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
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