.0680.836* Investor and Investee Variables Captive Investor 0.892***0.965***1.414*** -0.221-0.219-0.257 Log (Capital Managed (‘000) / Manager) 0.1280.1480.156 -0.052-0.0330.037 Log (Industry Market / Book) -0.469*-0.464*-0.179 -0.056-0.0450.084 Log (Book Value) -0.129*-0.136*-0.152 - 0.182*** - 0.189*** -0.289*** Early Stage Investee - 0.857*** - 0.830*** -0.328*-0.319 Entrepreneur Experience 0.0180.0300.034 -0.088**-0.074*-0.022 22

23. Table 12.7. Regression Analyses of Specific Veto and Control Rights For full table, see Cumming and Johan 2013 Chapter 12 Model 11: Replace CEO Model 12: First Refusal Model 13: Co- Sale Model 14: Anti- Dilution Model 15: Drag Along Model 16: Redempti on Model 17: Prot Against Issues Model 18: Veto Asset Sale Model 19: Veto Asset Purchase s Model 20: Veto Change Control Model 21: Veto Issue Equity Constant-6.777***-2.820-4.068-0.709-1.028-0.601-2.4030.4260.6330.741-3.452** Preplanned Exit Strategy Preplanned Acquisition0.282**0.199**0.447***0.485***0.057*0.139*** 0.262** * 0.226** * 0.203** * 0.148**0.077 Preplanned IPO-0.0340.1740.223-0.015-0.149**0.015-0.0030.0050.021-0.064-0.193 Legal and Economic Log (GNP Per Capita)0.682***0.2340.541*0.1150.1360.0610.379*-0.007-0.057-0.1540.335* German Legal Origin-0.123 -0.247-0.113**0.080 - 0.068*** -0.306**0.0350.0310.048-0.132 Socialist Legal Origin 0.402** * -0.949-0.6380.411-0.355 0.291** * 0.1710.1470.122 0.196** * Scandinavian Legal Origin-0.163 0.701-0.0880.029-0.001-0.319*-0.444**-0.414**-0.209 - 0.699** * Investor and Investee Captive Investor-0.1060.0050.269**-0.0360.017-0.0050.086 0.191** * 0.181**0.172** 0.405** * Log (Capital Managed (‘000) / Manager) 0.106**0.0250.812-0.026-0.0030.002-0.088**0.0340.049 0.133** * 0.013 Log (Industry Market / Book)-0.1820.051-0.2370.123*-0.00020.048*0.096-0.147-0.178*-0.025-0.037 Log (Book Value)-0.062*-0.022 - 0.177*** -0.007-0.016-0.002-0.019-0.033-0.013-0.0420.023 Early Stage Investee-0.323***0.210** - 0.423*** -0.080-0.152*-0.045*-0.172** - 0.253** * - 0.198** * -0.163** - 0.147** * Entrepreneur Experience-0.0290.0310.446-0.020 - 0.053** * -0.006-0.0160.0100.0090.0110.012 23

24. Table 12.8. Regression Analyses of Security Design For full table, see Cumming and Johan 2013 Chapter 12 LHS Variable = Common EquityLHS Variable = Convertible Preferred Equity Model 22Model 23Model 24Model 25Model 26Model 27Model 28Model 29Model 30Model 31 Constant0.1114.406-1.023-0.2595.2212.757***1.0692.6500.8331.322 Year of Investment Dummy Variables? No Yes No Yes Preplanned Exit Strategy Preplanned Acquisition - 0.226*** - 0.315*** - 0.328*** - 0.336*** - 0.353*** 0.188**0.143*0.184*0.136**0.301* Preplanned IPO-0.036-0.077-0.0870.0980.1130.220 Legal and Economic Environment Log (Legality)-0.039 - 0.989*** Log (GNP Per Capita)-0.4380.043-0.041-0.437-0.137-0.314-0.105-0.256 German Legal Origin0.196*0.1520.1760.1040.1180.1400.0500.002 Socialist Legal Origin - 0.581*** - 0.417*** - 0.457*** - 0.659*** 0.467**0.3870.554*0.692*** Scandinavian Legal Origin-0.113-0.166-0.126-0.343**0.362**0.495***0.348**0.579*** Investor and Investee Variables Captive Investor0.0050.0240.001-0.067-0.046-0.152 Log (Capital Managed (‘000) / Manager) -0.123** - 0.143*** - 0.255***.090**0.056**0.163** Log (Industry Market / Book)0.0400.031-0.120-0.113-0.0600.029 Log (Book Value)0.131***0.126***0.241***-0.054-0.025-0.072 Early Stage Investee0.188*0.223**.185**7.09E-02 Entrepreneur Experience0.092***0.099***0.051-0.046**-0.029**-0.065** 24

25. © Cumming & Johan (2013)Forms of VC Finance Summary Review of US VC Contracts Preplanned Exits Data Summary 1.Preplanned acquisition exits are associated with stronger investor veto and control rights, and a greater probability that convertible securities will be used, and a lower probability that common equity will be used; the converse is observed for preplanned IPOs. 2.Investors take fewer control and veto rights and use common equity in countries of German legal origin, relative to Socialist, Scandinavian and French legal origin. 3.More experienced entrepreneurs are more likely to get financed with common equity and less likely to be financed with convertible preferred equity, while more experienced investors are more likely to use convertible preferred equity and less likely to use common equity. 25