After this paper was accepted for publication, Ola Bengtsson passed away on January 5, 2014. Everyone who knew Ola will miss him very much.
Different Problem, Same Solution: Contract-Specialization in Venture Capital
Article first published online: 4 APR 2014
© 2014 Wiley Periodicals, Inc.
Journal of Economics & Management Strategy
Volume 23, Issue 2, pages 396–426, Summer 2014
How to Cite
Bengtsson, O. and Bernhardt, D. (2014), Different Problem, Same Solution: Contract-Specialization in Venture Capital. Journal of Economics & Management Strategy, 23: 396–426. doi: 10.1111/jems.12055
We are grateful to VCExperts and Joseph Bartlett for help with the contract data. This project was started when Ola Bengtsson was at Cornell University. We thank Brian Broughman, Charlie Kahn, Larry Ribstein, and participants at the Midwestern Law and Economics conference for helpful comments. All remaining errors are our own.
- Issue published online: 4 APR 2014
- Article first published online: 4 APR 2014
Real-world financial contracts vary greatly in the combinations of cash flow contingency terms and control rights used. Extant theoretical work explains such variation by arguing that each investor finely tailors contracts to mitigate investment-specific incentive problems. We provide overwhelming evidence from 4,561 venture capital (VC) contracts that this tailoring is overstated: even though there is broad variation in contracting across VCs, each individual VC tends to specialize, recycling familiar terms. In fact, a VC typically restricts contracting choices to a small set of alternatives: 46% of the time, a VC uses the same exact cash flow contingencies as in one of her previous five contracts. We document specialization in both aggregated downside protection, and in each individual cash flow contingency term. Such specialization remains economically and statistically significant even after controlling for VC and company characteristics. We also find that VCs learn to use new contractual solutions from other VCs in her syndication network. Our findings challenge the traditional premise that each investor selects from the universe of combinations of terms to match an investment's unique contracting problem. Rather, the cumulative evidence indicates that contract-specialization arises because investors better understand payoff consequences of familiar terms, and are reluctant to experiment with unknown combinations.