Summary and Concluding Remarks

  Venture capital and private equity funds hold small portfolios of entrepreneurial firms that are not well diversified, although this enables fund managers to take their time carrying out extensive due diligence before investments are made and to sit on boards of directors, monitor management, and add value to the enterprise by providing strategic, financial, marketing, human resource, and other advice during the investment life. However, because such funds are  not diversified, idiosyncratic risk matters; because idiosyncratic risk matters, agency costs matter, and thus the design of financial contracts matters.   This book is the first of its kind in the literature on venture capital and private equity to focus its theme specifically on the financial contracting between  parties in venture capital and private equity. One of the primary reasons for the existence of specialized venture capital and private equity funds is the occurrence of information asymmetries and agency costs. If idiosyncratic risks could  be diversified away and/or information asymmetries and agency costs were not present, there would be little scope for venture capital and private equity fund managers to provide value in ways that extend beyond that which banks or other sources of capital do for private and entrepreneurial firms. Part I, Chapter 2 provided an extended review of agency theory in the context of financial contracting with a focus on security design. With the empirical and international focus of this book, Chapter 3 reviewed institutional and legal differences across the countries considered and reviewed the empirical methods  used in the data analyses in each of the chapters of this book.   In Part II we showed that contracts are extremely important for limited partnership funds that act as financial intermediaries between institutional investors and their investee entrepreneurial firms (Chapter 5). As well, public policy that gives rise to“statutory contracts ” matters a great deal for venture capital and private equity fund-raising efforts (Chapters 7 and 9) and the performance of government-created funds (Chapter 9). Further, we showed that compensation is a significant element in venture capital and private equity fund structure  and explained the ways in which compensation varied across different countries (Chapter 6). We also addressed related issues of specialized fund mandates and style drift (Chapter 8) and considered the factors that are important  to institutional investors when they invest in venture capital and private equity funds (Chapter 4).     Part III focused on the relationship between fund managers and investee entrepreneurial firms. We addressed in detail issues relating to financial contracts design in terms of security choice (Chapters 10 and 11), adverse selection  (Chapter 12), corporate venture capital contracts (Chapters 11 and 13), and the use of specific veto and control rights in venture capital contracts (Chapter 14). Part IV started with Chapter 15 with an overview of factors that affect the extent of value-added provided by the investor and the impact of venture capital and private equity investment on innovative activity. We specifically considered the impact of financial contracts on the advice and monitoring provided by venture capital fund managers, as well as scope of disagreement with the investee (Chapter 16). Financial contracts by themselves are incomplete, and as such  other factors matter for investor value-added, including location (Chapter 17) and portfolio size (Chapter 18). Finally, in Part V we explained the central role of divestment or “ exit ” to the venture capital and private equity investment process. We overviewed factors that affect the extent of exit and duration of investment in Chapter 19.  Contracts that inefficiently govern the structure of funds have negative consequences for the exit performance of the fund (Chapters 20 and 21). Contractual structures affect the returns to venture capital and private equity investments, which in turn impacts investment valuations (Chapter 22). We also reviewed evidence (Chapter 22; see also Chapter 7), which showed that the ways in which valuations of unexited investments are reported to institutional investors depend significantly on contractual structures between the fund and its investee entrepreneurial firms. In short, all aspects of venture capital and private equity investment involve idiosyncratic risks and a central role for financial contracts. A striking feature about the venture capital and private equity market is the international differences in the size of markets around the world (Chapter 1; see also Armour and Cumming, 2006; Jeng and Wells, 2000). We had documented international differences in fund structures (Part II), contracts between funds and entrepreneurs (Part III), differences in value-added (Part IV), and differences in exit performance (Part V). International differences in venture capital markets are largely consistent insofar as poor legal conditions are associated with less efficient limited partnership contracts, less efficient managerial compensation, less efficient financial contracts with entrepreneurs, and less successful exit outcomes and financial returns. We may expect that countries with weaker venture capital and private equity markets will continue to lag behind with a poor supply of capital as long as poor legal conditions with weak shareholder rights and enforcement conditions persist in those countries. As well,  there is evidence that law impacts the demand for venture capital: Countries with entrepreneur-friendly bankruptcy laws are more likely to have a greater demand for venture capital (Armour and Cumming, 2006) and a greater rate of self-employment (Armour and Cumming, 2008). (For more generally on public policy toward venture capital, see Chapter 9; see also Kanniainen and Keuschnigg, 2003, 2004; Keuschnigg, 2003, 2004a,b; Keuschnigg and Nielsen, 2001, 2003a,b, 2004a,b,c.) Summary and Concluding Remarks 725 There has been some work on the real effects of venture capital and private equity, which we had reviewed in Chapter 15 (for a more detailed survey, see Cumming et al., 2007). Further research could consider international differences in the real effects in relation to contractual structures employed in different countries. International differences in venture capital may become blurred over time as markets become increasingly integrated. As we showed in Chapters 4 and 7, many institutional investors invest internationally in venture capital and private equity funds. Evidence on international contract structures, such as U.S. venture capital investment in Canadian entrepreneurial firms (Chapter 11) and crossborder European venture capital investment (Chapter 14) shows contracts are  written in ways that are very similar to those between entrepreneurs resident in those countries and domestic investors. Additional data on topic across other countries might, however, shed further light on topic. Finally, it is noteworthy that there is evidence that venture capital and private equity funds relocate their investee entrepreneurial firms to other countries after investment. For instance, Cumming et al. (2004a) show that Asia-Pacific venture capital funds often relocate their investee entrepreneurial firms to the United States after they invest but before they exit. Relocations yield higher returns than keeping the investee entrepreneurial firms in their respective country of origin. These differences can be explained by the improvement in legal conditions in the United States relative to the country of origin, as well as the increased size of the product market. Further work on transnationals in entrepreneurial, venture capital, and private equity markets would be a fruitful avenue for future work, particularly in relation to contract structures. As Meggingson (2004) predicts, it appears likely that there will be a growing trend toward a more global venture capital and private equity market around the world and greater internationalization of entrepreneurial ventures in the coming years. How and why venture capital and private equity contracts evolve in different countries will likely have significant implications for the performance and growth of venture capital and private equity markets.