Compensation Provisions in a Venture Capital-Limited Partner (VC-LP) Contract : A Theoretical Framework

Authors

  •   Sarita Mishra Research Scholar, School of Management, National Institute of Technology, Rourkela - 769 008, Odisha
  •   Dinabandhu Bag Faculty, School of Management, National Institute of Technology, Rourkela - 769 008, Odisha

DOI:

https://doi.org/10.17010/ijf/2016/v10i5/92949

Keywords:

Venture Capitalist Compensation

, VC Contract, Principal-Agent Model, Contractual Covenants, Limited Partner

G23

, G24, G31

Paper Submission Date

, June 7, 2015, Paper sent back for Revision, February 15, 2016, Paper Acceptance Date, March 9, 2016.

Abstract

In a venture capital (VC) deal, a partnership contract is designed to avoid different conflicts arising due to information asymmetry and agency problem and to make appropriate provision for compensation. This study investigated different theoretical approaches that have been deployed to understand this phenomenon. This article extracted the important aspects of the compensation structure and covenants required to set in the contract between venture capitalists and their limited partner (LP) in order to meet the agreed-upon proportion of return distribution and proposed a VC compensation model. Various studies were analyzed to get evidence on various aspects of a VC deal, such as the reasons why professional VCs exist, and factors that determine the design of a contract. Private ownership, information asymmetry, and illiquidity associated with a VC investment are key explanatory factors, which make VC - LP partnership agreement different from other financial contracts. The findings of this study could be alienated into two constituents. First, the compensation that a VC receives from its LP is performance based, which varies according to the size of the fund, experience of VC, past performance of VC, and signalling function. Second, some important covenants are generally mentioned in such a contract during raising funds for investments, though these are heterogeneous in each deal and their contribution in compensation allocation varies with each deal. In this study, we have proposed a compensation model for venture capitalists as a general partner by their limited partner, which is based on a principal-agent model. Also, this study focuses on contractual covenants, which are responsible for imparting flexible incentive provision and provide control over VC activity. The arrangement of VC compensation and covenants depend upon the management support and effort of VCs. This study can contribute to resolving the conflicts - between venture capitalists and their investors - that arise due to the agency problem and bring to light the compensation arrangement and provision of covenants used in the contract between VCs and their LPs.

Downloads

Download data is not yet available.

Downloads

Published

2016-05-01

How to Cite

Mishra, S., & Bag, D. (2016). Compensation Provisions in a Venture Capital-Limited Partner (VC-LP) Contract : A Theoretical Framework. Indian Journal of Finance, 10(5), 50–61. https://doi.org/10.17010/ijf/2016/v10i5/92949

Issue

Volume 10, Issue 5, May 2016

Section

Articles
Crossref
Scopus
Google Scholar
Europe PMC

References

Admati, A. R., & Pfleiderer, P. (1994). Robust financial contracting and the role of venture capitalists. The Journal of Finance, 49 (2), 371-402. DOI: 10.1111/j.1540-6261.1994.tb05146.x

Axelson, U., Strömberg, P., & Weisbach, M. S. (2009). Why are buyouts levered? The financial structure of private equity funds. The Journal of Finance, 64 (4), 1549-1582. DOI: 10.1111/j.1540-6261.2009.01473.x

Braun, R., & Schmidt, M. (2014). The limited partnership model in private equity: Deal returns over a fund's life. DOI : http://dx.doi.org/10.2139/ssrn.2411044

Caselli, S., Garcia-Appendini, E., & Ippolito, F. (2013). Contracts and returns in private equity investments. Journal of Financial Intermediation, 22 (2), 201-217. doi:10.1016/j.jfi.2012.08.002

Chung, J. - W., Sensoy, B. A., Stern, L., & Weisbach, M. S. (2012). Pay for performance from future fund flows: The case of private equity. Review of Financial Studies, 25 (11), 3259-3304

Covitz, D., & Liang, N. (2002). Recent developments in the private equity market and the role of preferred returns. Washington, D. C. : Division of Research and Statistics Board of Governors of the Federal Reserve System.

Da Rin, M., Hellmann, T.F., & Puri, M. (2011). A survey of venture capital research (NBER Working Paper No. 17523). Retrieved from http://www.nber.org/papers/w17523

Fama, E. F. (1980). Agency problems and the theory of the firm. The Journal of Political Economy, 88 (2), 288-307.

Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. The Journal of Law & Economics, 26 (2), 301-325.

Gilson, R. J., & Schizer, D. M. (2003). Understanding venture capital structure: A tax explanation for convertible preferred stock. Harvard Law Review, 116 (3), 874-916.

Gompers, P., & Lerner, J. (1996). Use of covenants: An empirical analysis of venture partnership agreements. Journal of Law and Economics, 39(2), 463-498.

Gompers, P., & Lerner, J. (1999). An analysis of compensation in the U.S. venture capital partnership. Journal of Financial Economics, 51(1), 3-44.

Gompers, P., & Lerner, J. (2000). Money chasing deals? The impact of fund inflows on private equity valuation. Journal of Financial Economics, 55 (2), 281-325.

Gompers, P., & Lerner, J. (2001). The venture capital revolution. The Journal of Economic Perspectives, 15 (2), 145-168.

Hart, O., (2001). Financial contracting. Journal of Economic Literature, 34 (4), 1079 -1100.

Holmstrom, B., & Milgrom, P. (1991). Multitask principal-agent analyses: Incentive contracts, asset ownership, and job design. Journal of Law, Economics, & Organization, 7 (Special Issue : Papers from the Conference on the New Science of Organization), 24-52.

Kaplan, S. N., & Strömberg, P. (2003). Financial contracting theory meets the real world : An empirical analysis of venture capital contracts. The Review of Economic Studies, 70 (2), 281-315. doi: 10.1111/1467-937X.00245

Krishnan, A., Ramasamy, R., & Joshi, P. L. (2014). An empirical study of non-financial measures' emphasis for the compensation schemes on different categories of strategic orientation in Malaysia. Indian Journal of Finance, 8 (12), 7-20. doi:10.17010//2014/v8i12/71688

Litvak, K. (2009). Venture capital limited partnership agreements: Understanding compensation arrangements. The University of Chicago Law Review, 76 (1), 161-218.

Mehta, V. (2004). Principal-agent issues in private equity and venture capital. Wharton Research Scholars Journal. Retrieved from http://repository.upenn.edu/cgi/viewcontent.cgi?article=1013&context=wharton_research_scholars

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48 (3), 261-297.

Mulcahy, D., Weeks, B., & Bradley, H. S. (2012). We have met the enemy…and he is us: Lessons from twenty years of the Kauffman Foundation's investments in venture capital funds and the triumph of hope over experience. DOI : http://dx.doi.org/10.2139/ssrn.2053258

Robinson, D. T., & Sensoy, B. A. (2013). Do private equity fund managers earn their fees? Compensation, ownership, and cash flow performance. Review of Financial Studies, 26 (11), 2760-2797. doi: 10.1093/rfs/hht055

Ross, S. A. (1973). The economic theory of agency: The principal's problem. The American Economic Review, 63 (2), 134-139.

Sahlman, W. A. (1988). Aspects of financial contracting in venture capital. Journal of Applied Corporate Finance, 1 (2), 23-36. DOI: 10.1111/j.1745-6622.1988.tb00163.x

Sahlman, W. A. (1990). The structure and governance of venture-capital organizations. Journal of Financial Economics, 27 (2), 473-521.

Venture Intelligence. (n.d.). Databases. Retrieved from http://www.ventureintelligence.com/db.htm

Zeckhauser, R. J., & Pratt, J. W. (Eds.). (1985). Principals and agents: The structure of business (p. 37). Boston: Harvard Business School Press.