NBER WORKING PAPER SERIES
CHARACTERISTICS, CONTRACTS, AND ACTIONS:
EVIDENCE FROM VENTURE CAPITALIST ANALYSES
Steven N. Kaplan
Per Strömberg
Working Paper 8764
http://www.nber.org/papers/w8764
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
February 2002
A previous version of this paper was entitled “How Do Venture Capitalists Choose and Monitor
Investments?”. We appreciate comments from Douglas Baird, Francesca Cornelli, Mathias Dewatripont,
Douglas Diamond, Paul Gompers, Felda Hardymon, Frederic Martel, Kjell Nyborg, David Scharfstein, Jean
Tirole, and Luigi Zingales, and seminar participants at Columbia, ECARE, the 2001 European Finance
Association meetings, Harvard Business School, HEC, INSEAD, London Business School, McGill,
Michigan, Notre Dame, Purdue, Stockholm School of Economics, Toulouse, University of Chicago,
Washington University, and Yale. This research has been supported by the Kauffman Foundation, by the
Lynde and Harry Bradley Foundation and the Olin Foundation through grants to the Center for the Study of
the Economy and the State, and by the Center For Research in Security Prices. Alejandro Hajdenberg
provided outstanding research assistance. We are grateful to the venture capital partnerships for providing
data. The views expressed herein are those of the authors and not necessarily those of the National Bureau
of Economic Research.
© 2002 by Steven N. Kaplan and Per Str
ö
mberg. All rights reserved. Short sections of text, not to exceed
two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is
given to the source.
Characteristics, Contracts, and Actions:
Evidence from Venture Capitalist Analyses
Steven N. Kaplan and Per Strömberg
NBER Working Paper No. 8764
February 2002
JEL No. G24, G32
ABSTRACT
We study the investment analyses of 67 portfolio investments by 11 venture capital (VC) firms.
VCs consider the attractiveness and risks of the business, management, and deal terms as well as expected
post-investment monitoring. We then consider the relation of the analyses to the contractual terms.
Greater internal and external risks are associated with more VC cash flow rights, VC control rights;
greater internal risk, also with more contingencies for the entrepreneur; and greater complexity, with less
contingent compensation. Finally, expected VC monitoring and support are related to the contracts. We
interpret these results in relation to financial contracting theories.
Steven N. Kaplan Per Strömberg
Graduate School of Business Graduate School of Business
The University of Chicago The University of Chicago
1101 East 58th Street 1101 East 58th Street
Chicago, IL 60637 Chicago, IL 60637
and NBER per.stromberg@gsb.uchicago.edu
steven.kaplan@gsb.uchicago.edu Tel: 773-702-0471
Fax: 773-834-3976
1
There is a large academic literature on the principal agent problem in financial
contracting. This literature focuses on the conflicts of interest between an agent, who is an
entrepreneur with a venture that needs financing, and a principal, who is the investor providing
the funds for the venture. Theory has identified a number of ways that the investor / principal
can mitigate these conflicts. First, the investor can engage in information collection before
deciding whether to invest, in order to screen out ex ante unprofitable projects and bad
entrepreneurs. Second, the investor can engage in information collection and monitoring once
the project is under way. Third, the financial contracts, i.e. the allocation of cash flow and
control rights, between the entrepreneur and investor can be designed to provide incentives for
the entrepreneur to behave optimally.
In this paper, we focus empirically on the information collection process and on the
relation between that process and the ensuing financial contracts. We do so by studying a
sample of venture capital (VC) investments in portfolio companies. To help the VC partnership
evaluate an investment in a company, it is common for the individual venture capitalist who
sponsors the investment to prepare a detailed investment analysis or memorandum for the other
partners. In this paper, we analyze the investment memoranda from 11 VC partnerships for
investments in 67 companies. We complement our analysis with information from the company
business plans, data on the financial contracts from Kaplan and Strömberg (2001), and data on
the subsequent performance of the companies.
While VCs are interesting in their own right, we think they also are interesting
theoretically in that they approximate investors assumed by theorists. VCs invest in
entrepreneurs who need financing to fund a promising venture. Although they are
2
intermediaries, VCs are sophisticated and have strong incentives to maximize value. At the same
time, they receive few or no private benefits of control.
1
Previous works has studied what venture capital partnerships (VCs) do and how they add
value. For example, Gorman and Sahlman (1989), Hellman and Puri (1998 and 2000), and
Lerner (1995) focus primarily on what VCs do after they have invested in a company. Kaplan
and Strömberg (2001) and Gompers (1995) focus on the nature of the financial contracts.
MacMillan, et al. (1985), MacMillan, et al. (1987), and Fried & Hisrich (1994) use evidence
from surveys of VCs to describe the characteristics of VC investments.
We believe this paper makes two contributions. First, it adds to existing work by
describing the characteristics and risks that VCs consider in actual deals. Second, this paper is
novel in considering how those characteristics and risks relate to the financial contracts (cash
flow rights and control rights) and, in turn, how the contracts are related to subsequent
monitoring. We are able to utilize the VCs’ direct assessments rather than the indirect proxies
(for risk and monitoring) used in most previous research.
First, we describe the VC analyses. These analyses include a set of investment theses or
rationales for making the investment and a discussion of the concomitant risks. Consistent with
academic and practitioner accounts, VCs explicitly consider the attractiveness of the opportunity
– the market size, the strategy, the technology, customer adoption, and competition – the
management team, and the deal terms.
2
VCs also explicitly delineate the risks involved in the
investments. The risks typically relate to the same characteristics that the VCs evaluate for
attractiveness.
1
See Hart (2001) for a concurring view.
2
See the work previously cited as well as Bygrave and Timmons (1992) or Quindlen (2000).
3
Next, we present direct evidence on VC actions or monitoring. We rely on the
investment analyses at the time of the initial investment that describe actions that the VCs took
before investing and that the VCs expect to undertake conditional on investing. We confirm that
VCs play a significant role in shaping and recruiting the senior management team. In at least
half of the investments, the VC expects to play an important role in recruiting management. We
also find that in more than one-third of the investments, the VC expects to provide value-added
services such as strategic advice or customer introductions. Because the investment memoranda
vary in the detail they provide, these results likely understate the VCs’ activities in this area.
These results support and complement the results in Hellman and Puri (2000 and 2002).
We then consider how the assessments in the VCs’ analyses interact with the design of
the financial contracts. We focus on the risks or uncertainties identified by the VCs in each
transaction, dividing them into risks that are: (1) associated with external uncertainty – the
relevant information is external to the firm and, we argue it is more likely that the VC and the
entrepreneur are equally informed; (2) associated with internal uncertainty – the relevant
information is internal to the firm and, we argue it is more likely that the VC is less informed
than the entrepreneur; and (3) associated with complexity. Greater external and internal risks are
associated with more VC ownership, more VC control, and more contingent compensation.
Greater internal risk is also associated with more contingent financing. Greater complexity is
associated with less contingent compensation. We interpret these results in relation to financial
contracting theories. For example, the relations between internal and external risk and control
are strongly consistent with the model in Dessein (2001). Similarly, the result for complexity
risk is consistent with theories like Holmstrom and Milgrom (1991) that focus on the use of
incentives in the presence of multiple objectives.
