Engineering Venture Capital Markets: Lessons from the American Experience

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Engineering Venture Capital Markets Lessons from
the American Experience

• Ronald J. Gilson
• Columbia and Stanford Law Schools
• _____________

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Methodology
Models
Connect the Dots
Empirical
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The Desirability of a National Venture Capital
Market

• The attraction of a national venture capital
  market is plain.
• Commercialize cutting edge science.
• Human capital based industries
• New job creation
• Not hamburger flipping
• Potential for developing economies to catch up.

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What Lessons Can Be Learned From the U.S.
Experience?

• Equally plain that the U.S. venture capital
  market is the worlds most developed and most
  successful.
• Two initial barriers to replicating the U.S.
  template that I will not consider today
• Basic social infrastructure
• Culture.

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What Lessons Can Be Learned From the U.S.
Experience?

• Focus will be on financial contracting.
• Financing early stage high technology must solve
  a set of contracting problems for a venture
  capital market to develop.
• Two themes
• The U.S system has solved these problems.
• Can we devise a plausible role for government in
  helping other nations solve these problems?

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The Role of the Government in Engineering a
Venture Capital Market

• The paradox
• Intuitively obvious role for government to help
  establish a market that has not developed on its
  own.
• But on average and across countries, government
  programs have not been very successful.

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The Goal A Contrarian Strategy for a Government
Role

• Extract from the U.S. experience a guide for
  government strategy to help engineer a venture
  capital market.
• Contrarian because I want to extract a role for
  government out of the experience of a system that
  did not depend on government.
• Contrarian because I am by instinct skeptical of
  industrial policy.

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The Thesis

• The genius of the U.S. system is private
  ordering.
• Key is an extremely effective contracting
  structure covering the entire VC cycle
• investment in a VC fund ? the VC funds
  investment in a portfolio company ? exit by which
  the VC funds investment is recycled.
• Strategic challenge
• Craft a role for government that facilitates
  creation of a market premised on private
  contracting, not government participation in the
  capital allocation decision.

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The Thesis (2)

• The engineering problem Resolving simultaneity.
• Creation of a venture capital market requires the
  simultaneous availability of three factors the
  provision of any one of which is contingent on
  the availability of the others
• Entrepreneurs
• Funds for investment
• An investment vehicle that gets the incentives
  right.

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Presentation Roadmap

• Overview of U.S. venture capital contracting why
  does it work?
• Three examples of government efforts to engineer
  a venture capital market one a failure, one a
  success, and a quite recent program that may be
  close to getting it right.
• Germany the WFG program.
• Israel The Yozma program.
• Chile The CORFU program.
• Lessons for a government strategy.

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U.S. Venture Capital Contracting

• The financial contracting problem
• VC contracting must confront three standard
  contracting problems that are supercharged in
  early stage investing because value consists
  largely of future growth options
• Uncertainty the inability to predict future
  events.
• Information asymmetry the entrepreneur knows
  much more about the project than the VC.
• Agency costs because of uncertainty and
  information asymmetry, the entrepreneur is in a
  position to take advantage of the VC.

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U.S. Venture Capital Contracting (2)

• The solution
• Intense incentives for all participants,
  including venture capitalists and entrepreneurs.
• Shift of control from the entrepreneur to the VC.
• Intense monitoring.
• The emphasis on exit to recycle VC contributions.
• Braiding of Investor/VC fund and VC
  fund/portfolio company contracts.

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Investors
VCs
99 capital/80 profits no control rights
-1 capital/20 profits
-Mandatory Distributions
VC Ltd. Ptnshp.
-Fixed Term
Design Responses to Uncertainty, Info. Asymmetry,
and Agency Incentives, Monitoring, Explicit and
Implicit Contracts, and Braiding of Investor/VC
and VC/Portfolio Contracts
-Repeat Play
-Staged Investment
-Transfer of Formal Elements of Control Released
on Success
-Intense Management Incentives
-Intense VC Monitoring
Portfolio Co.
The Venture Capital Contracting Structure
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Characteristics of U.S. Venture Capital
Contracting

• Incentivize venture capitalists
• Compensation depends on success VC get 20 of
  partnership profits though put up only 1 of
  capital..
• VC must succeed in order to raise new funds.
• Need to exit to recycle cash and non-cash
  contributions.
• Incentivize entrepreneur
• Staged financing shifts continuation decision
  from entrepreneur to VC reinforced by right of
  first refusal.
• Entrepreneur regains control on the ventures
  success (IPO).
• Existing equity and stock options.

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Characteristics of U.S. Venture Capital
Contracting (2)

• Structure facilitates VC monitoring.
• VC gets board control or significant
  representation.
• Additional protection from investor rights
  agreement redemption put investor can force
  redemption in bad states of the world.
• Geographically proximate lead VC.

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Overall Result

• Everyone has a powerful incentive to work hard.
• Entrepreneur to make money and regain control.
• VC to choose good portfolio companies and be able
  to raise new funds success and profits depends
  on doing these well.
• Everyone is monitored closely.
• Entrepreneur by VC.
• VC by the market.

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Implications for the Role of Government

• Can the government help solve the simultaneity
  problem the need for funds, a vehicle that
  solves contracting problems, and entrepreneurs
  all at the same time? Yes.
• By providing funds through the right contractual
  vehicle, government can encourage a supply of
  entrepreneurs and attract knowledgeable financial
  intermediaries.
• By restricting participation to being a limited
  partner, the government leaves capital allocation
  decisions to those with the right incentives.

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Example 1 The German WFG

• First German venture capital fund.
• Structure
• Founded by 29 German banks who put up 10 million
  DM.
• Government guaranteed up to 75 of fund losses.
• 12 person board 3 bank, 3 government, 2
  industry, 2 management consultants, two
  scientists.
• Mixed board committee made project selection.

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U.S. vs. WFG Contracting Practices

• U.S. VCs take substantial amounts of control
  WFG took minority position and obtained no
  control rights.
• Control and equity gives U.S. VCs the means and
  the incentive to monitor WFG lacked both.
• U.S. VCs have powerful financial incentives to
  succeed WFG had none.
• WFG returns were capped because entrepreneurs
  received a call option at cost plus moderate
  interest, and its losses were limited by the
  government guarantee.

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WFG Summary

• Government program resulted in
• no incentives
• no monitoring
• bad project selection.
• No surprise, the program also ended up with
  little success.
• Internal rate of return over life of program of
  negative 25.07 percent.

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Example 2 The Israeli Yozma Program.

• Israeli government established Yozma Ltd.in 1993.
• Yozma created 9 venture capital funds in which it
  was a partner.
• Yozma matched up to 40 of other investors
  capital,
• Other investors had a call option on Yozmas
  investment at (i) cost plus nominal interest, and
  (ii) 7 of future profits.
• Yozma did not make investment decisions.
• Note the difference between giving the fund a
  call option and, as in WFG, giving it to the
  entrepreneur.
• One increases the incentive to monitor and one
  decreases it.

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A Better Incentive Structure Yields a Better
Result

• Investment decisions made by those who bore the
  investments risk and return.
• Funds ultimately managed more than 200 million.
• In 1997, funds were successfully privatized.

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Example 3 the Chilean Corfu Program - 2001

• Government agency will invest in private venture
  capital funds conditioned on other large
  investors.
• The venture capital fund will be structured like
  a U.S. fund 2.5 annual fee and a large carried
  interest.
• CORFU return capped at 9.
• CORFU investment must be cashed out at the
  earlier of 15 years or the life of the fund.

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The CORFU Program Represents a Clear Example of
Government Engineering to Create a U.S. Style
Venture Capital Market

• Availability of government investment as a
  limited partner encourages growth of skilled
  local financial intermediaries seed capital for
  a VC market.
• Availability of venture capital funding through
  limited partnership vehicles encourages
  entrepreneurship.
• Government participation as a limited partner
  allows the government to provide funds but stay
  out of capital allocation process.
• U.S. example KKR, state pension funds, and the
  development of the U.S. private equity market.

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Conclusion and Qualification

• Systems always have more moving parts than
  engineers contemplate.
• Recent work, especially Thomas Hellmanns with
  respect to Germany, adds an additional factor to
  those I highlight as part of my three-factor
  simultaneity model Culture!
• I am profoundly skeptical of cultural
  explanations. They typically allow too many
  degrees of freedom cultural matters except when
  it doesnt, and then because culture has changed.
• At worst, Ive moved the ball into the
  culturalists court A cultural explanation
  requires far more discipline than offered thus
  far.