Conservatism and Innovation in Venture Capital Contracting

The imbalance in the supply and demand of venture capital of the past few years has led parties to look for new escape routes from the industry. There is the ‘survival of the fittest’ evidence that the number of active venture capital funds have significantly declined over the last five years. Other venture capital firms, hoping for a better future, are extending the duration of their funds. Only high quality funds seem to have a reasonable chance of receiving continuous funding for their activities. Under the circumstances, institutional investors are taking an active approach to the management of funds, evidenced by the inclusion of investor favorable terms and conditions in limited partnership agreements.  The increased attention paid to investor favorable provisions has highlighted  the weakened bargaining position of fund managers, and their new willingness to make capital contributions to their own funds.

With large pension funds and other institutional investors having abandoned the VC industry, attention is shifting from principle-agency based contractual mechanisms to a new pattern of fundraising that allows investors and fund managers to bring more value to the traditional venture capital model. Should investors in funds become more actively involved in the investment process and due diligence activities and provide direct advice to start-up companies? There are some funds that are proponents of this approach, seeking to build relationships that lead to joint development of new products. In this paper, Erik Vermeulen and I offer an analysis of the new trend toward a joint venture capital model that promises to have a disruptive effect on the traditional, but often underperforming, traditional venture capital model.

In our new paper, Conservatism and Innovation in Venture Capital Contracting, we conjecture that venture capitalists and their investors often fall prey to what is known as ‘collective conservatism.’  We investigate this conjecture by analyzing boilerplate provisions in limited partnership agreements. When investors accept suboptimal boilerplate provisions it is not because they believe that the standardized terms and conditions sufficiently align the interests of investors and fund managers, but merely because they think their peers, including their competitors, prefer to include them in the limited partnership agreement. We find that the financial crisis has facilitated some notable deviations in the boilerplate provisions that are aimed at returning confidence in the venture capital industry. We argue that a gradual shift may be taking place towards more investor-favorable limited partnership agreements or separate accounts and pledge funds arrangements. These shifts – which do not lead to significant changes in the limited partnership agreements – appear to be particularly effective for bigger funds that increasingly focus on later stage investments. We show that early stage funds are more inclined to enter into innovative collaborative agreements. Collaborative agreements differ from the traditional limited partnership agreements in that they focus less on curtailing principal agent problems and more on joint development and value creation.

The full paper is available here.