Performance, Structure and Compensation Contract of Indian Venture Capital Deal

Abstract

The globalisation of economic activities, the evolution of modern technology and specialisation of the value chain has brought immense transformation in the world economy. This encourages the formation of new organisation and collaboration between business partners. The impact of innovation on the economy and business is profound by developing a creative thinking environment. Despite the rising importance of high-tech startup development, the arrangement of finance emerges as a big challenge in this context. The risk associated with the reward in the startup ecosystem is the cause of difficulties in getting finance from many sources especially from conventional sources like a bank. Today when an entrepreneurial firm faces challenges in arranging fund for their survival, the availability of financing opportunity like Venture Capital(VC) open a new avenue to prove their innovation. Despite having a high potential for growth and opportunity, VC finance entails high uncertainties, information asymmetry problem, incentive problem and agency problem. High risk is associated with a venture capital investment due to imperfect and asymmetric information, multiple incentives and diversifying interest. Both VC Fund and Portfolio Company have exposed to such riskier environment of investment. In such a scenario, each party become an opportunist which create high agency cost (Holmstrom, 1979).
To minimise this problem and reduced agency cost is incurred due to the presence of conflicting situation, all the parties in VC investment signed contracts, or partnership agreement Venture Capitalist interacts with entrepreneur through the partnership arrangement with the agreed predefined condition in post-investment phase. Seminal works in developed countries have advocated that several contractual components influence the VC investment and the financing relationship between investor and investee. An efficient financial contract is highly required for the deal competence as it automatically realigns the incentives and ex-ante specification of governance structure for the contracting parties (Williamson, 1988). Allocation of cash flow right and control right has been made through some distinct contractual constituent like financial instrument and covenant. There is huge ambiguity lies in payout, structure and compensation provisions mentioned in the contract of a VC deal which puts uncertainty on the success of the deal. This aspect of a VC deal lacks sufficient research work which could make clarity on designing an optimal contract. This study concentrates on this point of a VC deal and put effort into bringing clarity on VC contract. Typically this thesis tries to answer few questions like: how this affect the working style of each party in a VC deal, what are the important provisions made in such contract, how they are designed to compensate Venture Capitalist aligned with their effort, most importantly how it could resolve the agency problem, minimize moral hazard and make the deals successful and more productive. By getting answers to these questions, the model for designing of the globally accepted optimal contract could be proposed. This study based upon an endogenous aspect of VC deal. The detailed available company and fund specific information are analysed through various statistical techniques like Binomial logistic regression, Analytical Hierarchy Process and Decision Tree analysis. This study finds cash flow right like participating preferred; various cash flow contingencies are most important aspects according to the investor’s point of view in Indian VC contract. The result of this study is in support of previous eminent literature (Bengtsson, 2011). This research strives to improve the performance of venture capital deal through structural and functional efficiency. This study will encourage venture investor to be vigilant and design an efficient contractual structure to avoid internal conflicts. The analysis of each structural aspect has incorporated the effort based variables like the experience of venture investor, realised revenue by Venture Capitalist, ownership percentage etc. The model for compensation structure developed in our study includes the effort on the part of venture investor. This could provide an additional reason for why there needs to be adequate compensation for good ventures. This study could pave a new way for the success of a VC deal in current scenario minimising conflict arising due to an agency problem. Understanding these contractual design in VC deal could show the way to frame an internationally conventional model and generalise the contract structure rather than making it locally suitable.