THE ALLOCATION OF CONTROL RIGHTS IN FINANCING PRIVATE COMPANIES: VIEWS OF ESTONIAN PRIVATE EQUITY AND VENTURE CAPITALISTS

1. Introduction One common feature of high-growth companies is heavy reliance on external sources of financing. In the current article, we analyze the financing of private companies by private equity and venture capital. Young companies in emerging industries are characterized by a high level of economic and technological uncertainty, the absence of credit history and collaterals and high level of information asymmetry, which prevents them of using more traditional sources of financing. Venture capital and private equity play a very important role in financing of these companies for that reason. As there is no easy way to exit the investment, venture capitalists must ensure that their interests are well protected and that the company is managed in the best possible way. Therefore the allocation of control rights is almost as important as the allocation of cash flow rights in venture capital projects. Control issues are especially important in countries with a low level of investor protection or in countries, where the principles of the good corporate governance are not yet fully developed. According to the empirical studies, the interests of minority shareholders are relatively well protected in Estonia (see Pistor et al. 2000). However, the enforcement of laws and regulations (effectiveness) in transition countries usually lag behind the quality of law (extensiveness) (Pajuste 2002). Previous research has suggested that control issues are far more important in Estonia than in United States (Sander 2003). The aim of the current article is to investigate the allocation of control rights in private equity and venture capital projects in Estonia. Some organizational changes due to the venture capitalist entrance to portfolio company are also indicated. A case study method is used and interviews are conducted to collect information about the current practice of venture capital investments in Estonia. There are several similar studies conducted in developed countries (see e.g. Lehtonen 2000, Virtanen 1996). The situation in developing and transition countries has been less examined. The paper is structured as follows. The first section gives the theoretical background. The second section describes the research methodology and gives some background information about sample companies. Next section presents the results of interviews with the representatives of sample companies. The last section includes the synthesis of theory and practice, as well as managerial implications. 2. Theoretical background Control rights have been defined by Tirole (2001) as "the right for a player (or a group of players) to affect the course of action once the firm has gotten started" (p13). The formal distribution of control rights is determined by the nature of the claims (debt, equity, or hybrid instrument), business laws (Commercial Code, Law of Obligations Act, Bankruptcy Code, etc.), companies' bylaws, and covenants associated with the financial contracts and term sheets. However, as noted by Tirole (2001) players without formal control rights may actually enjoy substantial control over their organizations (for example large minority shareholder often decides for the majority group of smaller ones, companies with diverse ownership are controlled by managers even if the formal control belongs to the shareholders, etc.). The choice of financing instrument is the first aspect affecting the allocation of control. Aghion and Bolton (1992) developed a theoretical model according to which the choice of financial instrument should depend on which governance structure (entrepreneur control, contingent control, and investor control) is the most effective. They suggested that control rights should belong to the entrepreneurs, if such a governance structure is feasible. In this case the company should be financed by using non-voting equity (preferred shares) (Ibid). In some countries (e.g. …