Title: Understanding the Economic Value of Legal Covenants in Investment Contracts: A Real-Options Approach to Venture Equity Contracts
Abstract: Valuing early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies. This inability to come up with robust point estimates of value should not and does not lead to a breakdown of market liquidity: instead, efforts are redirected towards the design of investment contracts which materially skew the distribution of payoffs in favor of the venture investors. In effect, limitations in valuation abilities are addressed by designing the investment contracts as baskets of real options instead of linear payoff functions. This paper investigates four common features (covenants) of venture capital investment contracts from a real option perspective, using both analytical solutions and numerical analyis to draw inferences for a better understanding of contract features. The impact of the concept for pricing issues, valuation negotiation and for contract design are considered. It is shown, for example, how contingent pre-contracting for follow-up rounds is theoretically a better proposition than the simple rights of first refusal commonly found in many contracts. We also provide for results (such as timing of investments, lengths of rounds, choices of liquidation levels, conversion levels) that take into account full interaction of the different features considered. We document some complex facts, such as the concavity of the VC contract value depending on the amount invested at the different stages, the actual share impact of the most common anti-dilution feature, some endogenous motivation for early VC exits from otherwise performing companies and stress overall the importance of a full analysis for efficient contract negotiations and understanding.
Publication Year: 2002
Publication Date: 2002-01-01
Language: en
Type: article
Access and Citation
Cited By Count: 14
AI Researcher Chatbot
Get quick answers to your questions about the article from our AI researcher chatbot