Allocation Of Control Rights And Cash Flow Rights In Venture Capital Invested Firms

Venture capital plays a very important role in promoting technological innovation and economic development. Furthermore, venture capital contracts are key to the smooth progress and success of venture capital investment. Through reviewing the literatures about venture capital contracts, we find that the empirical literature such as Sahlman (1990), Kaplan & Str?mberg (2003, 2004) get a series of conclusions about the terms of venture capital contracts and contractual governance mechanism. However, compared to the empirical analysis, the theoretical literature on the venture capital contracts is less developed. Hence,in this paper, we apply the theory of incomplete contracts in analyzing the allocation of control rights and cash flow rights in venture capital firms on the basis of expanding and improving the shortcomings of existing studies.First of all, we study the allocation of control rights and cash flow rights in venture capital firms by taking the entrepreneurs'specific human capital investment into consideration. When a venture issues common stock or bond to finance, neither the unilateral right of control granted to the entrepreneur nor to the venture capitalist leads to the optimal decision-making. However, when a venture issues convertible bond and allocates control rights rationally, the venture can achieve the optimal decision-making. Futhermore, the optimal convertible bonds are designed and the necessary and sufficient condition for the optimal entrepreneur's efforts are analyzed.Secondly, we analyze the allocation of cash flow rights and multiple control rights in venture capital invested firms. Usually, a venture needs to allocate the liquidation right, replacement right and cash flow right simultaneously. When the venture issues bond to finance, neither the unilateral right of control granted to the entrepreneur nor to the venture capitalist leads to the optimal decision-making. However, when the venture issues common stock to finance and the entrepreneur'private benefit is less than a threshold level, the unilateral right of control granted to the entrepreneur can lead to the optimal decision-making. Once the private benefit of entrepreneur is greater than a threshold level, neither the unilateral right of control granted to the entrepreneur nor to the venture capitalist leads to the optimal decision-making. Furtherly, when the venture issues convertible bond and allocates control rights rationally, the venture can achieve optimal decision-making.Thirdly, we analyze the allocation of control rights on the exit modes of a venture under the framework of stage financing. There are two important exit modes in the venture capital investment, namely IPO and acquisition. Because of the incompleteness of contracts, the control rights about the exit modes should be allocated in initial contracting. How to allocate the control rights? Which factors affect the allocation of control rights? In order to study these issues, we analyze the control rights granted to venture capitalists or entrepreneurs respectively. Based on the analysis of the advantages and disadvantages of two different allocations of control rights and the comparison of their efficiencies, we reveal the dominant allocation of control rights.Fourthly, we analyze the optimal initial allocation of control right and renegotiations after information revealing under different expectations of project prospects in the framework of stage financing. It is shown that, the optimal initial allocation of control right is relevant with both the initial expectation of project prospects and the share proportion of the venture capitalist. The less the venture capitalist's share proportion and the better the initial expectation of project prospects, the more efficient the control right being allocated to the entrepreneur. The expectation updated determines the optimal re-allocation of the control right in the second stage financing. The worse the updated expectation, the more likely will the venture capitalist liquidate the project, or the more efficient the control right being adjusted to the venture capitalist in the case the venture project is not cleared.Finally, we analyze the conflicts of benefits between venture capitalists and entrepreneurs whose cash flow rights are inconsistent in nature. We apply the framework of incomplete contracts to discuss venture capitalists'stages investment decisions, renegotiations and the transfer of control rights in the framework of stage investment. It is shown that, the venture capitalist will continue to invest the project and release the control rights to the entrepreneurs when the performance of the first stage is good. The better performance of the first stage and the smaller the uncertainty of the second stage, the more likely will the venture capitalist continue to invest the project and release the control rights to the entrepreneurs.