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Engineering Venture Capital Markets: Lessons from the American Experience


The Desirability of a National Venture Capital Market ... Incentivize venture capitalists: ... Incentivize entrepreneur: ... – PowerPoint PPT presentation

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Title: Engineering Venture Capital Markets: Lessons from the American Experience

Engineering Venture Capital Markets Lessons from
the American Experience
  • Ronald J. Gilson
  • Columbia and Stanford Law Schools
  • _____________

Connect the Dots
The Desirability of a National Venture Capital
  • 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.

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

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

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
  • But on average and across countries, government
    programs have not been very successful.

The Goal A Contrarian Strategy for a Government
  • 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.

The Thesis
  • The genius of the U.S. system is private
  • 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.

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

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.

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
  • 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.

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.

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
Characteristics of U.S. Venture Capital
  • Incentivize venture capitalists
  • Compensation depends on success VC get 20 of
    partnership profits though put up only 1 of
  • VC must succeed in order to raise new funds.
  • Need to exit to recycle cash and non-cash
  • 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.

Characteristics of U.S. Venture Capital
Contracting (2)
  • Structure facilitates VC monitoring.
  • VC gets board control or significant
  • Additional protection from investor rights
    agreement redemption put investor can force
    redemption in bad states of the world.
  • Geographically proximate lead VC.

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.

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
  • By restricting participation to being a limited
    partner, the government leaves capital allocation
    decisions to those with the right incentives.

Example 1 The German WFG
  • First German venture capital fund.
  • Structure
  • Founded by 29 German banks who put up 10 million
  • Government guaranteed up to 75 of fund losses.
  • 12 person board 3 bank, 3 government, 2
    industry, 2 management consultants, two
  • Mixed board committee made project selection.

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.

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.

Example 2 The Israeli Yozma Program.
  • Israeli government established Yozma 1993.
  • Yozma created 9 venture capital funds in which it
    was a partner.
  • Yozma matched up to 40 of other investors
  • 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
  • One increases the incentive to monitor and one
    decreases it.

A Better Incentive Structure Yields a Better
  • 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.

Example 3 the Chilean Corfu Program - 2001
  • Government agency will invest in private venture
    capital funds conditioned on other large
  • The venture capital fund will be structured like
    a U.S. fund 2.5 annual fee and a large carried
  • CORFU return capped at 9.
  • CORFU investment must be cashed out at the
    earlier of 15 years or the life of the fund.

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
  • 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.

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