1. © Cumming & Johan (2013)Forms of VC Finance Legal Conditions and Venture Capital Governance Cumming & Johan (2013, Chapter 13) 1

2. © Cumming & Johan (2013)Forms of VC Finance Issues Addressed in this Chapter Introduction Evidence Conclusion What drives corporate governance structures in VC finance? How do different legal and institutional frameworks in different countries affect international differences in corporate governance structures? Three dimensions: – time from fundraising to deal origination – syndication and co-investment – board seats and security choice 2

3. © Cumming & Johan (2013)Forms of VC Finance Prior work Introduction Evidence Conclusion Law and Finance – La Porta et al. (1997; 1998); Berkowitz et al. (2003) Venture Capital meets Law and Finance – VC Contracts: Gilson and Schizer (2003); Kapland Stromberg (203,2005); Lerner and Schoar (2005); Cumming and Johan (2006); – VC Exits: Black and Gilson (1998); Schleifer /Wolfenzon (2002); Cumming et al. (2006 ); Bienz/Walz (2007) – Size of VC Markets Jeng and Wells (2000); Armour and Cumming (2006 ) – Public policy Keuchnigg/Nielsen (2001, 2003, 2004) – Datasets not large (200 or so observations) due to private nature of VC data 3

4. © Cumming & Johan (2013)Forms of VC Finance New Insights in this Chapter Introduction Evidence Conclusion Complementary Elements of Legal Conditions and VC Governance Worldwide: – Screening – Syndication – Co-investment – Board Seats – Functional Definition of Security Data – 3838 VC - backed companies – 39 countries, developed and developing, worldwide – Extensive confidential details not previously studied 4

5. © Cumming & Johan (2013)Forms of VC Finance Law and Venture Capital Governance Introduction Evidence Conclusion Law quality facilitates – Deal screening time – Syndication – Effectiveness of boards Law quality mitigates – Co-investment – Securities requiring periodic cash flows pre-exit How to measure law quality – Legality (Berkowitz et al.’s weighted average of La Porta et al.’s indices) – Legal Origin versus Country Dummy Variables 5

6. © Cumming & Johan (2013)Forms of VC Finance Data Introduction Evidence Conclusion 3838 VC - backed companies 39 countries, developed and developing, worldwide Source: CEPRES, Germany Partnership among practitioners worldwide to improve data quality for decision making in private equity Extensive confidential details not previously studied Little expected sample bias – Good and poor performing investments – Exited and un-exited investments – Matches profile of VC investments across countries and across time 6

7. © Cumming & Johan (2013)Forms of VC Finance Time to Deal Origination Introduction Evidence Conclusion Time from starting the VC fund until the first-round lead investment Not previously studied in any single or multiple country study Hazard models Legality index from 20 to 21 (e.g. France versus US) lowers the time until lead first investment by 12% Legality index from 10 to 11 (e.g. Philippines versus Indonesia) lowers the time until lead first investment by 24% Faster time to deal origination in common law countries by approx. 30% 7 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security

8. © Cumming & Johan (2013)Forms of VC Finance Time to Deal Origination Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security # Ent Firms Average Duration (Holding Period in Days) until First Investment Difference Test (means) Median Duration (Holding Period in Days) until First Investment Difference Test (medians) Legality Index > 20.5 2052 718.762 -8.479*** 469 p <= 1.21e-08*** Legality Index < 20.5 1140 1042.399660 8

9. © Cumming & Johan (2013)Forms of VC Finance Time to 1 st Lead InvestmentModel (1): AllModel (3): AllModel (7): EarlyModel (9): Early Market and Legal Factors Log (1+ MSCI Return at Inv Date)2.193***2.407***2.312**0.494*** Log (Committed Capital Overall Market at Inv Date) -0.538***-0.648***-0.454***-0.047 Log (Legality Index)2.298** 2.728*** Log (GNP Per Capita) 0.714*** 0.705*** French Legal Origin Dummy -0.252*** -0.360*** Germany Legal Origin Dummy -0.080 -0.280** Scandinavian Legal Origin Dummy -0.702** -0.611** VC Fund Characteristics Log (Fund Manager Experience)-0.044-0.053-0.115**-0.188*** Log (Fund Vintage Date)-1.604***-1.671***-1.635*** log (Fund Capital / General Partner)-0.083* -0.018 Entrepreneurial Firm Characteristics Seed Stage0.475***0.669***0.439***0.837*** Start-up Stage0.1480.282*0.1950.282* Early Stage-0.055-0.025 Expansion Stage-0.0630.081 Log (Industry Market / Book)0.428***0.342***0.403***0.535*** Model Diagnostics Total Number of Observations2284315910911298 Pseudo R 2 0.0530.0600.0510.020 Industry, Year, Country, VC firm dummies included Table 13.4 9

10. © Cumming & Johan (2013)Forms of VC Finance Syndication and Co-Investment Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Syndication – Typically ‘Good’ – Decision making, value-added, 2 heads better than 1 – Legality 20 to 21: increases the probability of syndication by 3.8% – Legality 10 to 11: increases the probability of syndication by 5.5% – Legal origin ambiguous effect Co-Investment – Typically ‘Bad’ – One VC fund bails out bad investments of prior VC fund from the same VC organization – Legality 20 to 21: reduces probability of co-investment by 1.8% – Legality 10 to 11: reduces the probability of co-investment by 3.5% – Legal origin ambiguous effect 10

11. © Cumming & Johan (2013)Forms of VC Finance Syndication and Co-Investment Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security # Ent Firms Proportion of Syndicated Investments Difference Test # Ent Firms Proportion of Co- Investments Difference Test Legality Index > 20.513030.413 -0.848 1875 0.167 -4.650*** Legality Index < 20.58480.432 930 0.270 11

12. © Cumming & Johan (2013)Forms of VC Finance Syndication and Co-Investment Model (13): Syndication Model (15): Syndication Model (19): Co-Investment Model (21): Co-Investment Constant-2.239***-1.847***-0.873*-1.012** Market and Legal Factors Log (1+ MSCI Return at Inv Date)0.028-0.007-0.104**-0.069 Log (Committed Capital Overall Market at Inv Date)0.118***0.124***0.085***0.081*** Log (Legality Index)0.577** -0.369*** Log (GNP Per Capita) 0.115**-0.093*** French Legal Origin Dummy 0.218***-0.005 Germany Legal Origin Dummy 0.0210.105* Scandinavian Legal Origin Dummy 0.069-0.056 VC Fund Characteristics Log (Fund Manager Experience)-0.129***-0.125***0.028*** Log (Fund Age at First Investment since Fundraising)-0.012**-0.013**-0.016*** Log (Fund Vintage Date)-0.100***-0.086***0.120***0.115*** Log (VC Firm Age) Entrepreneurial Firm Characteristics Seed Stage0.174***0.190*** Start-up Stage Early Stage0.140***0.147***0.002-0.005 Expansion Stage-0.065**-0.062*0.0170.008 Log (Industry Market / Book)0.125***0.118***0.047***0.056*** Investment Characteristics Log (Amount Invested)-0.006-0.005-0.002 Sample Selectivity Correction Model Diagnostics Total Number of Observations3176315931763159 Pseudo R 2 0.2120.2140.2660.271 Industry, Year, Country, VC firm dummies included Table 13.5 12

13. © Cumming & Johan (2013)Forms of VC Finance Board Seats and Functional Security Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Board seats – VC board representation more important than that of other investors (Gompers and Lerner 1999 MIT Press) – Legality 20 to 21: increases the probability of board seats by 4.2% – Legality 10 to 11: increases the probability of board seats by 8.1% Functional security – Security mandates periodic cash flows paid back to the investor prior to an exit event – Not previously considered in any VC study for single and/or multiple countries – Legality ambiguous effect – English legal origin approx 16% less likely to require periodic cash flows 13

14. © Cumming & Johan (2013)Forms of VC Finance Board Seats and Functional Security Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security # Ent Firms Proportion of Investments with Board Seats Difference Test # Ent Firms Proportion of Investments with Periodic Cash Flows Difference Test Legality Index > 20.5 8280.722 -0.240 20520.335 -5.072*** Legality Index < 20.5 3780.728 11400.429 14

15. © Cumming & Johan (2013)Forms of VC Finance Control and Cash Flow Rights Model (25) Board Seats Model (27) Board Seats Model (31) Conv- ertible Security Model (33) Conv- ertible Sectrity Constant-1.798**-3.797***-2.121***-2.595*** Market and Legal Factors Log (1+ MSCI Return at Inv Date)0.0960.0740.257***0.079 Log (Committed Capital Overall Market at Inv Date)0.050***0.049***0.0180.043** Log (Legality Index)0.852*** -0.098 Log (GNP Per Capita) 0.446*** 0.022 French Legal Origin Dummy 0.133*** 0.160*** Germany Legal Origin Dummy -0.058* -0.023 Scandinavian Legal Origin Dummy -0.224** 0.188* VC Fund Characteristics Log (Fund Manager Experience)-0.119***-0.113***-0.046***0.024 Log (Fund Age at First Investment since Fundraising)-0.004-0.005-0.016***-0.029*** Log (Fund Vintage Date)-0.140***-0.127***0.224***0.184*** log (Fund Capital / General Partner) -0.043*** Entrepreneurial Firm Characteristics Seed Stage0.290***0.282***-0.110***-0.135*** Start-up Stage-0.263***-0.252***-0.236***-0.142*** Early Stage0.186***0.182***-0.191***-0.124*** Expansion Stage0.091***0.090***0.0090.024 Log (Industry Market / Book)0.205***0.200***-0.115***-0.126*** Investment Characteristics Lead Investor0.296***0.280***0.125***0.093*** Log (Amount Invested)-0.055***-0.053***0.042***0.055*** Sample Selectivity Correction Model Diagnostics Total Number of Observations3176315931762267 Pseudo R 2 0.321 0.2070.195 Industry, Year, Country, VC firm dummies included Table 13.6 15

16. © Cumming & Johan (2013)Forms of VC Finance Robustness Checks Introduction Evidence Conclusion Country dummy variables for English, US, France, German versus legal origin Alternative explanatory variables – Market conditions, e.g., MSCI, VC capital in market – VC fund characteristics – Entrepreneurial firm characteristics – Transaction characteristics Exclusion of certain countries – e.g., exclude developed countries Exclusion of different years – e.g., exclude all years prior to 1995 16

17. © Cumming & Johan (2013)Forms of VC Finance Related Evidence Introduction Evidence Conclusion Chapter 22 Better legal standards  higher VC/PE returns Better legal and accounting standards  less likely to observe inflated values of unexited investees reported to institutional investors prior to exit Based on data from 39 countries around the world >5000 transactions 17

18. © Cumming & Johan (2013)Forms of VC Finance Concluding Remarks Introduction Evidence Conclusion Law quality facilitates – Deal screening time – Syndication – Effectiveness of boards Law quality mitigates – Co-investment – Securities requiring periodic cash flows pre-exit (in conjunction with high-tech investment) Legality has a more pronounced effect on emerging markets Effective VC investment will continue to lag behind in emerging countries whilst legal quality remains deficient 18