Contracts In The Venture Capital Cycle

Venture capital (also known as VC or Venture) is a type of private equity capital typically invested by professional financiers for early-stage, high-potential, and growth companies. As an emerging industry, venture capital plays an important role in the development of economic sectors such as information, biotechnology and so on. China's venture capital emerges since the international venture capital came into China, and is still in an embryonic stage of development at present.The core value of this venture capital lies in the effective mitigation of the problems such as information asymmetry and agency problems through the enforcement of contract terms in the contracts, based on the law designed in the U.K. and the U.S. Venture capital has been literally imported into China where law system and enforcement environment differ significantly from Western countries where venture capital has been developed. As a result, venture capital could not operate efficiently under Chinese law framework.This paper will use as a model, explore the logical reasons of reducing agency costs in venture capital contracts. It will also propose relevant improvement procedures in the area that the relevant regulations of venture capital are deficient. This paper will provide valuable insights for the effective development of venture capital in China.There are five chapters in this thesis. The outline of the chapters is as follows:Chapter 1:"Contract Parties of Venture Capital": There are three parties in venture capital: venture capital investors, venture capitalists, and entrepreneurs. Two groups of legal relationship (between venture capital investors and venture capitalists, and between venture capital entrepreneurs) are established. The problem of information asymmetry existing in two agency-principal relationships results in the emergence of agency costs. Therefore, how to design a set of proper incentive mechanisms to regulate the conflict of interests'behaviours and reduce agency costs is crucial to the efficient development of venture capital.Chapter 2:"Financial Contract in American Venture Capital": Financial contract is designed for adjusting the conflict of interests between venture capital investors and venture capitalists. This chapter examines the historical evolution of venture capital organizational forms, and concludes that limited partnership as the dominant form of venture capital is the result of inherent advantage and historical selection. On the basis of this, it analysis incentive and restrict mechanisms of limited partnership agreements. Incentive mechanisms for general partners are the management rights and rights to obtain the compensation. General partners could not only get 3% of fixed management fees, but also achieve 20% of profit distribution, which closely align the interests of general partners to those of limited partners. There are two ways to restrict general partners, one is through restrictive covenants to limit general partners management rights, and the other is to grant more rights to limited partners such as rights to get broad information, monitoring rights, voting rights for important events, and right to participate in normal partnership business. Companied with installmental capital injection and dividing terms without mistakes so that abandon disappointing enterprises, which are effective ways to restrict general partners rights.Chapter 3:"Investment Contract in American Venture Capital": Investment contract in venture capital is a contract between venture capitalists, and entrepreneurs. The conflict of interest at the investment stage is mainly between controlling shareholders and minority shareholders in a closely held company. Therefore, this chapter aims to protect the rights and interests of minority shareholders through designing a contract, and to consider a better way for them to leave a company when the situation is detrimental to them.This thesis states the distribution of two parties'rights and obligations in terms of the shareholding structure, corporate governance, and exit and profit distribution. In the allocation of shareholding structure, Venture capital investors generally buy preference shares in order to reduce risk. The shareholding should not exceed 20% at the initial investment, but this proportion gradually rises at the later stage of raising capital. Anti-dilution terms will be used to prevent dilute shareholding. In corporate governance mechanisms, arrangement for the board of directors is not according to the shareholding proportion, and venture capitalists are also occupying certain board positions. In addition, venture capital investors as minority shareholders have also rights of veto. Therefore, venture capital investors as minority shareholders could participate in the course of business operations. Finally, registration rights, puts rights, drag along, tag along and liquidation preference rights are all benefit for the exit of venture capital investors, and those rights also ensure the fair value for the share buy-back.Chapter four:"Contract Freedom and Law Compulsory in America Venture Capital": It is inevitable to avoid the degree of law compulsory when considering contract freedom. In the context of venture capital, it is vital to investigate whether the contract autonomy could refuse the application of fiduciary duty, or amend its terms. Fiduciary duty under the contractual theory suggests that fiduciary duty is a default term that two parties should have put it into the contract if they do not concern its costs. Therefore, fiduciary duty is important to save two parities costs in terms of negotiation and supervisions. However, it is not free for the application of fiduciary duty, beneficiary needs to make up the costs deriving from fiduciary's unselfishness behaviours, opportunity costs that constraint fiduciary activeness and substantial costs for litigations. If beneficiary has other methods which are less costly than above costs, such as contract design, to effective restrict fiduciary's behaviors, fiduciary duty should be allowed to waiver. Whether fiduciary duty is allowed to waivor or not, it should take into account the costs and benefits of other relevant mechanisms for restricting fiduciary behaviours. In venture capital, it is important to consider both contract remedy and reputation mechanism to determine the scope of the application of fiduciary duty. As for individual case concerning exploitations of beneficiary interests, the beneficiary could pursuit the ex post remedy to compensate in the case of unfair situation.Chapter 5:"Law Preparation for China's Development of Venture Capital Contract": China's venture capital is still at very early stage, developing contractual form of venture capital is just an experiment. This chapter firstly analysis the deficiency of law preparation in current contractual model of venture capital, and propose the recommendations for financial contract, investment contract and waiver for fiduciary duty. As for financial contract, it proposes to emphasize monitoring rights of general partners; as for investment contract, it should reconcile laws for internal and external, optimize the standard categorization of company, further autonomy for limited company, more diversified investment vehicles, improvement of system of stock option. Finally, this author suggests that China is still in an immature market environment in terms of contractual parties of venture capital, reputation mechanisms, and effectiveness of legal system. Therefore, only waiver specific types of fiduciary duties could be applied. There can not be a complete waiver in the application of fiduciary duties.