VENTURE CAPITAL CONTRACT DESIGN: AN
EMPIRICAL ANALYSIS OF THE CONNECTION
BETWEEN BARGAINING POWER AND VENTURE
FINANCING CONTRACT TERMS
Spencer Williams"
ABSTRACTThis Article presents an empirical analysis of the connection between
bargaining power and contract design using an original dataset of over
5,500 equity and debt venture financings from 2004–2015. Using thetotal supply of venture capital in the U.S. as a measure of relative
bargaining power between entrepreneurs and investors, this Article
finds that venture capital supply has a statistically significant
relationship with price and non-price terms in both equity and debt
financings. These results contradict one of three theoretical accountsof bargaining power and support the other two.

TABLE OF CONTENTSINTRODUCTION ............................................................................ 106
I. THE THEORETICAL CONNECTION BETWEEN BARGAINING
POWER AND CONTRACT DESIGN ......................................... 110
A. IRRELEVANCE THEORY ..................................................... 110
B. DIRECT EFFECT THEORY ................................................... 113
C. INDIRECT EFFECT THEORY ................................................ 117
II. VENTURE FINANCING CONTRACT TERMS.............................. 123
A. EQUITY FINANCINGS ......................................................... 123
1. Pre-Money Valuation................................................. 125
2. Amount Raised ........................................................... 127
3. Liquidation Preference .............................................. 128
4. Participation .............................................................. 130
5. Anti-Dilution .............................................................. 131"

Teaching Fellow, Stanford Law School Program on Corporate Governance and Practice.
The author would like to thank Afra Afsharipour, Jordan Barry, Abraham Cable, John
Crawford, Colleen Honigsberg, Cathy Hwang, Michael Klausner, Elizabeth Pollman,
George Triantis, and Samuel Weinstein.

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6. Redemption ................................................................ 132
7. Dividends ................................................................... 133
8. Pay-to-Play ................................................................ 134
9. Drag-Along ................................................................ 135
10. Staged Financing ..................................................... 135
B. DEBT FINANCINGS ............................................................ 136
1. Interest Rate ............................................................... 137
2. Amount Raised ........................................................... 137
3. Maturity...................................................................... 137
4. Conversion ................................................................. 138
5. Warrants .................................................................... 140
6. Collateral ................................................................... 141
7. Subordination............................................................. 141
8. Repayment Multiple ................................................... 142
9. Staged Financing ....................................................... 142
III. METHODOLOGY AND DATA................................................... 142
A. INDEPENDENT VARIABLE: SUPPLY OF
VENTURE CAPITAL .......................................................... 143
B. DEPENDENT VARIABLES: VENTURE FINANCINGCONTRACT TERMS .......................................................... 146
C. VENTURING FINANCING DATA .......................................... 149
IV. RESULTS AND DISCUSSION .................................................... 151
CONCLUSION ................................................................................ 158
APPENDIX ..................................................................................... 160
INTRODUCTION
When parties negotiate a contract, how does their bargaining power
affect the contract’s design? This Article empirically examines thisquestion using an original dataset of venture financing contracts.
The academic literature on the effect of bargaining power on contract
design remains unsettled. 1 Under the traditional contractarian view ofcontract design put forth by law-and-economics scholars, bargaining
power affects the distribution of value via the price term but does not have
1. See infra Part I (discussing alternative theories regarding if and how bargaining
power impacts contract terms). This Article uses the term “contract design” to refer tothe collection of non-price terms that make up the design of a contract. See Albert Choi
& George Triantis, The Effect of Bargaining Power on Contract Design, 98 VA. L. REV.
1665–69 (2012) [hereinafter Choi & Triantis, Bargaining Power].

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an effect on non-price terms. 2 According to this view, the parties willagree to the set of non-price terms that maximizes the total value of thedeal. The parties will then divide up this value via the price term based on
their relative bargaining power. In other words, bargaining power
determines how the pie is sliced, but not the size or flavor of the pie. As
a result, with respect to contract design, this view has been described as
an “irrelevance” theory.3
This irrelevance theory of bargaining power, however, runs contrary
to the views and experiences of practicing transactional attorneys andbusinesspeople. In the common conception of a business deal, the party
with greater bargaining power will receive more favorable terms.
Practitioners commonly assert that bargaining power has a direct effecton non-price terms and therefore is far from irrelevant with respect tocontract design.4 According to practitioners, parties use their negotiating
leverage to craft the terms of the deal in their favor, including non-priceterms.5 While this is a view primarily advanced by practitioners, scholars
have provided support for this direct effect theory.6
In recent years, Albert Choi and George Triantis have worked totheoretically reconcile the traditional irrelevance theory of bargaining

2. See ROBERT E. SCOTT & JODY S. KRAUS, CONTRACT LAW AND THEORY 58–60(4th ed. 2007); Douglas G. Baird, The Boilerplate Puzzle, 104 MICH. L. REV. 933, 934–
38 (2005); Choi & Triantis, Bargaining Power, supra note 1, at 1668 n.4 andaccompanying text; George L. Priest, A Theory of the Consumer Product Warranty, 90
YALE L.J. 1297, 1320–21 (1981); Alan Schwartz, A Reexamination of Nonsubstantive
Unconscionability, 63 VA. L. REV. 1053, 1072–74 (1977); Alan Schwartz & Robert E.
Scott, Contract Theory and the Limits of Contract Law, 113 YALE L.J. 541, 552–54(2003); Alan Schwartz & Louis Wilde, Product Quality and Imperfect Information, 52
REV. ECON. STUD. 251, 251–52, 258 (1985); infra Part I.A (discussing the origins of theirrelevance theory and its key claims). This Article refers to price terms as terms that aresolely or primarily distributional. The clearest example of a price term is the price in a
simple purchase contract. Non-price terms, however, can also have distributional effects.
See Choi & Triantis, Bargaining Power, supra note 1, at 1667 n.2.
3. Choi & Triantis, Bargaining Power, supra note 1, at 1670. Choi & Triantis
further divide the irrelevance theory into two irrelevance propositions: (1) the strongform version, which states bargaining power has no effect on the non-price terms of acontract and (2) the weak-form version, which states bargaining power may affect nonprice terms but does not affect the parties’ ability to reach the optimal non-price terms
under the circumstances. Id.
4. See sources cited infra note 35.
5. See sources cited infra note 35.
6. See sources cited infra note 38.

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power with the practitioner-supported direct effect theory.7 They propose
a number of theories for how bargaining power might affect contract
design, the most compelling of which is the indirect effect theory. 8
According to this theory, bargaining power has a direct effect on the priceof the deal, which in turn alters the likelihood of adverse selection andmoral hazard. 9 As discussed in greater detail below, worse prices forparties seeking financing lead to more severe adverse selection and moral
hazard problems.10 The parties respond to these problems by altering thecontract terms that address adverse selection and moral hazard, thereby
changing the value-maximizing design of the contract. 11 Bargaining
power therefore indirectly effects non-price terms by changing theiroptimal forms.
The irrelevance, direct effect, and indirect effect theories provide
different predictions for whether and how bargaining power affects
contract design and the mechanisms through which these effects occur.
This Article empirically tests these competing theories using an original
dataset of 5,564 venture financing contracts (both equity and debt) from2004–2015. The Article analyzes how the relative bargaining power
between entrepreneurs and investors relates to specific terms in theventure financing contracts they negotiate.
For many reasons, venture financing contracts are an effective
context in which to examine the impact of bargaining power on contract
design. First, venture contracts have received substantial attention inacademic literature and the mechanisms through which they function are

7. See Choi & Triantis, Bargaining Power, supra note 1; Albert Choi & George
Triantis, Market Conditions and Contract Design: Variations in Debt Contracting, 88
N.Y.U. L. REV. 51, 52–57 (2013) [hereinafter Choi & Triantis, Market Conditions].
8. See Choi & Triantis, Bargaining Power, supra note 1, at 1683–87
9. Id. Adverse selection and moral hazard are problems that arise when there isasymmetric information between the contracting parties. Adverse selection broadly refers
to the fact that the parties do not know everything about each other at the time ofcontracting. Moral hazard, on the other hand, refers to the fact that the parties cannot
perfectly observe each other’s behavior after they have entered into a contract. See Choi
& Triantis, Market Conditions, supra note 7, at 53 n.6. The indirect effect theory requires
the presence of asymmetric information. This is not a stringent requirement, however,
because asymmetric information typically exists in some form in most contracting
scenarios. Id. at 72.
10. Choi & Triantis, Market Conditions, supra note 7, at 72; see infra Part I.C.
11. See infra Part I.C.

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generally well-understood.12 Second, the terms in venture contracts arehighly customizable and can take on a variety of different forms, which
therefore enables the parties involved to modify the terms in response tochanging incentives.13 Third, information asymmetry is prevalent during
the negotiation of venture contracts, and as a result adverse selection andmoral hazard are common problems that must be addressed by contract.14
Fourth, venture financing negotiations typically take place between
sophisticated parties represented by legal counsel, and therefore bothsides can generally be assumed to understand the contract terms and theirimplications.
Using the total supply of venture capital in the U.S. as a measure of
the relative bargaining power between entrepreneurs and investors, this
Article finds venture financing supply has a statistically significant
relationship with price and non-price terms in both equity and debt
financings. These results contradict the irrelevance theory of bargaining
power and provide support for the direct and indirect effect theories.
This Article makes three primary contributions to the literature on
bargaining power and contract design. First, the Article analyzes how thebargaining power theories apply to venture financings and develops
empirical tests for each theory. Second, the Article provides an expansive
empirical look into the design of thousands of venture financing contracts
spanning over more than a decade. Third, the Article uses this empiricalevidence to test the competing theories.
The Article’s findings have significant practical implications forentrepreneurs, investors, and attorneys. They can draw upon these results
to gain a deeper understanding of how bargaining power influences priceand non-price terms in the contracts they negotiate, thereby enabling themto design more effective contracts.
The remainder of the Article proceeds as follows. Part I explores thethree competing theories for the connection between bargaining powerand contract design and discusses how they can be empirically tested. Part
12. See, e.g., Steven N. Kaplan & Per Strömberg, Characteristics, Contracts, andActions: Evidence from Venture Capitalist Analyses, 59 J. FIN. 2177 (2004) [hereinafter
Kaplan & Stromberg, Characteristics, Contracts, and Actions]; Steven N. Kaplan & Per
Stromberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis
of Venture Capital Contracts, 70 REV. ECON. STUD. 281–82 (2002) [hereinafter Kaplan& Stromberg, Financial Contracting Theory Meets the Real World]; see also infra Part
II.
13. See sources cited supra note 12.
14. Venture financing contracts typically facilitate long-term investments in earlystage companies working with innovative technologies and business models.

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II provides an overview of venture financings and discusses specificcontract terms that will be empirically analyzed. Part III discusses theempirical methodology and describes the data. Part IV presents theempirical results and discusses them in the context of the three bargaining
power theories. The Article ends with a short conclusion that discusses
the implications of the results and opportunities for further research.
I. THE THEORETICAL CONNECTION BETWEEN BARGAINING
POWER AND CONTRACT DESIGN
Three alternative theories have dominated the literature on
bargaining power and contract design: the traditional contractarian
irrelevance theory, the direct effect theory championed by practitioners,
and the indirect effect theory advanced by Choi and Triantis. This Part
explores if and how bargaining power is expected to affect contract design
under these theories and describes how each theory can be empiricallytested.
A. IRRELEVANCE THEORY
In its simplest form, the irrelevance theory of bargaining power statesbargaining power does not have an effect on contract design, but rather
merely influences the distribution of the contract surplus via the priceterm. 15 While this irrelevance theory requires a number of demanding
assumptions,16 the basic logic of the theory is compelling: if the parties
have perfect information and negotiating costs are zero, the parties will
design the contract in such a way that maximizes its total joint value. Thisis a contractarian application of the classic Coase Theorem.17 Once theparties have identified the value-maximizing design of the contract, they
will divide up the surplus based on their relative bargaining power,
typically through the price term. As a result, bargaining power has a
distributional effect on the contract, but does not affect the contract’s
design. Figure 1 depicts the irrelevance theory.

15.
16.

See sources cited supra note 2 and accompanying text.
The most important assumptions are that the parties have perfect information andthere are no transaction costs.
17. R. H. Coase, The Problem of Social Cost, 3 J.L. & ECON. 1, 15–16 (1960); see
Choi & Triantis, Bargaining Power, supra note 1, at 1678 n.31.

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Figure 1: Irrelevance Theory of Bargaining Power18

The irrelevance theory of bargaining power has its origins in
discussions regarding the use of one-sided contracts by a monopolist.19
While some legal scholars had initially claimed a monopolist would use
its superior bargaining power to force one-sided terms on its counterparty,
law-and-economics scholars argued in response that a monopolist would
use the same value-maximizing contract design as a seller in a competitivemarket. 20 The monopolist would then use its dominant bargaining
position to extract the value created by the efficient contract design.21 In
subsequent years, the irrelevance theory has been extended beyondmonopolists and contracts of adhesion to include business negotiations

18.
19.
20.

For a discussion of the sources of bargaining power, see infra Part III.A.
See Choi & Triantis, Bargaining Power, supra note 1, at 1667–68.
See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW § 4.9 (7th ed. 2007);
Choi & Triantis, Bargaining Power, supra note 1, at 1667–68 nn.1, 3 and accompanying
text; Friedrich Kessler, Contracts of Adhesion—Some Thoughts About Freedom ofContract, 43 COLUM. L. REV. 629, 632 (1943); Richard A. Posner, Natural Monopoly
and Its Regulation, 21 STAN. L. REV. 548, 584–85 (1969).
21. See sources cited supra note 20.

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between sophisticated parties with both similar and differing bargaining
positions.22
A common response to the irrelevance theory is many non-priceterms in a contract can have distributional effects as well, and therefore
could be influenced by bargaining power.23 Yet if the core assumptions of
the theory hold true, it argues these terms will still take on their mostefficient forms regardless of bargaining power.
A simple example can be illustrative. In this hypothetical, a buyer
and seller are negotiating for the sale of a used car. The parties havereached a price of $3,000 for the car. The final term to negotiate is thelocation of arbitration should any issues arise after the sale. For proximity
reasons, the buyer prefers location A and the seller prefers location B. The
buyer, however, is far more time constrained than the seller, so values theproximity of location A more than the seller values the proximity oflocation B. If the parties select location A, the buyer will receive theequivalent of $20 of value and the seller will receive nothing, whereas if
the parties select location B, the buyer will receive nothing and the seller
will receive $10. The arbitration selection clause has both efficiency anddistributional effects. Yet regardless of which party has greater bargaining
power, the parties will always select location A. If the buyer has greaterbargaining power, it will clearly select location A. If the seller has greaterbargaining power, the seller will still select location A because it
maximizes the total value of the contract. The seller will agree to location
A in exchange for a price increase of somewhere between $10 and $20.24
Even though the arbitration selection term has a distributional effect, therelative bargaining power of the parties does not affect its optimal form.

22. See ROGER FISHER ET AL., GETTING TO YES: NEGOTIATING AGREEMENTWITHOUT GIVING IN 105 (2d ed. 1991); DAVID A. LAX & JAMES K. SEBENIUS, THE
MANAGER AS NEGOTIATOR: BARGAINING FOR COOPERATION AND COMPETITIVE GAIN 129(1986); JEFFREY Z. RUBIN & BERT R. BROWN, THE SOCIAL PSYCHOLOGY OF BARGAINING
AND NEGOTIATION 217 (1975); Baird, supra note 2, at 941; Nina Burkardt et al., PowerDistribution in Complex Environmental Negotiations: Does Balance Matter?, 7 J. PUB.
ADMIN. RES. & THEORY 247, 252, 269 (1997); Choi & Triantis, Bargaining Power, supranote 1, at 1679–80 nn.33–34 and accompanying text; Schwartz & Scott, supra note 2, at
554.
23. See sources cited supra note 2.
24. The size of the price increase within this range will depend on the relative
bargaining power of the parties.

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Scholars have empirically demonstrated a relationship between
bargaining power and price in numerous contexts including consumerfacing contracts of adhesion and venture financings. 25 With respect tonon-price terms and the irrelevance theory’s core assertion thatbargaining power does not affect these terms, the empirical evidence ismixed.26
In the venture financing context, the irrelevance theory would be
empirically supported by a finding that bargaining power is not connected
to non-price terms in venture financing contracts.27
B. DIRECT EFFECT THEORY
Unlike the irrelevance theory of bargaining power, the direct effecttheory claims bargaining power not only influences the price of a contract,
but the design of the contract as well. According to this theory, the party
with greater bargaining power uses its superior negotiating position, notonly to secure a good price, but also to extract value from its counterparty
via non-price terms. This theory suggests a party with greater bargaining
power may push for a non-price term that is advantageous from a
distributional perspective even if the term does not maximize the total
25. See Choi & Triantis, Bargaining Power, supra note 1, at 1669 n.6; Paul Gompers& Josh Lerner, Money Chasing Deals? The Impact of Fund Inflows on Private Equity
Valuations, 55 J. FIN. ECON. 281, 283 (2000) (finding a positive relationship between
valuations of venture capital investments and inflows to venture capital funds); Florencia
Marotta-Wurgler, Competition and the Quality of Standard Form Contracts: The Caseof Software License Agreements, 5 J. EMPIRICAL LEGAL STUD. 447, 451 (2008) (finding
a connection between price and market share in end user license agreements).
26. For empirical evidence supporting the second assertion of the irrelevance theory,
see Marotta-Wurgler, supra note 25, at 447–51; Priest, supra note 2, at 1297, 1320–21.
But see Omri Ben-Shahar & James J. White, Boilerplate and Economic Power in Auto
Manufacturing Contracts, 104 MICH. L. REV. 953, 959, 971 (2006); George G. Bogert &Eli E. Fink, Business Practice Regarding Warranties in the Sale of Goods, 25 ILL. L.
REV. 400, 413–15 (1930); Antonio Cabrales et al., Hidden Information, Bargaining
Power, and Efficiency: An Experiment, 14 EXPERIMENTAL ECON. 133, 135, 155–56(2011); Paul Gompers & Josh Lerner, The Use of Covenants: An Empirical Analysis of
Venture Partnership Agreements, 39 J.L. & ECON. 463, 489–96 (1996); Sharat Raghavan,
Essays in Entrepreneurial Finance and Strategy 17–19, 52–56 (2012) (unpublished Ph.D.
dissertation, University of California, Berkley), http://digitalassets.lib.berkeley.edu/etd/
ucb/text/Raghavan_berkeley_0028E_12579.pdf [https://perma.cc/DB7H-QVGZ]; seealso Choi & Triantis, Bargaining Power, supra note 1, at 1669 nn.5, 8 and accompanyingtext.
27. See infra Part II for a full discussion of price and non-price terms in equity anddebt venture financings.

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value of the contract. To revisit the used car example from Part I.A., if theseller has greater bargaining power, it may insist on using location B for
arbitration even though location A increases the total value of the deal by$10. This reasoning runs counter to the value-maximizing Coasean
bargaining described by the irrelevance theory. Figure 2 depicts the direct
effect theory.
Figure 2: Direct Effect Theory of Bargaining Power

Critics of the direct effect theory often question why the party withthe superior bargaining power would not instead agree to the valuemaximizing set of non-price terms and then extract its share of theincreased surplus via the distributional price term. 28 Answers to thisquestion can be found in the irrelevance theory’s core assumption of
perfect contracting conditions. As this demanding assumption is relaxed
to better approximate real-world negotiations, parties are less likely to

28. See Choi & Triantis, Market Conditions, supra note 7, at 54–55; George G.
Triantis, Financial Contract Design in the World of Venture Capital, 68 U. CHI. L. REV.
305, 319–21 (2001).

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achieve the optimal contract design. 29 If parties do not have perfect
information, then they may not be able to determine the value-maximizing
form of a non-price term.30 In addition, if there are steep transaction costs
to negotiating non-price terms, then the value gained from identifying the
optimal form of a given term may not be sufficient to justify thenegotiating effort required.31 In the used car example, the seller may notknow how much more the buyer prefers location A to location B, and as
a result may prefer to push for location B to extract $10 of value rather
than try to negotiate a price increase in exchange for agreeing to location
A. Real-world business negotiations also differ from the perfectcontracting utopia of the irrelevance theory because many are negotiatedin stages and through agents such as lawyers and bankers.32 If price isnegotiated first by the business parties and then non-price terms arenegotiated subsequently by lawyers, this bifurcation of the negotiation
can lead to a breakdown of the perfect contracting conditions assumed by
the irrelevance theory.33 In the used car example, if the price of the car
has been definitively set by the time the parties negotiate the arbitration
location term, the seller will have no incentive to agree to location A
because the seller will have no mechanism by which to extract value from

29. See OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE 32–33(1995); LAX & SEBENIUS, supra note 22, at 38–40, 245–46; ROBERT H. MNOOKIN ET AL.,
BEYOND WINNING: NEGOTIATING TO CREATE VALUE IN DEALS AND DISPUTES 9 (2000);
Ian Ayres & Robert Gertner, Strategic Contractual Inefficiency and the Optimal Choiceof Legal Rules, 101 YALE L.J. 729, 735–36, 742 (1992); Choi & Triantis, Bargaining
Power, supra note 1, at 1687–89; Oliver Hart & John Moore, Property Rights and the
Nature of the Firm, 98 J. POL. ECON. 1119, 1132 (1990); Jason Scott Johnston, Strategic
Bargaining and the Economic Theory of Contract Default Rules, 100 YALE L.J. 615,
615–16, 636–37 (1990).
30. See sources cited supra note 29.
31. See sources cited supra note 29.
32. See JAMES C. FREUND, ANATOMY OF A MERGER: STRATEGIES AND TECHNIQUESFOR NEGOTIATING CORPORATE ACQUISITIONS 53–55 (1975); MNOOKIN ET AL., supra note
29, at 129–35; Albert Choi & George Triantis, The Design of Staged Contracting 1–4(Apr. 3, 2017) (unpublished manuscript), http://www.law.columbia.edu/sites/default/files/microsites/academicfellows/design_of_staged_contracting_with_abstract_170403.pdf[https://perma.cc/M4LB-PC28] [hereinafter Choi & Triantis, Staged Contracting]; Choi
& Triantis, Bargaining Power, supra note 1, at 1690–96; Cathy Hwang, Deal Momentum,
65 UCLA L. REV. (forthcoming 2017).
33. See Choi & Triantis, Bargaining Power, supra note 1, at 1690–96.

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this more efficient form of the term. 34 Under imperfect contracting
conditions, parties may be unable to reach the value-maximizing form of
the contract assumed by the irrelevance theory, and as a result they may
resort to using their bargaining power to extract value via distributionallyfavorable non-price terms as described by the direct effect theory.
The primary champions of the direct effect theory have traditionallybeen practicing attorneys and businesspeople. Practitioner support for the
direct effect theory often comes in two forms: anecdotal evidence ofparties with substantial bargaining power using their negotiating leverage
to secure favorable terms and claims that as macroeconomic conditions
shift to favor one class of deal participants over another, the average (or“market”) form of a particular non-price term moves accordingly. 35
Practitioner claims of bargaining power directly affecting contract terms
appear in a wide variety of contexts including lending, corporate
acquisitions, and venture capital. 36 For example, deal attorneys
representing technology startups and venture capitalists note that“market” terms in venture financings shifted to favor investors following
the dot com bust in the early 2000s.37
34. The seller could potentially trade the arbitration location for a change in anothernon-price term that has a distributional benefit for the seller, but if this change is awayfrom the value-maximizing form of the term then there remains an efficiency loss.
35. See ANA LAI & STEVEN M. BAVARIA, STANDARD & POOR’S RATINGSDIRECT,
THE LEVERAGING OF AMERICA: COVENANT-LITE LOAN STRUCTURES DIMINISHRECOVERY PROSPECTS 2 (2007); NIXON PEABODY LLP, SEVENTH ANNUAL MAC SURVEY
2 (2008); Choi & Triantis, Bargaining Power, supra note 1, at 1693 (discussing how
material adverse change (MAC) definitions in merger agreements shift between sellerfriendly and buyer-friendly forms); Choi & Triantis, Market Conditions, supra note 7, at
53–55 (discussing how lending covenants were primarily borrower-friendly from 2000–
2007 and then shifted to be lender friendly after the financial crisis); Eric Goodison,
Covenant-Lite Loans: Traits and Trends, PRAC. L.J., Sept. 2011, at 36, 37, www.paulweiss.com/media/105718/plj_sep11.pdf [https://perma.cc/V5S3-WKP5]; Joseph Bartlett,
Sea Change, VC EXPERTS, https://www.vcexperts.com/reference/buzz/63 [https://perma.
cc/ZP2Y-4F2U] (last visited Oct. 3, 2017) (discussing how venture financing terms
became much more investor-friendly following the dot com crash of 2000–2001);
Knowledge@Wharton, Private Equity Bidding Wars: When Capital-Rich Funds
Compete, Intangibles Win the Deal, U. PA. WHARTON SCH. (Apr. 26, 2007),
http://knowledge.wharton.upenn.edu/article.cfm?articleid=1721[https://perma.cc/FZG9-6V9E]. See also Elisabeth de Fontenay, Law Firm Selection andthe Value of Transactional Lawyering, 41 J. CORP. L. 393, 395–98, 405–13 (2015).
36. See sources cited supra note 35.
37. See Bartlett, supra note 35.

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While the direct effect theory has been primarily advanced bypractitioners, scholars have provided empirical evidence of a connection
between bargaining power and non-price terms in multiple contracting
contexts.38 When explaining their findings that bargaining power has aneffect on non-price terms, scholars often invoke some form of the direct
effect theory. For example, in the context of venture financing contracts,
in a 2012 study of equity venture financings, Sharat Raghavan finds
evidence of a connection between bargaining power and certain venture
financing terms.39 Raghavan justifies this connection with the basic formof the direct effect theory: the party with more bargaining power getsbetter terms.40
In the venture financing context, the direct effect theory would be
empirically supported by the following two findings. First, a finding thatbargaining power is broadly connected to non-price terms in venture
financing contracts. If parties are using their bargaining power to push formore favorable non-price terms, we should expect to see a connection
between bargaining power and a variety of non-price terms. Second, afinding that bargaining power is connected to non-price terms that do nothave efficiency effects and are instead used by the parties to extract value
alongside the primary price terms. As discussed in Part I.C, there aremany non-price terms that enhance the overall efficiency of the deal by
responding to adverse selection and moral hazard. Some non-price terms,
however, do not have efficiency effects and are instead mechanisms
through which the parties can extract value. The direct effect theory
predicts a connection between bargaining power and these valueextraction terms. As discussed in Part II, venture financing contracts
include value-extraction terms such as dividends and warrants.
C. INDIRECT EFFECT THEORY
The indirect effect theory advanced by Choi and Triantis works tobridge the gap between the irrelevance theory promoted by law-andeconomics scholars and the direct effect theory championed bypractitioners. According to this theory, bargaining power directly affects
38. See Ben-Shahar & White, supra note 26, at 953, 959, 971; Bogert & Fink, supranote 26, at 400, 413–15; Cabrales et al., supra note 26, at 133–35, 155–56; Gompers &Lerner, supra note 26, at 464, 489–96; Raghavan, supra note 26, at 17–19, 52–56.
39. Raghavan, supra note 26, at 17–19, 52–56.
40. Id. at 57.

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the price of the contract, which in turn alters the severity of adverse
selection and moral hazard, and as a result indirectly modifies the optimal
forms of the non-price terms that respond to these problems.41 Like theirrelevance theory, the indirect effect theory maintains that the set of nonprice terms selected by the parties maximizes the overall value of thecontract under the circumstances. 42 Unlike the irrelevance theory,
however, the indirect effect theory claims bargaining power has an impact
on the value-maximizing contract design. 43 The indirect effect theory
therefore agrees with the direct effect theory’s conclusion that bargaining
power affects non-price terms, but disagrees as to the mechanism throughwhich this effect occurs. Whereas the direct effect theory claims thatparties use their bargaining power to directly extract value via
distributionally favorable but potentially inefficient non-price terms, theindirect effect theory argues that parties still reach the optimal contract
design, but that this optimal design is altered by bargaining power. Figure
3 depicts the indirect effect theory.

41. See Choi & Triantis, Bargaining Power, supra note 1, at 1683–87; see also supranote 9 (discussing adverse selection and moral hazard). Choi & Triantis also propose analternative version of the indirect effect theory in which a change in price alters a party’s
willingness to substitute price for non-price terms. For example, an entrepreneur who
receives a high valuation for their company may be more willing to trade a decrease invaluation for better non-price terms. Choi & Triantis, Bargaining Power, supra note 1,
at 1681–83. This Article does not focus on this version of the indirect effect theory for
two reasons. First, it assumes parties rationally substitute price for non-price terms, which
is not clear in the venture financing context. Second, it is empirically difficult (orpotentially impossible) to distinguish the effects of this theory from the direct effecttheory.
42. See Choi & Triantis, Bargaining Power, supra note 1, at 1681. Even though theindirect effect theory contends that the parties select the optimal non-price terms given
the presence of asymmetric information, it acknowledges that the total value of thecontract would be higher if there was no information asymmetry. With perfect
information and zero transaction costs, the indirect effect theory predicts the same
contract design as the irrelevance theory.
43. Id. This assumes the presence of asymmetric information.

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Figure 3: Indirect Effect Theory of Bargaining Power

Choi and Triantis develop the indirect effect theory primarily in thecontext of a basic lending market.44 In this context, a macro-level increaseor decrease in the supply of credit shifts bargaining power in favor ofborrowers or lenders, respectively.45 As a result, the interest rate (which
serves as the price of the deal) rises when the supply of credit decreases
and falls when the supply increases. 46 In the presence of asymmetric
information, lenders are not able to perfectly identify the riskiness of aparticular borrower.47 If the interest rate increases due to a decrease in thecredit supply, less risky borrowers will opt-out of the lending market,
thereby increasing the percentage of riskier borrowers left behind.48 Thisis a classic case of adverse selection. In order to screen between less risky
and riskier borrowers, lenders can use non-price terms such as restrictive

44.
45.
46.
47.

See Choi & Triantis, Market Conditions, supra note 7, at 55–56.
Id.
Id.
Id.; see also Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets
with Imperfect Information, 71 AM. ECON. REV. 393 (1981).
48. Choi & Triantis, Market Conditions, supra note 7, at 55–56.

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covenants and collateral requirements. 49 These non-price terms are farless attractive to riskier borrowers, and therefore less risky borrowers cancredibly signal their quality by agreeing to the more stringent terms.50 As
shifts in bargaining power move the interest rate up and down, the severityof adverse selection will increase and decrease, respectively, andconsequently the optimal form of the non-price terms will change
accordingly.51 Bargaining power therefore has an indirect effect on the
optimal contract design.
Moral hazard also plays a role in the lending market example. As
greater bargaining power on the part of the lender pushes the interest rateup, the borrower’s share of the proceeds from the deal decreases due toan increased debt overhang. 52 As a result, the borrower is incented topursue riskier projects and/or squander the assets through misbehavior
because the borrower receives a smaller payoff from a successful project
due to the lender’s debt position. 53 This moral hazard problem
exacerbates the misalignment of post-borrowing incentives between the

49. See id. at 55–56, 58; Cem Demiroglu & Christopher M. James, The Information
Content of Bank Loan Covenants, 23 REV. FIN. STUD. 3700, 3705 (2010); Nicolae
Gârleanu & Jeffrey Zwiebel, Design and Renegotiation of Debt Covenants, 22 REV. FIN.
STUD. 749, 749 (2009); Alan Schwartz, Security Interests and Bankruptcy Priorities: A
Review of Current Theories, 10 J. LEGAL STUD. 1, 14–21 (1981); George G. Triantis,
Secured Debt under Conditions of Imperfect Information, 21 J. LEGAL STUD. 225, 252–
58 (1992).
50. Triantis, supra note 49, at 252–58; see also Choi & Triantis, Market Conditions,supra note 7, at 62–64.
51. See Choi & Triantis, Market Conditions, supra note 7, at 66–68.
52. Id. at 55–56, 68. For example, if a borrower borrows $100 to complete a projectthat is worth $200, the borrower will retain more of the surplus if the interest is $10 versus$20.
53. Id. For example, assume a borrower borrows $100 and has to choose between
two projects. Project A has a 100% chance of paying $200. Project B has a 50% chanceof paying $290 and a 50% chance of paying $0, for a total expected value (EV) of $145.
From a value-maximizing standpoint, Project A is superior to project B; it has a higher
EV and is less risky. Assume the lender has no recourse if the borrower cannot repay theloan. If the interest on the loan is $10, the borrower will receive a net EV of $90 for
Project A ($200 - $110) and $90 for Project B (($290 - $110) / 2) and will therefore beindifferent between the two. If the interest is $20, however, the borrower will receive a
net EV of $80 for Project A ($200 - $120) and $85 for Project B (($290 - $120) / 2) andwill therefore prefer Project B assuming the borrower is risk neutral. As the interest rateincreases, the borrower has a greater incentive to pursue riskier projects.

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lender and the borrower.54 The lender can respond by including covenants
that constrain the borrower’s behavior after the loan is made.55 As theinterest rate fluctuates due to changes in bargaining power, the moral
hazard problem will increase and decrease in severity. The optimal formsof the non-price terms used to respond to moral hazard are therefore
influenced by shifts in bargaining power.56
The indirect effect theory can be extended to equity and quasi-equity
investing in the context of venture financings.57 As is the case in the basic
lending market example, venture investing is rife with asymmetric
information. Venture investors are primarily investing in companies thatare developing innovative technologies and business models. In manycases, the founders of these companies have never started a businessbefore. For explanatory purposes, we can think of a simplified version of
the venture investing landscape that contains two types of companies inwhich to invest: low-quality and high-quality. While entrepreneurs know
their company type, venture investors can only imperfectly assesscompany type. 58 This is the venture capital version of the adverse
selection problem. As bargaining power shifts between entrepreneurs andinvestors, the prices of venture financings increase or decrease,respectively. In a market with low prices, high-quality companies with
sufficient funding will opt-out of the market, preferring to wait for prices
to increase. 59 Low-quality companies, on the other hand, will be less

54.
55.

Id.
Id. at 55–56, 58, 68–70; see also Arnoud W. A. Boot et al., Secured Lending and
Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results, 101
ECON. J. 458, 465 (1991); Clifford W. Smith, Jr. & Jerold B. Warner, On Financial
Contracting: An Analysis of Bond Covenants, 7 J. FIN. ECON. 117 (1979); see generally
George G. Triantis, A Free-Cash-Flow Theory of Secured Debt and Creditor Priorities,
80 VA. L. REV. 2155 (1994).
56. See Choi & Triantis, Market Conditions, supra note 7, at 70–71.
57. As discussed below, debt in the venture financing context is typically convertible
to equity and therefore debt venture financings can be thought of as quasi-equity
investing. See infra Section II.B.
58. In the real world, company quality is a spectrum and entrepreneurs do not know
the quality of their companies with certainty. As in this theoretical simplification,
however, entrepreneurs have better information regarding the quality of their companies
than venture investors.
59. Some high-quality companies will still have to raise money in a low-price market
because of capital needs.

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likely to exit the market and will continue attempting to raise capital.60 As
a result, there will be a higher proportion of low-quality companies
seeking capital in a low-price market relative to a high-price market. To
screen between low and high-quality companies, investors can use nonprice terms that take effect if a company does poorly such as a term thatwithholds future financing if the company fails to hit certain achievement
milestones. 61 These terms are costlier for low-quality companies andtherefore allow high-quality companies to credibly signal their quality toinvestors.62 The lower the price, the more severe the adverse selection
problem, which in turn necessitates more stringent, investor-favorable
terms. Relative bargaining power between entrepreneurs and investors
therefore alters the optimal forms of these non-price terms.
Moral hazard also comes into play in the venture financing context.
Venture investors typically make equity investments via preferred stockand quasi-equity investments via convertible debt, both of which have theright to receive payment before the common stock held byentrepreneurs. 63 Increased bargaining power on the part of investors
pushes prices down, which means investors receive a larger share of thecompany in exchange for a given amount of money.64 Investor ownershipin this context functions similarly to a debt overhang in the basic lending
context, and therefore entrepreneurs are incented to take greater risks
and/or squander company resources via misbehavior.65 To respond to thispost-investment moral hazard problem, investors can push for non-priceterms that constrain the entrepreneur’s behavior such as a term that
requires investor approval for certain key actions.66 The lower the price,
the greater the moral hazard problem and therefore the greater the
60. Low-quality companies are less likely to have sufficient funds on hand to be able
to wait for prices to increase. In addition, low-quality companies have to spend more time
fundraising and meet with a greater number of investors to secure financing.
61. See infra Part II for a discussion of which terms can be used as screening
mechanisms for adverse selection.
62. Agreeing to investor-favorable terms could also signal inexperience on the partof the entrepreneur and/or a need for capital on a short timeframe. As a result, thesesignals can be noisy.
63. See infra Part II.
64. See infra Section II.A.1.
65. See supra note 53 and accompanying text. This example functions similarly inthe venture investing context because investors (both equity and debt) are entitled acertain payment before the entrepreneur receives anything.
66. See infra Part IV for a discussion of which terms can be used to respond to moral
hazard.

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importance of these restrictive terms. As in the case of adverse selection
discussed above, bargaining power influences the value-maximizing
design of venture financing contracts.
In the venture financing context, the indirect effect theory would be
empirically supported by the following two findings. First, a finding thatbargaining power is connected to efficiency-enhancing non-price terms
that act as screening mechanisms in response to adverse selection and/or
constrain the entrepreneur’s behavior in response to moral hazard.
Second, a finding that bargaining power is not connected to non-priceterms that do not respond to adverse selection and/or moral hazard andare instead intended merely for value-extraction. Unlike the direct effecttheory, the indirect effect theory contends that bargaining power does nothave an effect on these value-extraction terms.
II. VENTURE FINANCING CONTRACT TERMS
This Part provides an overview of equity and debt venture financingsand discusses the mechanics and implications of specific terms containedin the empirical sample. Subpart A covers equity financings and Subpart
B covers debt financings.
A. EQUITY FINANCINGS
The classic form of venture financing in the U.S. is a preferred stock
equity financing in which investors received shares of preferred stock in
exchange for their capital.67 Shares of preferred stock typically contain abroad set of additional rights and benefits that set these shares apart fromthe shares of common stock held by founders and employees. 68 In
addition to the contractual rights granted by the preferred stock, equity
investors will often receive representation on the company’s board of
directors.69 If there are multiple investors, a member of the lead investor
67. Equity venture investments can take the form of common stock purchases aswell. Common stock, however, is rarely sold to investors other than friends and family
and very early angel investors. A company’s first institutional equity investment is almost
always via preferred stock.
68. See William W. Bratton, Venture Capital on the Downside: Preferred Stock andCorporate Control, 100 MICH. L. REV. 891 (2002). Many of these rights are discussed in
the subparts below.
69. Board representation is often considered the most important non-price term. A
seat on the board gives the investor a formal say in key decisions regarding the company’s

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the board seat.
Entrepreneurs, investors, and venture attorneys often characterize
the terms in a venture financing as either “economics” or “control.”70
Economic terms are generally seen as terms that determine how the valueof the company is divided between the parties whereas control terms
determine how decisions regarding the company are made and who has
the power to make them.71 There is a common saying in Silicon Valley(often regarded as the heart of the venture world), “you can haveeconomics or control, but not both.”72 First-time entrepreneurs are often
believed to focus too heavily on economics whereas more experienced
entrepreneurs understand the importance of control.73 According to theirrelevance theory discussed in Part I.A, bargaining power should only
affect distributional economic terms whereas control terms (along withthe rest of the contract design terms) should take their most efficient forms
regardless of bargaining power. The direct and indirect effect theories, on
the other hand, contend that bargaining power affects control terms as
well, though they disagree on the mechanism through which thisconnection occurs.
Venture financings (both equity and debt) also contain a long-term
relationship aspect that differentiates them from many other contracting
contexts. Practitioners frequently describe the venture investing
relationship as a marriage between the entrepreneur and the investors.74
The investors will be represented on the company’s board and will usually
be the entrepreneur’s first stop when raising subsequent financing.75 In
addition, venture investors frequently act as counselors and advisors tostrategy and operations as well as the hiring of officers such as the CEO. In addition, thedecision-making authority granted by a board seat fills in gaps left by the contractual
rights specified in the financing contracts.
70. Interview with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017);
Telephone Interview with Anonymous Source (Apr. 13, 2017).
71. Telephone Interview with Anonymous Source (Apr. 13, 2017). Some terms will
have both economic and control implications. See sources cited supra note 2.
72. Id.
73. Interview with Anonymous Source, in Palo Alto, Cal. (Apr. 17, 2017).
74. With lawyers often serving as marriage counselors.
75. If current investors decide not to participate in subsequent financing rounds, thissends a bad signal to outside investors.

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their portfolio companies even if they do not sit on the board.76 Both sides
know they will have to work with one another for many years for thecompany to be successful, and as a result they want their counterpart tobe happy with the arrangement.77 One experienced attorney distinguishedthis approach from the “scorched earth” strategy of an M&A deal inwhich the parties part ways at the conclusion of the transaction.78 This
relational aspect therefore affects the negotiation of venture financing
contracts, especially in the early stages of a company’s life. In the words
of a prominent Silicon Valley venture attorney, “You’re picking a partner.
It’s not zero sum.”79
The remainder of this Part discusses the equity financing terms that
the Article empirically analyzes in Part IV.80
1. Pre-Money Valuation
The pre-money valuation is the most important term in an equity
venture financing because it functions as the price of the deal and, in
conjunction with the amount raised, determines the percentage of thecompany that will be owned by the investors. The term gets its namebecause it refers to the value the parties assign to the company before theinvestors put in their money.81
76. Investors who can provide valuable advice and connections in addition to capitalare often referred to as “smart money,” and have an advantage over investors who only
provide capital.
77. Telephone Interview with Anonymous Source (April 13, 2017).
78. Id.
79. Id.
80. The most important non-price terms that are not analyzed in this Article (because
they do not appear in the dataset) are board representation and protective provisions. The
later typically specify certain company actions for which the company must obtainapproval from a specified percentage of investors in addition to the board of directors.
81. See Model Legal Documents: Term Sheet, NAT’L VENTURE CAP. ASS’N, http://
nvca.org/resources/model-legal-documents [https://perma.cc/XK5D-FXYP] (follow“Term Sheet” hyperlink) (last visited Oct. 3, 2017) [hereinafter NVCA Model Term
Sheet]. A simple example can be helpful to demonstrate how the pre-money valuation
sets the price of the deal and its impact on ownership percentage. In this hypothetical, thecompany is seeking its first venture capital investment. There are ten million shares ofcommon stock outstanding that have been issued to the founders and early employees.
Early employees will often receive options instead of shares. For the purposes ofcalculating the pre-money valuation, options outstanding are treated the same as shares
outstanding. This includes options and shares that are subject to vesting. The company islooking to raise $2 million to finance the development of its business. If the parties agree

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In a typical venture financing, the lead investor discusses a general
range of pre-money valuations with the entrepreneur before the investor
presents the entrepreneur with a term sheet. 82 This is known as“socializing” the deal. During this process, the investor and theentrepreneur also discuss other key terms such as board seats. 83 The
investor will not present the entrepreneur with a term sheet unless theinvestor is reasonably confident the entrepreneur will be happy with the
pre-money valuation and key terms.84 As one attorney put it, the investor
will not “propose” unless they think the entrepreneur will “say yes.”85
After the investor puts a term sheet on the table, the parties negotiate thepre-money valuation and key terms. According to experienced venture
attorneys, these key terms are the terms most likely to be affected bybargaining power because they are fundamental to the deal.86 In manyon a pre-money valuation of $6 million, the post-money valuation will be $8 million, theprice per share of the preferred stock will be $0.60, the investors will receive 3,333,333
shares and they will own 25% of the company following the investment (price per share= $6 million pre-money / 10 million shares outstanding = $0.60; investor shares = $2
million investment / $0.60 price per share = 3,333,333 shares; investor ownership
percentage = 3,333,333 investor shares / 13,333,333 total shares = 25%). If instead theparties agree on a pre-money valuation of $8 million, the post-money valuation $10
million, the price per share of the preferred stock will be $0.80, the investors will receive
2,500,000 shares and they will own 20% of the company following the investment (priceper share = $8 million pre-money / 10 million shares outstanding = $0.80; investor shares= $2 million investment / $0.80 price per share = 2,500,000 shares; investor ownership
percentage = 2,500,000 investor shares / 12,500,000 total shares = 20%). As can be seenfrom this example, a higher pre-money valuation leads to a higher price per share for the
preferred stock and a lower ownership percentage for the investors. Entrepreneurs
therefore prefer a higher pre-money valuation whereas investors prefer a lower premoney valuation.
82. Interview with Anonymous Source, in Palo Alto, Cal. (Apr. 17, 2017). A term
sheet is a preliminary agreement that describes a number of key terms, including the priceof the deal. For an example of a term sheet, see NVCA Model Term Sheet, supra note 81.
Venture financings will often involve multiple venture investors. This is commonlyreferred to as a “syndicated” deal, with the group of investors being the “syndicate.” Thelead investor is typically the investor putting in the largest amount of capital.
83. Interview with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017);
Telephone Interview with Anonymous Source (Apr. 13, 2017); Interview with
Anonymous Source, in Palo Alto, Cal. (Apr. 17, 2017).
84. Interview with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017).
85. Id.
86. Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview
with Anonymous Source, in Palo Alto, Cal. (Apr. 17, 2017).

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cases, the parties will negotiate these terms without their lawyers.87 If theparties trade changes in price for changes in key terms, they will almost
always do so during the socialization period and/or the negotiation of theterm sheet.88 Once the parties agree on the term sheet, they will rarelychange the price or other terms listed in the term sheet. 89 Terms notincluded in the term sheet are then negotiated by the parties’ lawyers who
are tasked with preparing the official financing documents. This staged
negotiation process is a potential reason why the final design of thecontract may deviate from the value-maximizing form predicted by theirrelevance theory.90
All three bargaining power theories predict greater bargaining poweron the part of entrepreneurs leads to higher pre-money valuations.
2. Amount Raised
The amount raised is generally the simplest term in a venture
financing contract. It is the total amount of capital the investors put into
the company in the financing. Like the pre-money valuation, the amountraised is often set in the term sheet at the beginning of the negotiation.91
For a given pre-money valuation, the greater the amount raised, thegreater the investor’s post-financing ownership percentage.
While at first glance it might seem that entrepreneurs with greaterbargaining power will raise more money, this is not necessarily the case.
A startup company usually raises money under the assumption its value
will increase over time. As the company’s valuation increases, theentrepreneur has to give up less ownership to raise a given amount ofmoney.92 If an entrepreneur has the option to raise up to $5 million at a
$15 million valuation, but predicts the company only needs to raise $2
million to get to a point where it can raise money again at a $30 million
valuation, the entrepreneur is unlikely to raise the entire $5 million
amount. That being said, entrepreneurs will often raise more capital than
87.
88.

Interview with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017).
Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017);
Telephone Interview with Anonymous Source (Apr. 13, 2017).
89. See Choi & Triantis, Staged Contracting, supra note 32, at 8–9; Hwang, supranote 32 (manuscript at 10).
90. See generally Choi & Triantis, Staged Contracting, supra note 32 andaccompanying text.
91. See NVCA Model Term Sheet, supra note 81, at 1.
92. See NVCA Model Term Sheet, supra note 81 and accompanying text.

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the bare minimum to provide a “buffer,” especially if they expect the
supply of capital to decrease in the future.93 As a result, the amount ofmoney raised is likely to be determined less by the relative bargaining
power of the parties and more by the company’s funding needs and theentrepreneur’s expectations of valuation growth and availability of future
capital.
3. Liquidation Preference
In the event of a liquidation of the company (by dissolution, sale,merger, etc.), shares of preferred stock typically carry the right to receivea fixed payment before any payment is made to holders of common stock
such as entrepreneurs and early employees. 94 This right to receive
payment before the common stockholders is known as the liquidationpreference. 95 The amount of the liquidation preference is usually amultiple (often 1X) of the original price per share of the preferred stock.96
The liquidation preference is the feature of preferred stock that creates aneffect similar to a debt overhang.97
If a company has multiple series of preferred stock (such as Series
A, B, etc.), the financing documents will specify the order of the various
liquidation preferences. 98 The most common ordering mechanism isknown as “pari passu” which means the different series of preferred stock
will receive payment at the same time on a pro rata basis.99 Occasionally,

93.
94.

Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017).
See NVCA Model Term Sheet, supra note 81, at 2–3. Early employees will often
hold stock options that convert into shares of common stock.
95. Id.
96. See id. For example, if there are two million shares of preferred stock outstanding
with a price per share of $0.50 and a liquidation preference multiple of one, then thepreferred stockholders collectively have a right to receive the first $1 million in the eventof a liquidation (liquidation preference = 2 million preferred shares * $0.50 price pershare * 1X multiple = $1,000,000).
97. See supra Part I.C.
98. See Model Legal Documents: Certificate of Incorporation, NAT’L VENTURE CAP.
ASS’N, 6–7 n.14, http://nvca.org/resources/model-legal-documents [https://perma.cc/XK
5D-FXYP] (follow “Certificate of Incorporation” hyperlink) (last visited Oct. 3, 2017)and accompanying text.
99. See id.

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however, a series of preferred stock will be specified as junior or senior
to other series in the distribution ordering.100
In a typical equity financing, preferred stockholders have the option
to convert their shares to common stock in the event of a liquidation.101
The conversion price is typically set equal to the original purchase priceof the preferred shares so the shares convert on a one-to-one basis.102 If
preferred stockholders convert to common, they forfeit their liquidationpreference. They will therefore only convert if doing so will give them apayout greater than their liquidation preference. 103 The liquidationpreference functions as downside protection for preferred stockholders
while still providing them with the option of unbounded upside.104
Liquidation preferences, particularly preferences with a multiple
greater than one, can act as a screening mechanism to help investors
identify a company’s quality in response to adverse selection. Because
preferred stockholders are likely to convert to common (and therefore lose
their liquidation preference) in the event of a lucrative liquidation event,liquidation preferences are more likely to take effect for low-quality
companies. High liquidation preferences are costlier for low-quality
companies and therefore allow high-quality companies to signal their
quality to investors. While high liquidation preferences can help respond100. See id. For example, consider a hypothetical company with three series ofpreferred stock: A, B, and C. Series A and B are pari passu with each other, but Series C
is senior to both A and B. There are one million shares of each series. Series A, B, and C
have liquidation preferences of $0.50, $1.00, and $2.00, respectively, for a totalliquidation preference of $3.5 million. The company then receives an acquisition offer of$5 million. Series C would be entitled to the first $2 million, Series A and B would jointly
be entitled to the next $1.5 million, and the common stockholders would receive the final$1.5 million. If, however, the offer was only for $3 million, Series C would still receive
the first $2 million, but now Series A and B would have to split the remaining $1 million
on a pro rata basis. The common stockholders would receive nothing.
101. See NVCA Model Term Sheet, supra note 81, at 4.
102. Id.
103. For example, assume a company has one million shares of preferred stock witha liquidation preference of $1.00 per share and nine million shares of common stock. If
the preferred stockholders convert to common, they will receive 10% of the totalliquidation amount (investor ownership percentage = 1 million investor shares / 10
million total shares = 10%). As a result, they will only convert to common for aliquidation amount greater than $10 million (break-even valuation = $1 million
liquidation preference / 10% ownership = $10 million).
104. If the liquidation preference multiple is greater than 1, the liquidation preference
provides the investor with a guaranteed minimum return assuming there is sufficientvalue at the point of liquidation to cover the preference.

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to adverse selection, they also create a debt overhang effect that increases
the severity of moral hazard.
4. Participation
While preferred stockholders generally must give up their liquidationpreference to share in the upside of the deal by converting to common,
this is not the case if the preferred stock contains a participation right.105
Participation allows the preferred stockholders to share the liquidation
proceeds pro rata with the common stockholders in addition to receiving
their liquidation preference. 106 Equity venture financings withparticipation will sometimes contain a term referred to as a “participation
cap.”107 Under a participation cap, preferred stockholders have the option
to (1) receive their liquidation preference and participate with thecommon stockholders up to a limit (usually a multiple of the original
purchase price of the stock) or (2) convert to common.108
Capped participation is effectively a more extreme version of aliquidation preference. The higher the cap, the costlier the term is for lowquality companies. High-quality companies are more likely to achieve
total liquidation amounts that will render a cap irrelevant, so capped
participation can function as a signaling mechanism to respond to adverse
selection. Uncapped (or “full”) participation, on the other hand, is very
costly for both high and low-quality companies and therefore has little
105.
106.

See NVCA Model Term Sheet, supra note 81, at 2–3.
Id. In the example from supra note 103, assume the preferred shares have aparticipation right. If the company receives an acquisition offer of $11 million, thepreferred stock would receive $1 million for its liquidation preference and an additional$1 million via participation for a total of $2 million (liquidation preference = $1.00 per
share * 1 million investor shares = $1 million; participation = 10% ownership * ($11
million - $1 million) = $1 million, for a total of $2 million). Without participation, theinvestors would convert to common and receive 10% ownership * $11 million = $1.1
million.
107. See NVCA Model Term Sheet, supra note 81, at 3.
108. See id. In the example from supra note 106, assume there is a participation capof two times the original purchase price, for a total of $2 million. In this case, the preferredstockholders will only convert to common when doing so provides them with a payoutof greater than $2 million, which will only occur for total liquidation amounts of morethan $20 million (break-even valuation = $2 million participation cap / 10% ownership =$20 million). The break-even valuation without participation was $10 million. See supranote 103.

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efficiency implications. As a result, uncapped participation is a valueextraction term rather than an efficiency term. Both capped and uncapped
participation exacerbate the moral hazard problem.
5. Anti-Dilution
Most equity venture financings contain a provision known as “antidilution protection” that protects preferred stockholders in the event thecompany raises capital at a later date at a price per share less than the pricethe preferred stockholders paid.109 Raising capital at a valuation less thanthe valuation of a previous round is known as a “down round” andtypically signals the company is not performing well. “Anti-dilution
protection” functions by reducing the price at which the preferred stock
converts into common stock. 110 As discussed in Part II.A.3, the initialconversion price is usually set equal to the original purchase price of thepreferred stock. Each share of preferred stock converts into a number ofshares of common stock equal to the quotient of dividing the original
purchase price by the conversion price.111 The preferred stock therefore
initially converts into common stock at a one-to-one ratio, but will convert
into a greater number of shares of common stock if the conversion priceis reduced via anti-dilution protection.
The most severe (and investor favorable) form of anti-dilution
protection is known as “full ratchet” protection. Under full ratchet
protection, in the event of a down round, the conversion price of thepreferred stock is set equal to the purchase price of the new shares.112 Fullratchet protection functions the same regardless of how much money israised in the down round.113

109. See NVCA Model Term Sheet, supra note 81, at 4–5. This type of anti-dilution
protection is generally referred to as “price-based” protection. This is distinct from antidilution protection for non-economic stock modifications such as stock splits, which all
venture financings contain.
110. Id.
111. Id. at 1–2, 4–5.
112. Id. at 5. For example, if a company with Series A preferred shares with aconversion price of $1.00 per share and full ratchet protection raises a Series B round at$0.80 per share, the conversion price of the Series A shares becomes $0.80. The Series
A shares go from converting into one share of common each to 1.25 shares of common
each (number of shares of common per share of preferred = $1.00 original purchase price/ $0.80 conversion price = 1.25 shares).
113. Id.

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A less severe (and more common) form of anti-dilution protection is
known as “weighted average” protection. As the name suggests, weighted
average protection modifies the change in the conversion price based on
the size of the down round relative to the total capitalization of thecompany.114 The larger the amount of money raised in the down round,the larger the drop in the conversion price.115 Weighted average protection
helps protect investors against down round dilution but does not penalize
the company as severely as full ratchet protection. When determining theeffect of weighted average protection, there are two general ways tocalculate the total capitalization of the company: “broad based” weighted
average protection and “narrow based” weighted average protection.
Broad based protection includes options and other similar securities
whereas narrow based protection only includes shares of stock
outstanding.116 Broad based protection results in a smaller reduction in theconversion price and therefore is more favorable for the company.117
Anti-dilution protection only takes effect in the event of a downround and is therefore costlier for low-quality companies, with full ratchet
being costlier than weighted average and broad based being costlier thannarrow based. Investors can use the different forms of anti-dilution
protection as a screening mechanism to respond to adverse selection.
6. Redemption
A right of redemption allows the preferred stockholders to force thecompany to repurchase their preferred shares at a price equal to theoriginal purchase price of the shares.118 Redemption rights often require a
vote of a certain percentage of the preferred stockholders to prevent oneoff redemptions.119 Some redemption rights are only exercisable after acertain amount of time, such as one year. Most startups do not operatewith sufficient cash on hand to redeem their outstanding preferred shares,
so in many cases the exercise of a redemption right will effectively force
a dissolution of the company.

114.
115.
116.
117.
118.
119.

Id. at 4–5.
Id.
Id.
Id.
Id. at 6.
Id.

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Investors are unlikely to exercise a redemption right unless thecompany is performing poorly. 120 As a result, redemption rights arecostlier for low-quality companies that are more likely to be in a positionin which investors want to exercise. Investors can use redemption rights
as a screening mechanism to respond to adverse selection. Once theinvestment has been made, investors can also use the threat of exercise todeter excessive risk-taking and misbehavior by the entrepreneur, thereby
mitigating the moral hazard problem.
7. Dividends
In the context of a large public company, dividends are typically used
as a method to distribute cash to the company’s stockholders. This is not
the case for dividends in the context of a preferred stock venture
financing. Preferred stock dividends are usually only payable in the eventof a liquidation. 121 These dividends generally come in two forms:
cumulative and non-cumulative.122 Cumulative dividends automaticallyaccrue every year.123 Non-cumulative dividends only accrue “when andif” declared by the company’s board of directors, which rarely occurs.124
In both cases, the size of the dividend per share is equal to a percentageof the original purchase price of the preferred stock.125
In practice, dividends are typically regarded as far less important
than other terms in an equity financing and serve little to no efficiency

120. There are situations in which an investor will need to cash out of the company
even if the company is performing well. For example, if the investor’s limited partners
are demanding liquidity. The voting threshold requirement prevents investors from using
the redemption right in this type of situation. In this situation, another investor will
typically purchase the shares of the investor who wants to liquidate.
121. See NVCA Model Term Sheet, supra note 81, at 2 n.4. Dividends are occasionally
payable upon redemption and/or conversion to common stock. Id.
122. Id. at 2.
123. Id.
124. Id.
125. Id. For example, assume a company raises a Series A with a liquidationpreference of $1.00 per share and cumulative dividends of 10%. If the company has aliquidation event three years later, the liquidation preference on the Series A shares will
be $1.30 (liquidation preference = $1.00 initial liquidation preference + 3 years * $1.00
original purchase price * 10% dividend = $1.30). Dividends typically do not compound.

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purpose.126 As a result, dividends are best characterized as a method ofvalue extraction.
8. Pay-to-PlayA pay-to-play provision requires preferred stockholders toparticipate pro rata in all future equity financing rounds or suffer a varietyof consequences.127 The most severe form of punishment is converting theinvestor’s shares of preferred stock to shares of common stock, thereby
stripping the investor of all the additional rights and benefits of thepreferred.128 A less severe (but still considerable) consequence is allowing
the investor to keep its preferred shares, but taking away the liquidationpreference and/or anti-dilution protection of those shares. 129 The least
serious punishments are to demote the investor’s preferred shares to be
junior with respect to all other preferred shares and/or take away the rightto participate in future rounds.130
While investors may not want to invest in a subsequent financing
round for a variety of reasons,131 investors are less likely to want to invest
additional money in a low-quality company. Because pay-to-playprovisions incent investors to invest in subsequent rounds, theseprovisions are more valuable for low-quality companies. Pay-to-playprovisions (or the lack thereof) can be used as a signaling mechanism torespond to adverse selection. These terms also have an effect on moral
hazard because they restrict the ability of investors to withhold additional
capital from an entrepreneur who is engaging in excessive risk-taking or
misbehavior.

126. Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview
with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017).
127. See NVCA Model Term Sheet, supra note 81, at 5–6.
128. Id. at 6.
129. Id.
130. Id.
131. Alternative reasons include a poor economy, a venture fund reaching the end of
its investing life and an investor shifting its focus on a different industry or stage (i.e.
early versus late).

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9. Drag-Along
A drag-along provision allows the preferred stockholders the right toforce the entrepreneur and other major holders of common stock to votein favor of a liquidation event that has been approved by a threshold levelof the preferred stockholders.132 A drag-along right effectively enables thepreferred stockholders to decide when to liquidate the company.
Preferred stockholders are unlikely to push for a liquidation that theentrepreneur disagrees with unless the company is performing poorly. As
a result, a drag-along provision is costlier for a low-quality company andtherefore can be used as a signaling mechanism to respond to adverse
selection. Investors can also use the threat of a forced liquidation to deter
excessive risk-taking and/or misbehavior by the entrepreneur, thereby
mitigating moral hazard.
10. Staged Financing
A staged financing (also known as a “tranched” or “milestone”
financing), is one in which the investors contribute capital over multiple
stages.133 The different stages can be separated by time (with investors
having the option to invest more at each stage) or can be tied to theachievement of specific technological or business milestones.134 The useof a staged financing increases the expected return on investment due tothe time value of money and reduces the risk associated with theinvestment if the company must achieve certain performance goals before
the investors are required to commit additional capital.135
Staged financings are costlier for low-quality companies because
they are less likely to perform well during the waiting period and achieve
performance milestones. Investors can therefore use staged financings to132. See NVCA Model Term Sheet, supra note 81, at 11–12. Drag-along provisions
usually apply to holders of greater than 1% of the common stock. Id.
133. Id. at 1 n.2. A staged financing is distinct from separate funding rounds such as
Series A, B, etc. because the price and terms of the deal are the same across the stages.
134. Id. Examples of performance milestones include reaching a certain number ofdaily/monthly active users, hitting a revenue target or getting government approval for a
product (such as FDA approval for a medical device).
135. Consider two investments, one in which an investor commits $2 million ofcapital to a company on January 1, 2018, and one in which the investor commits $1
million on January 1, 2018, and $1 million on July 1, 2018. Assuming all else is equal,
the second investment will give the investor a higher return because the investor is able
to earn a market rate of return on $1 million between January 1 and July 1.

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respond to adverse selection. Staged financings also respond to moral
hazard because entrepreneurs are less likely to misbehave and/or takeexcessive risks if they still need to secure future stages of financing.
B. DEBT FINANCINGS
Debt financings, while less studied than equity financings, play animportant role in the venture financing landscape.136 Debt financings areoften used before a company raises its first equity round and in between
subsequent equity rounds. As will be discussed below, the debt issued inthese financings usually converts into preferred stock during the next
equity round. 137 These investments can therefore be viewed as quasiequity investments.138 Unlike most equity financings, however, investors
in a debt financing rarely receive representation on the company’s boardof directors. There are two primary benefits to using a debt financing
relative to an equity financing: (1) a debt financing does not require theparties to determine a valuation for the company and (2) a debt financing
is generally faster and much less expensive than an equity financing.139
Debt financings allow early stage companies to postpone raising capital
via an equity financing until they are more developed and can therefore
secure a higher pre-money valuation.140

136. The convertible debt discussed in this subpart is distinct from “venture debt”
which typically describes traditional loans targeted at early-stage companies. See Darian
M. Ibrahim, Debt as Venture Capital, 2010 U. ILL. L. REV. 1169, 1171–74 (2010).
137. See WSGR Note Term Sheet Generator (Convertible Notes), WILSON SONSINIGOODRICH & ROSATI P.C., https://www.wsgr.com/WSGR/Display.aspx?SectionName=practice/termsheet-convertible.htm [https://perma.cc/B5ES-XBSV] (last visited Oct. 3,2017) [hereinafter WSGR Convertible Note Term Sheet Generator]; id. (follow “Launch”
hyperlink; then follow “About Convertible Note Financings” in the drop-down box); seealso John F. Coyle & Joseph M. Green, Contractual Innovation in Venture Capital, 66
HASTINGS L.J. 133 (2014).
138. Another form of quasi-equity investing gaining traction in recent years is the
Simple Agreement for Future Equity (SAFE). Made popular by Y Combinator (aprestigious startup accelerator), a SAFE is similar to a convertible note, but contains far
less terms and is not considered a debt instrument. See Startup Documents, Y
COMBINATOR (Feb. 2016), https://www.ycombinator.com/documents [https://perma.cc/
RNG7-CTZX].
139. Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017).
140. See supra Part II.A.1. for the benefits of a higher pre-money valuation

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The remainder of this Part discusses the debt financing terms that the
Article empirically analyzes in Part IV.
1. Interest Rate
The interest rate in a debt venture financing functions similarly to theinterest rate in a basic loan. Interest accrues periodically on the principalof the loan as well as any accrued but unpaid interest. The main difference
is interest in the venture context is generally not payable until maturity or
conversion.141 As is the case in the basic lending context, the interest rate
for a debt financing functions as the price of the deal.142 The irrelevance,
direct effect, and indirect effect theories predict greater bargaining poweron the part of investors should lead to higher interest rates. All threebargaining power theories predict greater bargaining power on the part ofentrepreneurs leads to lower interest rates.
2. Amount Raised
The amount raised in a debt financing can be analyzed in much thesame way as the amount raised in an equity financing, which is discussed
in Part II.A.2. As is the case with equity financings, entrepreneurs areunlikely to raise larger amounts of capital in debt financings simply
because they have greater bargaining power. As discussed in Section
II.B.4, debt in the venture context typically converts into equity based on
the valuation set in the next equity round. Because an entrepreneur
generally expects the value of their company to increase round by round,they would not want to raise substantially more convertible debt than they
predict they will need. As result, the amount raised in a debt financing is
unlikely to be influenced by bargaining power.
3. Maturity
The maturity of a debt venture financing is the length of time after
which the principal of the loan and any accrued interest is payable unless

141. See WSGR Convertible Note Term Sheet Generator, supra note 137 (follow“Launch” hyperlink; then follow “Notes – Interest Payments” in the drop-down box).
142. The conversion terms of the convertible debt also function as price terms inconjunction with the interest rate. See infra Part II.B.4.

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the debt has already converted to equity.143 If the debt has yet to convert
by the maturity date, investors can either require the principal and interest
be repaid or negotiate an extension of the loan.144 Startups tend to spend
the money they raise on expenses such as rent, salaries, and assets thatcannot be easily liquidated, while at the same time generating little if any
revenue. As a result, most companies will not be able to repay theprincipal and interest on a debt financing if they hit the maturity date
before the debt converts to equity.145
Over a given period of time, a low-quality company is less likely tosecure a subsequent equity financing that causes their convertible debt toconvert into equity. Shorter maturities are costlier for low-quality
companies because they are at greater risk of hitting the maturity date
before a conversion event. Investors can therefore use the length of thematurity as a screening mechanism to respond to adverse selection.
Maturity length can also be used to respond to moral hazard. A company
with a shorter maturity date is more likely to be in a scenario in which it
has to renegotiate the loan terms with its investors, who can use the threatof requiring repayment to curb excessive risk and/or misbehavior taking
by the entrepreneur.
4. Conversion
The terms that govern the conversion of debt into equity are the mostimportant provisions in a convertible debt financing. The set of investors
making convertible debt investments is mostly the same set of investors
making equity investments.146 These investors are looking for high risk,
high return investments and therefore generally make convertible debt
investments with the expectation the debt will convert into equity.147 As
mentioned above, convertible debt converts into equity during the next
equity financing round based on the valuation set in that round.148 This
143. See WSGR Convertible Note Term Sheet Generator, supra note 137 (follow“Launch” hyperlink; then follow “Notes – Term” in the drop-down box).
144. Id.
145. Id.
146. Debt investments tend to skew towards angel investors and venture capital funds
focused on early stage investments.
147. These investors are not simply looking for a 5–10% debt return.
148. See WSGR Convertible Note Term Sheet Generator, supra note 137 (follow“Launch” hyperlink; then follow “Notes – Conversion” in the drop-down box).

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allows convertible debt financings to largely ignore the complicated, time
consuming, and contentious issue of valuation.
To compensate convertible debt investors for putting their money inearlier than equity investors, debt financings often contain a conversion
discount term. 149 This discount reduces the effective price per shareconvertible debt investors end up paying upon conversion. 150 The
conversion rate will occasionally increase with time. 151 While lesscommon than a conversion discount, another price reduction mechanism
used in convertible debt financings is a term known as a “conversion cap.”
A conversion cap places a ceiling on the valuation at which the debt will
convert into equity.152 If the company receives a valuation in the next
equity round above the conversion cap, the debt will convert based on thecap value.153 Debt financings will sometimes contain both a conversion
discount and a conversion cap. If this is the case, the debt will typically149. Id. (follow “Launch” hyperlink; then follow “Notes – Automatic Conversion –Conversion Price” in the drop-down box).
150. For example, assume a company raises $500,000 in convertible debt with a 10%
interest rate and a 20% discount rate. One year later, the company raises its first equity
financing round in which it sells shares of preferred stock at $1.00 per share. The
convertible debt would convert into preferred stock at a price of $0.80 per share for a
total of 687,500 shares (convertible debt price per share = $1.00 equity price per share *(100% - 20% discount rate) = $0.80 per share; number of preferred shares = $500,000 *(1 + 10% interest) ^ 1 year / $0.80 price per share = 687,500 shares).
151. See WSGR Convertible Note Term Sheet Generator, supra note 137, (follow“Launch” hyperlink; then follow “Notes – Automatic Conversion – Increasing DiscountTab” in the drop-down box; select “Increasing discount to price paid in qualified
financing”; then follow “Next”). For example, the conversion rate might start at 20% andincrease by 5% every year.
152. Id. (follow “Launch” hyperlink; then follow “Notes – Automatic Conversion –Valuation Cap”).
153. Id. In the example from supra note 150, instead of a 20% discount, assume theconvertible debt has a $5 million conversion cap. One year later, the company raises its
first equity financing round at a $10 million valuation with a price per share of $1.00. In
this case, the conversion cap would take effect and the debt would convert at a price pershare of $0.50 for a total of 1,100,000 shares (convertible debt price per share = $1.00
equity price per share * $5 million conversion cap / $10 million valuation = $0.50 per
share; number of preferred shares = $500,000 * (1 + 10% interest) ^ 1 year / $0.50 priceper share = 1,100,000 shares).

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convert at the lower of the two prices determined by the discount and thecap.154
In conjunction with the interest rate, the conversion terms function
as the price of a debt financing deal. Convertible debt investors intend to
become equity investors and the conversion terms determine the price atwhich the debt converts to equity. In addition to their price effects, theconversion terms have implications for adverse selection and moral
hazard. Relative to a discount rate, a conversion cap is costlier for a highquality company because a high-quality company is more likely toachieve a valuation that exceeds the cap. The choice between a discountand a cap can be used as a screening mechanism to respond to adverse
selection. A discount that increases with time can be used as a screening
mechanism as well because an increasing discount is costlier for lowquality companies that take longer to convert their debt into equity. An
increasing discount can also mitigate moral hazard because anentrepreneur is less likely to engage in wasteful post-investment
misbehavior if the price of the investment continues to rise over time.
5. Warrants
A warrant gives an investor the right to purchase extra shares of thecompany at a specified price.155 In this sense, a warrant functions like astandard call option.156 Warrants are generally exercisable for preferredstock sold in the next equity financing round, but are sometimes
exercisable for common stock. 157 The number of shares available forpurchase is typically a percentage of the principal amount of the loan andany accrued interest.158 The exercise price can range from the price set in154. In the example from supra note 150, if the debt has both a 20% discount and a$5 million cap, the discount price would be $0.80 per share whereas the cap price would
be $0.50 per share. The debt would therefore convert at $0.50 per share.
155. See WSGR Convertible Note Term Sheet Generator, supra note 137 (follow“Launch” hyperlink; then follow “Warrants” in the drop-down box).
156. A call option is a standard security that gives the holder a right to purchaseanother security (usually a share of stock) at a specified price (known as the strike price)
for a specified amount of time.
157. See WSGR Convertible Note Term Sheet Generator, supra note 137 (follow“Launch” hyperlink; then follow “Warrants – Shares” in the drop-down box).
158. Id. (follow “Launch” hyperlink; then follow “Warrants – Share Amount” in thedrop-down box). For example, a loan of $500,000 with 10% interest and 10% warrant
coverage would enable the investor to purchase up to $55,000 of stock after one year

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the next equity round to a de minimis price such as $0.01.159 Warrants areprimarily used to increase an investor’s potential equity stake in thecompany (sometimes at a very low price) and therefore are primarily amethod of value extraction.
6. CollateralCollateral in the venture financing context functions similarly tocollateral in the basic lending context. Debt secured by collateral is placed
ahead of general creditors with respect to recovery from the collateral.160
Because startups lack common forms of collateral such as physical assets
and accounts receivable, convertible debt is often secured by thecompany’s intellectual property. In some rare cases, investors will require
an entrepreneur to secure a loan with a portion of their personal assets.
Securing convertible debt is costlier for low-quality companies because
they are more likely to default on their obligations and have theircollateral seized. Investors can use collateral requirements as a screening
mechanism to respond to adverse selection. Collateral can also respond to
moral hazard because an entrepreneur is less likely to take excessive risk
and engage in wasteful post-investment misbehavior if important assets
are pledged as collateral, especially if those assets belong to theentrepreneur personally.
7. Subordination
A company’s existing creditors may require convertible debt in a
venture financing be subordinated to their interests. 161 Alternatively,
future creditors may require subordination of existing convertible debt asa requirement to lend.162 Subordination is primarily determined by the
relative positions and interests of a company’s multiple creditors and(warrant coverage = $500,000 loan * (1 + 10% interest) ^ 1 year * 10% warrant coverage= $55,000).
159. Id. (follow “Launch” hyperlink; then follow “Warrants – Exercise Price” in thedrop-down box).
160. Id. (follow “Launch” hyperlink; then follow “Security Interest” in the drop-downbox).
161. Id. (follow “Launch” hyperlink; then follow “Subordination” in the drop-downbox).
162. Id.

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therefore is unlikely to be affected by the bargaining power relationshipbetween the company and the investors.
8. Repayment Multiple
A repayment multiple requires a company to pay investors a multipleof the loan amount in addition to accrued interest in the event the loan is
repaid instead of converting to equity.163 Repayment multiples increase
the cost of repayment relative to conversion. A low-quality company isless likely to achieve a subsequent equity financing that results inconversion, and therefore a repayment multiple carries a heavier cost.
Investors can use repayment multiples to screen for company quality inthe presence of adverse selection.
9. Staged Financing
Staged debt financings function the same way as staged equity
financings discussed in Part II.A.10 and have the same implications foradverse selection and moral hazard.
III. METHODOLOGY AND DATA
To resolve the disagreement between the three theories of bargaining
power discussed in Part I, this Article empirically examines theconnection between terms in venture financing contracts and a measureof the relative bargaining power between entrepreneurs and investors.
This Part discusses the Article’s empirical methodology and describes theempirical data. Subpart A discusses the independent variable of interest
used to represent bargaining power, Subpart B discusses the dependent
variables used to represent contract design, and Subpart C describes theventuring financing data.

163. Id. (follow “Launch” hyperlink; then follow “Notes – Repayment Premium on
Change of Control or IPO” in the drop-down box). For example, a loan of $1 million witha 1.2X multiple would require repayment of $1.2 million, plus interest.

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A. INDEPENDENT VARIABLE: SUPPLY OF VENTURE CAPITAL
To empirically test the connection between bargaining power andcontract design, the Article needs a measure of the relative bargaining
power between entrepreneurs and investors. While there is somedisagreement in the negotiation and contract literature over how to define
and measure bargaining power, 164 it is commonly characterized as thenegotiating force between the parties and is intrinsically tied to eachparty’s best alternative to the negotiated agreement (BATNA). 165 The
better a party’s BATNA, the stronger their bargaining power. Dependingon the contracting context, there will be different sources of bargaining
power that contribute to the overall relative bargaining power between theparties.166
In the venture financing context, numerous sources determine therelative bargaining power between the entrepreneur and investors. Somesources only affect the specific entrepreneur and investors at hand (suchas the quality and popularity of the entrepreneur’s product), whereas othersources affect all entrepreneurs and investors (such as the overall strengthof the economy). In interviews with experienced venture attorneys, theydescribed a wide range of sources that affect bargaining power in venture
financings, including: the market opportunity for the company’s product,
the development level of the product, the entrepreneur’s level ofexperience, the lead investor’s level of experience, the quality of theengineering team, the stage of the investment, whether the company went
through an accelerator program such as Y Combinator, the supply ofavailable venture capital, the exit environment, the strength and numberof the company’s competitors, the number of investors interested in the164. See LAX & SEBENIUS, supra note 22, at 249; RICHARD A. POSNER, ECONOMICANALYSIS OF LAW 101–04 (3d ed. 1986); Choi & Triantis, Bargaining Power, supra note
1, at 1674; Duncan Kennedy, Distributive and Paternalist Motives in Contract and Tort
Law, with Special References to Compulsory Terms and Unequal Bargaining Power, 41
MD. L. REV. 563, 623 (1982).
165. FISHER ET AL., supra note 22, at 97–105; Choi & Triantis, Bargaining Power,
supra note 1, at 1675.
166. Some scholars have attempted to classify the sources of bargaining power. For
example, Choi & Triantis break the sources of bargaining power into five categories: “(1)demand and supply conditions, (2) market concentration, (3) private information, (4)patience and risk aversion, and (5) negotiating skills and strategy.” See Choi & Triantis,
Bargaining Power, supra note 1, at 1675–76.

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company, the trendiness of the company’s industry, the regulatoryenvironment, and the relative experience of the attorneys on both sides.167
This Article uses the total supply of venture capital as a measure of
the relative bargaining power between entrepreneurs and investors. The
greater the total supply of venture capital, the greater the entrepreneur’sbargaining power. When there is more available venture capital,
bargaining power shifts towards the entrepreneur because there are moreinvestors and more capital competing to invest in startup companies,
thereby improving the entrepreneur’s BATNA. While demand for venture
capital (i.e. the number of startups seeking financing and the amount offinancing they are seeking) can increase in response to the increase insupply, demand changes more slowly than supply because entrepreneurs
first have to start and grow companies. 168 There are a number ofadvantages to using venture supply to represent bargaining power. First,
the supply of venture capital will affect the relative bargaining power inall financings. Other, more idiosyncratic sources may only affectbargaining power in a subset of financings. Second, venture financing
supply is quantifiable and therefore lends itself well to empirical analysis.
Third, venture financing supply affects bargaining power in both equity
and debt financings. 169 Fourth, the use of venture financing supply torepresent bargaining power is consistent with prior empirical research inthe venture financing context.170
Venture financing supply is measured by the total one-year lagged
limited partner inflows to U.S. venture capital firms.171 The Article uses
inflows to U.S. venture capital firms because almost all of the companies
in the sample are located in the U.S.172 One-year lagging is necessary to

167. Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview
with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017); Telephone Interview
with Anonymous Source (Apr. 13, 2017); Interview with Anonymous Source, in Palo
Alto, Cal. (Apr. 17, 2017).
168. See Gompers & Lerner, supra note 26, at 282–84.
169. The same set of investors is generally making both equity and debt venture
investments and these investors received their capital from the same broad set of sources.
170. See Gompers & Lerner, supra note 26, at 282–83; Raghavan, supra note 26, at
50–51.
171. Adjusting all dollar values to 2015 dollars accounts for inflation.
172. U.S. companies represent over 95% of the equity financings and over 97% of thedebt financings. See infra Appendix.

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account for the seasonality of limited partner contributions. 173 For theempirical analyses, the Article uses the log of the lagged inflows as theindependent variable.174 This measure of venture supply is consistent withprior empirical research.175
The data on venture financing inflows were obtained from Thomson
ONE, a financial information database maintained by Thomson
Reuters. 176 Thomson ONE collects information on limited partner
contributions to U.S. venture capital firms and reports the aggregate
amount.
Chart 1 shows the one-year lagged inflows by quarter from 2004 to2015 in billions of 2015 U.S. dollars.177

173. A disproportionate percentage of limited partner contributions to venture capital
firms take place in the fourth quarter of the year. See Gompers & Lerner, supra note 26,
at 294; Raghavan, supra note 26, at 13.
174. Using a log transformation helps to account for the positive skew of the inflow
data by bringing the distribution closer to a normal distribution. A log transformation also
helps with interpretation of regression results by enabling analysis of percentile changes
in the transformed variable. See generally How Can I Interpret Log Transformed
Variables in Terms of Percent Change in Linear Regression? | SAS FAQ, UCLA INST.
FOR DIGITAL RES., https://stats.idre.ucla.edu/sas/faq/how-can-i-interpret-log-transformed-variables-in-terms-of-percent-change-in-linear-regression [https://perma.cc/RNU3-7H
MX] (last visited Oct. 4, 2017).
175. See Gompers & Lerner, supra note 26, at 294; Raghavan, supra note 26, at 13.
176. See Thomson ONE, THOMSON REUTERS, https://www.thomsonone.com [https://perma.cc/4QNQ-VGMZ] (last visited Oct. 4, 2017).
177. Inflow data is presented quarterly because the financing dates in the empiricalsample are given by quarter.

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Chart 1: Lagged Venture Financing Inflows 2004–2015 ($B2015)

B. DEPENDENT VARIABLES: VENTURE FINANCING CONTRACT TERMS
This Article uses multiple terms from venture financing contracts as
dependent variables to test how contract design responds to changes inbargaining power. Tables 1 and 2 describe the dependent variables forequity and debt financings, respectively. The tables list the primaryfunctions of the variables in venture financings: price, efficiency (aresponse to moral hazard and/or adverse selection) or value extraction.
Table 1: Equity Financing Dependent Variables
Dependent
Variable
Log PreMoney
Valuation
Log Amount
RaisedLiquidation
PreferenceType

Description

Continuous

Log of the premoney valuation in$M2015Log of the amountraised in $M2015
Whether theliquidation

Continuous
OrderedCategorical178

Function
Price
N/A
Value
Extraction

178. The coding values for the ordered categorical variables are contained in the
Appendix.

2017]VENTURE CAPITAL CONTRACT DESIGN

Preference
Multiple

BoundedParticipation

BinaryParticipation
Cap
Participation
Cap Size
Anti-Dilution

BinaryRedemption

BinaryDividends

OrderedCategorical

Dividend Rate

BoundedPay-to-Play

BinaryPay-to-Play
Punishment

OrderedCategorical

BoundedOrderedCategoricalpreference is senior,pari-passu, or junior
The size of theliquidationpreference multiple
Whether the
preferred stock
participates
Whether there is acap on participation
The size of theparticipation cap
Whether the antidilution protection isfull ratchet, narrow
based weighted
average, broad based
weighted average, or
none
Whether there is aredemption
provision
Whether thedividends are
cumulative, noncumulative, or none
The dividend
percentage rate
Whether there is a
pay-to-playprovision
Whether the pay-toplay punishment isconversion to juniorpreferred, loss ofliquidationpreference, orconversion tocommon stock147

Efficiency
Value
Extraction
Efficiency
Efficiency
Efficiency

Efficiency
Value
Extraction
Value
Extraction
Efficiency
Efficiency

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Drag-Along

BinaryStagedFinancing

BinaryWhether there is a
drag-along provision
Whether thefinancing is staged[Vol. XXIII
Efficiency
Efficiency

Table 2: Debt Financing Dependent Variables
Dependent
VariableInterest RateType
BoundedLog Amount
RaisedMaturity179

Continuous

Conversion

BinaryConversion
Discount

BinaryDiscount Rate

BoundedIncreasing
Discount

BinaryConversion
Cap

BinaryOrderedCategorical

Description
The interest
percentage rate
Log of the amountraised in $M2015
Whether thematurity is less thansix months, between
six months and one
year, one year, or
greater than one year
Whether the debt isconvertible into
equityWhether the debt
converts at a
discount
The size of theconversion discountrate
Whether theconversion discountrate increases withtime
Whether there is aconversion cap

Function
Price
N/A
Efficiency

Efficiency
Price/
Efficiency
Price
Efficiency

Price/
Efficiency

179. This is an ordered categorical variable instead of a bounded or continuous
variable because maturities are coded categorically in the empirical sample.

2017]VENTURE CAPITAL CONTRACT DESIGN

Warrants

BinaryCollateral

BinarySubordination

BinaryRepayment
Multiple
Repayment
Multiple Size
StagedFinancing

BinaryBounded
BinaryWhether warrants
were issued
Whether the debt iscollateralized
Whether the debt issubordinatedWhether there is arepayment multiple
The size of therepayment multiple
Whether thefinancing is staged

149
Value
Extraction
Efficiency
N/A
Efficiency
Efficiency
Efficiency

C. VENTURING FINANCING DATAThis Article uses an original empirical sample of 5,564 venture
financings (4,075 equity financings and 1,489 debt financings) ranging
from 2004 to 2015.180 The data for these financings were collected by aninternational law firm. 181 For each financing, the firm represented theentrepreneur. At the completion of each financing, the entrepreneur’s
attorney would record a broad set of contractual and descriptive data forthe deal, including the data used for the dependent and control variables
described in Subparts B and C. Data for every variable is not available forevery financing, so most of the regressions are based on subsets offinancings.182
Using data collected by a single law firm or a small set of firms iscommon in the empirical literature on contractual provisions. 183 Thatbeing said, there are advantages and disadvantages to using a dataset
180. This dataset is substantially larger than previous studies of venture financing
contracts. See Raghavan, supra note 26, at 49–50 n.12 and accompanying text.
181. In the interest of the firm’s privacy and the privacy of its clients, the Article omits
the firm’s name. The firm anonymized the data before providing the dataset to the author.
Companies and investors in the dataset are identified using alphanumeric strings, and as
a result their real identities are protected.
182. Raghavan, supra note 26, at 49–50. This is consistent with prior empiricalresearch on venture financing contract terms. Id.
183. See, e.g., Kaplan & Stromberg, Characteristics, Contracts, and Actions, supranote 12; Kaplan & Stromberg, Financial Contracting Theory Meets the Real World,
supra note 12.

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compiled by one law firm. The primary disadvantage is the possibility
that the sample is not representative of venture financings that do not
involve the particular firm. If this is the case, the results drawn from thissample may not translate to venture financings more broadly. This
concern, however, is mitigated in the following ways. First, entrepreneursin the U.S. are typically represented by a law firm by the time they raise
venture capital, especially institutional capital. 184 As a result, mostventure financings will involve a law firm negotiating contract provisions
on behalf of the entrepreneur. Second, in the context of venture
financings, most established law firms approach the representation ofentrepreneurs in a similar manner. While negotiating strategies andcontractual preferences will differ from firm to firm and lawyer to lawyer,
these differences are likely small compared to the high degree ofsimilarity in representation.185 Third, while the choice of law firm may
have some effect on contract design, it is unlikely to change thefundamental relationship between bargaining power and contract designthat is the focus of this Article. Fourth, this sample is very broad. It
contains thousands of financings from 2004–2015 involving thousands ofdifferent companies. These companies come from dozens of states andoperate in numerous industries. The financings range from small seedstage investments at the beginning of a company’s life to massive latestage investments before a company goes public. The breadth of thesample increases the likelihood it is representative of venturing financings
as a whole.
There are two primary advantages to using financing data collectedby a law firm. First, the data on contract provisions in this sample are far
more granular than contract data from alternative sources such as online
venture databases. This sample contains substantial data on non-priceterms, which are relatively rare and difficult to obtain. Second, the data inthis sample have a high degree of reliability. The data for each financing
were recorded by an attorney familiar with the financing at the time of thefinancing’s conclusion. This method of data collection is likely to resultin data that is more reliable than data from alternative sources.186
184.
185.
186.

Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017).
Id.
See Raghavan, supra note 26, at 50, 50 n.11 (citing Steven N. Kaplan et al., How
Well Do Venture Capital Databases Reflect Actual Investments? (Sept. 2002)(unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=939073[https://perma.cc/4WRV-P67N]).

2017]VENTURE CAPITAL CONTRACT DESIGN

151

Summary statistics for the empirical sample are contained in the
Appendix.
IV. RESULTS AND DISCUSSION
This Part presents the empirical results and discusses them in thecontext of the three bargaining power theories from Part I.
Table 3 presents the results of each dependent variable in the equity
financing sample being regressed on the log of venture financing inflows
using an ordinary least squares (OLS) regression that controls for thecompany’s industry187, the location of the company’s headquarters188, thetype of lead investor189 (venture capital firm, angel investor, or strategic
investor190), and the round of financing (e.g. Series A, B, etc.).191 The
187. The company’s industry is included as a control variable because standard
contract terms can differ by industry. In addition, the trendiness of the company’s
industry can have a substantial effect on bargaining power. For example, most venture
investors are currently much more interested in investing in artificial intelligencesoftware startups than physical consumer product startups. Interview with Anonymous
Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview with Anonymous Source, in
Mountain View, Cal. (Apr. 13, 2017); Telephone Interview with Anonymous Source(Apr. 13, 2017); Interview with Anonymous Source, in Palo Alto, Cal. (Apr. 17, 2017).
188. The location of the company’s headquarters is included as a control variablebecause there is a strong preference among investors for companies located in technology
hubs such as Silicon Valley, Seattle, or New York. In addition, there are regional
preferences for certain contract terms. Interview with Anonymous Source, in Palo Alto,Cal. (Mar. 29, 2017); Interview with Anonymous Source, in Mountain View, Cal. (Apr.
13, 2017); Telephone Interview with Anonymous Source (Apr. 13, 2017).
189. The lead investor’s type is included as a control variable because different typesof investors prefer to invest in different types of companies and have different preferenceswith respect to contract terms. For example, angel investors typically care far less about
control terms and tend to invest in earlier stage companies. Interview with Anonymous
Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview with Anonymous Source, in
Mountain View, Cal. (Apr. 13, 2017); Telephone Interview with Anonymous Source(Apr. 13, 2017). The Article focuses on the lead investor because this investor typicallymanages the contract negotiation process. Interview with Anonymous Source, in Palo
Alto, Cal. (Mar. 29, 2017); see also Raghavan, supra note 26, at 12 (citing Rajarishi
Nahata, Venture Capital Reputation and Investment Performance, 90 J. FIN. ECON. 127,
131 (2008)).
190. “Strategic investor” is a term used to describe in-house venture investment teams
at companies such as Google.
191. Round of financing is included as a control variable because standard contract
terms differ by round. In addition, entrepreneurs tend to have more bargaining power inlater rounds because by that point the company has shown some level of success.

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regressions use standard errors clustered at the company level. Somecompanies appear multiple times in the sample for different rounds offinancing. Venture financing terms (like many terms in repeat contracts)are often “sticky,” and as a result a term is more likely to appear in a
subsequent financing if it appeared in a prior financing. 192 Clustering
standard errors at the company level helps mitigate this issue.193
Table 3: OLS Regression Results for Equity Financings
Dependent
Variable
Log Pre-Money
Valuation
Log Amount
RaisedLiquidation
Preference
Preference
Multiple
Participation
Participation Cap
Participation Cap
Size
Anti-Dilution

Log Inflows

Observations

R-Squared

0.1355**(0.0629)0.0774(0.0543)-0.0367(0.0339)0.0222(0.0222)0.0149(0.0254)0.0066(0.0380)-0.0684(0.0822)-0.0228

3,501

0.43

4,063

0.39

2,484

0.06

3,527

0.03

3,853

0.08

1,627

0.05

684

0.08

3,835

0.05

Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview with
Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017); Telephone Interview with
Anonymous Source (Apr. 13, 2017). The empirical sample also contained data on thestage of the company’s financing (e.g. early, middle, late, etc.) and stage of development(e.g. startup, product development, selling product etc.). Categories within thesevariables, however, were not consistently applied and therefore the data were not reliable
enough to use in the regression analyses.
192. Telephone Interview with Anonymous Source (Apr. 13, 2017).
193. See A. Colin Cameron & Douglas L. Miller, A Practitioner’s Guide to ClusterRobust Inference 2–3 (2015) (unpublished manuscript), http://cameron.econ.ucdavis.edu/research/Cameron_Miller_JHR_2015_February.pdf [https://perma.cc/6NY3-GQ3A].
Clustered standard errors help account for the fact that the terms across multiple deals forthe same company are more likely to be similar by “clustering” these deals together for
purpose of the regression analysis.

2017]VENTURE CAPITAL CONTRACT DESIGN

153(0.0264)0.0131
3,939(0.0210)
Dividends-0.0480**
3,916(0.0222)
Dividend Rate
-0.00663,226(0.0706)
Pay-to-Play-0.0157
3,907(0.0156)
Pay-to-Play-0.0250
261
Punishment(0.0430)
Drag-Along-0.1008***
2,863(0.0302)
Staged Financing-0.0009
4,075(0.0134)
Statistical Significance Levels: * = 10%, ** = 5%, *** = 1%
Redemption

0.10
0.09
0.02
0.06
0.08
0.08
0.04

As can be seen in Table 3, the log of venture financing inflows has astatistically significant relationship with the following dependent
variables in the equity financing sample: log of pre-money valuation,
dividends, and drag-along.
Table 4 presents the results of each dependent variable in the debt
financing sample being regressed on the log of venture financing inflows
using an OLS regression that controls for the company’s industry, thecompany’s location, the type of lead investor, the prior round of
financing,194 and the one-year treasury rate.195 Like the equity regressions,the debt regressions use standard errors clustered at the company level.
Table 4: OLS Regression Results for Debt Financings
Dependent
VariableInterest Rate

Log Inflows

Observations

R-Squared-1.2214***(0.3479)

1,071

0.15

194. Prior round of financing is included as a control variable for the same reason
round of financing is included in the equity regressions. Debt financings are not specified
by round, however, so prior round is used instead.
195. The treasury rate is included as a control variable because it represents the riskfree borrowing rate and therefore is often used as a baseline for setting interest rates. The
Article uses the one-year rate to match the standard length of a venture debt investment.

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Log Amount
RaisedMaturity

0.1892
1,488
0.29(0.1281)0.2681**1,054
0.18(0.1069)
Conversion-0.0738**
1,086
0.06
(0.0297)
Conversion
0.2347***988
0.17
Discount(0.0581)
Discount Rate
-8.0502***638
0.08(2.9570)
Increasing-0.0975*585
0.08
Discount(0.0587)
Conversion Cap
0.0705849
0.33(0.0680)
Warrants-0.1848***
1,457
0.18
(0.0464)
Collateral-0.0691
1,489
0.13(0.0436)
Subordination-0.0480
1,076
0.20(0.0567)
Repayment-0.0730
1,062
0.06
Multiple(0.0455)
Repayment
1.5932177
0.22
Multiple Size
(1.4905)
Staged Financing
0.0151
1,489
0.06(0.0251)
Statistical Significance Levels: * = 10%, ** = 5%, *** = 1%
As can be seen in Table 4, the log of venture financing inflows has astatistically significant relationship with the following dependent
variables in the debt financing sample: interest rate, maturity, conversion,
conversion discount, discount rate, increasing discount, and warrants.
For robustness, the bounded independent variables (both equity anddebt) are also tested using tobit regressions, the binary variables using
probit regressions, and the ordered categorical variables using ordered
probit regressions. The results of these unreported regressions are
consistent with the OLS results presented in Tables 3 and 4.

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155

Price
Tables 3 and 4 show a statistically significant positive relationshipbetween venture financing inflows and price. In both equity and debt
financings, a greater supply of venture capital is associated with better
prices for entrepreneurs—higher pre-money valuations in equity
financings and lower interest rates and discount rates in debt financings.
These results are consistent with findings from previous studies showingthat there is a positive relationship between bargaining power and price.196
All three theories of bargaining power discussed in Part I predict thisrelationship between inflows and price.
Irrelevance Theory
As discussed in Part I.A, the irrelevance theory contends thatbargaining power has no effect on non-price terms. The irrelevance theory
therefore predicts that venture financing inflows are not connected with
non-price terms in venture financing contracts. The results presented inTables 3 and 4, however, contradict this core assertion of the irrelevancetheory. In both equity and debt financings, the supply of venture capital
has a statistically significant relationship with non-price terms. These
results are further evidence that the irrelevance theory is not an accurate
description of how bargaining power affects contract design in the realworld.
Direct Effect Theory
As discussed in Part I.B, the direct effect theory claims that parties
use their bargaining power to directly advocate for more favorable nonprice terms, including value-extraction terms that do not enhance theoverall efficiency of the contract. The direct effect theory makes thefollowing two empirical predictions:(1) Venture financing inflows are broadly connected with a variety
of non-price terms in venture financing contracts.
(2) Venture financing inflows are connected with non-price valueextraction terms that do not enhance contract efficiency.

196. See sources cited supra note 26; Marotta-Wurgler, supra note 25, at 447–51;
Priest, supra note 2, at 1298, 1320–21.

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The results do not support the direct effect theory’s first predictionthat venture financing inflows are broadly connected with non-priceterms. This is especially true in the equity financing sample. Inflows
appear to be related to specific non-price terms rather than non-priceterms generally.
The results raise an interesting question as to why venture financing
inflows are associated with certain non-price terms but not others. If
parties use bargaining power to directly advocate for more favorable nonprice terms, then why do many terms show no connection with venture
financing inflows? The beginning of an answer to this question may befound in a point consistently raised by experienced venture practitioners:
different sources of bargaining power affect different terms. 197 For
example, one attorney noted that the quality and popularity of acompany’s product will have a large effect on pre-money valuation but
will have relatively little effect on non-price terms related to control of
the company.198 On the other hand, the entrepreneur’s level of experience
is unlikely to affect price but will substantially impact negotiations
regarding control.199 Based on this reasoning, it is possible that venture
financing inflows only affect a subset of contract terms and that the otherterms are potentially influenced by other sources of bargaining powersuch as product quality and entrepreneur experience. Understanding theextent of these other relationships is beyond the scope of this Article. The
conclusion below proposes additional research to explore this concept.
The results support the direct effect theory’s second prediction that
venture financing inflows are connected with non-price value-extraction
terms that do not enhance efficiency. Table 3 shows inflows have anegative relationship with dividends in equity financings. A greater
supply of venture capital is associated with dividend terms that are morefavorable for entrepreneurs. Table 4 shows inflows have a negative
relationship with the use of warrants in debt financings. A greater supplyof venture capital is associated with less use of warrants. Both dividends
and warrants are terms used for value extraction.

197. Interview with Anonymous Source, in Palo Alto, Cal. (Mar. 29, 2017); Interview
with Anonymous Source, in Mountain View, Cal. (Apr. 13, 2017); Interview with
Anonymous Source in Palo Alto, Cal. (Apr. 17, 2017).
198. Interview with Anonymous Source in Palo Alto, Cal. (Apr. 17, 2017).
199. Id.

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157

Indirect Effect Theory
As discussed in Part I.C, the indirect effect theory claims thatbargaining power has an indirect effect on contract design by affecting
the price of the contract, which in turn alters the severity of adverse
selection and moral hazard and, by extension, the terms that respond tothese problems. The indirect effect theory makes the following two
empirical predictions:(1) Venture financing inflows are connected with non-price terms
that enhance contract efficiency by responding to adverse
selection and/or moral hazard.
(2) Venture financing inflows are not connected with non-pricevalue-extraction terms that do not enhance contract efficiency.
This prediction is in opposition with the second prediction of thedirect effect theory.
The results provide some support for the indirect effect theory’s firstprediction that venture financing inflows are connected with non-priceterms that respond to adverse selection and/or moral hazard. Table 3
shows a negative relationship between inflows and drag-along provisions
in equity financings. A greater supply of venture capital is associated withless use of drag-along rights. Table 4 shows a positive relationshipbetween inflows and maturity length in debt financings, as well as
whether debt converts at a discount. Table 4 also shows a negative
relationship between inflows and whether conversion discounts increase
with time. A greater supply of venture capital is associated with longer
maturities, more debt converting at a discount, and fewer conversion
discounts increasing with time. All of these terms respond to adverse
selection and/or moral hazard. Yet numerous terms that respond toadverse selection and/or moral hazard are not associated with inflows;
most notably, participation and anti-dilution provisions in equity
financings, the use of collateral in debt financings, and staged financingsin both equity and debt financings.
The results do not support the indirect effect theory’s second
prediction that venture financing inflows are not connected with nonprice value-extraction terms that do not enhance efficiency. As discussed
above, venture financing inflows are connected with dividends in equity
financings and warrants in debt financings, both of which are valueextraction terms that do not respond to adverse selection and/or moral
hazard.

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The results paint a picture that resembles a combination of the direct
and indirect effect theories. The irrelevance theory, on the other hand,ultimately fails to describe real-world contracting because of the failureof its core assumption of perfect contracting conditions. Venture
financings, like all real-world contracting contexts, contain numerous
contracting imperfections such as imperfect information and transaction
costs. In the presence of these imperfections, the irrelevance theory’s
namesake assertion that bargaining power is irrelevant to contract design
does not hold true.
While it is possible that the connections between venture financing
inflows and non-price terms observed in the results are driven entirely by
the direct effect mechanism, the more likely explanation is that themechanisms proposed by both the direct and indirect effect theories are atplay in the venture financing context.200 Both the direct and indirect effecttheories argue that bargaining power affects contract design because of
the lack of perfect contracting conditions assumed by the irrelevancetheory. Due to contracting imperfections such as imperfect informationand transaction costs, the direct effect theory claims that parties will be
unable to determine and/or achieve the value-maximizing contract design
and as a result will use their bargaining power to extract value via
advantageous terms. The indirect effect theory claims these contracting
imperfections lead to moral hazard and adverse selection and that theparties adjust the non-price terms to respond to these problems. The
results of this Article suggest that imperfect contracting conditions resultin bargaining power having both direct and indirect effects on venture
financing contract design.
CONCLUSION
This Article theoretically and empirically analyzed the connection
between bargaining power and contract design using an original datasetof over 5,500 equity and debt venture financings from 2004–2015. The
Article framed this analysis within the context of three competing theories
regarding the connection between bargaining power and contract design:
the irrelevance, direct effect, and indirect effect theories. Using the total
200. It is not possible that indirect effects are responsible for all of the connections
see in the results because the indirect effect theory does not contemplate a relationshipbetween bargaining power and value-extraction terms that do not respond to adverse
selection and/or moral hazard.

2017]VENTURE CAPITAL CONTRACT DESIGN

159

supply of venture capital in the U.S. as a measure of the relative
bargaining power between entrepreneurs and investors, the Article findsthat venture financing supply has a statistically significant relationshipwith price and non-price terms in both equity and debt financings. These
results contradict the irrelevance theory, which contends that bargaining
power only affects price, not non-price terms. The irrelevance theory fails
to describe real-world contracting due to the failure of its core assumptionof perfect contracting conditions. The results also provide support for the
direct and indirect effect theories and suggest that bargaining power has
both direct and indirect effects on contract design in the venture financing
context.
The results of this study have significant implications forentrepreneurs, investors, and attorneys. The supply of venture capital isconnected to the price of venture financings as well as certain non-priceterms. The parties to a financing (and their lawyers) should be aware ofthese connections before they sit down at the negotiating table. In
particular, entrepreneurs would be well served by understanding howmarket conditions affect financing terms when planning and negotiating
their fundraisings. Looking more broadly, parties in any contracting
context will be better equipped to reach value-maximizing agreements ifthey understand how different sources of bargaining power are related tocontract terms.
Developing a better understanding of how different sources ofbargaining power are related to contract terms requires additional
research. First, research on negotiating strategies and norms is critical forunderstanding the mechanisms through which sources of bargaining
power can influence contract design. For example, in the venture
financing context, important questions include: (1) who negotiates whichterms (clients vs. lawyers) and when are these terms negotiated, (2) how
often and under what circumstances do parties trade changes in non-priceterms for changes in price, and (3) how do entrepreneurs and investors
interpret signals sent by each other during negotiations? Practitioner
interviews and surveys will shed light on these and similar questions.
Testing the connections between different sources of bargaining powerand contract terms, on the other hand, will require additional empiricalanalyses similar to those conducted in this Article. In the venture
financing context, protective provisions and board seats are critical nonprice terms that deserve empirical investigation. With respect to sourcesof bargaining power, it would be interesting to examine less-studied
qualitative sources such as product quality, entrepreneur experience, andindustry trendiness.

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OF CORPORATE & FINANCIAL LAW[Vol. XXIIIAPPENDIX
DEPENDENT VARIABLE CODING
This section contains the coding values for the ordered categoricaldependent variables.
Liquidation Preference
Value
1
2
3

Category
JuniorPari-Passu
SeniorAnti-Dilution

Value
1
2
3
4

Category
None
Weighted Average Broad Based
Weighted Average Narrow Based
Full Ratchet
Dividends

Value
1
2
3

Category
None
Non-Cumulative
Cumulative
Pay-to-Play Punishment

Value
1
2
3

Category
Convert to Common
Lose Liquidation Preference
Convert to Junior Preferred
Maturity

Value
1

CategoryLess than six months

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2
3
4

161

Between six months and one year
One year
Greater than one year

EQUITY FINANCING SUMMARY STATISTICS
This section provides summary statistics for the empirical sample of
4,075 equity financings ranging from 2004 to 2015.
Number of Closings Per Quarter (2004–2015)

Company Industry
Industry
Clean Technology and Renewable
EnergyCommunications and Networking
Electronics and Computer Hardware
Financial Institutions*Life Sciences
Media and Information Services
Nanotechnology*
Retail and Non-Technology Products
Semiconductors

Frequency
287

Percentage
7.04

469
221
32
875
397
15
213
177

11.51
5.42
0.79
21.47
9.74
0.37
5.23
4.34

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Services
Software
Other

307
7.53
1,065
26.13
17
0.42
Total
4,075
100
* For the regression analyses, these industries are included in the “Other”
category because they represent less than 1% of the total sample.
Location of Company Headquarters
Location
AZ - Arizona
CA - California*
CO - Colorado
CT - Connecticut
DC - District of Columbia
FL - Florida
GA - Georgia
HI - Hawaii
IA - Iowa
ID - Idaho
IL - Illinois
IN - Indiana
KY - Kentucky
LA - Louisiana
MA - Massachusetts
MD - Maryland
ME - Maine
MI - Michigan
MN - Minnesota
MO - Missouri
MT - Montana
NC - North Carolina
NH - New Hampshire
NJ - New Jersey
NM - New Mexico
NV - Nevada

Frequency
12
2,611
40
5
9
11
13
3
4
1
11
12
4
1
23
23
1
5
6
4
2
16
2
12
3
14

Percentage
0.29
64.07
0.98
0.12
0.22
0.27
0.32
0.07
0.1
0.02
0.27
0.29
0.1
0.02
0.56
0.56
0.02
0.12
0.15
0.1
0.05
0.39
0.05
0.29
0.07
0.34

2017]VENTURE CAPITAL CONTRACT DESIGN

163

NY - New York*OH - Ohio
OK - Oklahoma
OR - Oregon
PA - Pennsylvania
RI - Rhode Island
SC - South Carolina
SD - South Dakota
TN - Tennessee
TX - Texas*
UT - Utah*
VA - Virginia
VT - Vermont
WA - Washington*
WI - Wisconsin
WV - West Virginia
Foreign*

166
4.07
6
0.15
6
0.15
20
0.49
19
0.47
1
0.02
2
0.05
1
0.02
3
0.07
352
8.64
57
1.4
25
0.61
2
0.05
383
9.4
4
0.1
3
0.07
177
4.34
Total
4,075
100
* These locations are included in the regression analyses because they
represent more than 1% of the total sample.
Lead Investor Type
Investor TypeAngel
Strategic/Corporate
Venture CapitalUnknown

Frequency
595
469
2,888
123
Total
4,075

Percentage
14.6
11.51
70.87
3.02
100

Round
Round
Seed
A
B
C

Frequency
250
1,411
840
567

Percentage
6.13
34.63
20.61
13.91

164

FORDHAM JOURNAL
OF CORPORATE & FINANCIAL LAWDEF or higher
Unknown

288
134
99
486
4,075

Total

[Vol. XXIII
7.07
3.29
2.43
11.93
100

Liquidation Preference
Liquidation Preference
JuniorPari-Passu
Senior
Total

Frequency
11
1,274
1,199
2,484

Percentage
0.44
51.29
48.27
100

Participation
Participation
No
Yes
Total

Frequency
2,226
1,627
3,853

Percentage
57.77
42.23
100

Participation Cap
Participation Cap
No
Yes
Total

Frequency
861
766
1,627

Percentage
52.92
47.08
100

Anti-Dilution
Anti-Dilution
None
Weighted Average Broad Based
Weighted Average Narrow Based
Full Ratchet
Total

Frequency
285
3,256
179
115
3,835

Percentage
7.43
84.9
4.67
3.00
100

2017]VENTURE CAPITAL CONTRACT DESIGN

165

Redemption
Redemption
No
Yes
Total

Frequency
3,060
879
3,939

Percentage
77.68
22.32
100

Dividends
Dividends
None
Non-Cumulative
Cumulative
Total

Frequency
470
3,110
336
3,916

Percentage
12.00
79.42
8.58
100

Pay-to-Play
Pay-to-Play
No
Yes
Total

Frequency
3,563
344
3,907

Percentage
91.20
8.80
100

Pay-to-Play Punishment
Pay-to-Play Punishment
Convert to Common
Lose Liquidation Preference
Convert to Junior Preferred
Total

Frequency
243
15
3
261

Percentage
93.1
5.75
1.15
100

Drag-Along
Drag-Along
No
Yes
Total

Frequency
1,201
1,662
2,863

Percentage
41.95
58.05
100

166

FORDHAM JOURNAL
OF CORPORATE & FINANCIAL LAW[Vol. XXIIIStaged Financing
Staged Financing
No
Yes
Total

Frequency
3,763
312
4,075

Percentage
92.34
7.66
100

Numerical Variables
Variable

Observations

Mean

Min.

Max.

59.20

Standard
Deviation
230.49Pre-Money
Valuation($M2015)
AmountRaised($M2015)
Preference
Multiple
Participation
Cap Size
Dividend
Rate (%)

3,501

0.01

8,860.85

4,063

11.80

28.99

0.01

998.26

3,527

1.11

0.41

1

5

684

2.51

0.71

1

4

3,226

7.70

1.37

0.02

52

2017]VENTURE CAPITAL CONTRACT DESIGN167

DEBT FINANCING SUMMARY STATISTICS
This section provides summary statistics for the empirical sample of
1,489 debt financings ranging from 2004 to 2015.
Number of Closings Per Quarter (2004–2015)

Company Industry
Industry
Clean Technology and Renewable
EnergyCommunications and Networking
Electronics and Computer
HardwareFinancial Institutions*Life Sciences
Media and Information Services
Nanotechnology*
Retail and Non-Technology
Products
Semiconductors
Services
SoftwareFrequency
176

Percentage
11.82

142
71

9.54
4.77

4
333
159
3
83

0.27
22.36
10.68
0.2
5.57

48
98
368

3.22
6.58
24.71

168

FORDHAM JOURNAL
OF CORPORATE & FINANCIAL LAW[Vol. XXIII

Other

4
0.27
Total
1,489
100
* For the regression analyses, these industries are included in the “Other”
category because they represent less than 1% of the total sample.
Location of Company Headquarters
Location
AZ - Arizona
CA - California*
CO - Colorado*CT - Connecticut
DC - District of Columbia
FL - Florida
GA - Georgia
HI - Hawaii
IA - Iowa
ID - Idaho
IL - Illinois
IN - Indiana
MA - Massachusetts
MD - Maryland
MI - Michigan
MN - Minnesota
MT - Montana
NC - North Carolina
NH - New Hampshire
NJ - New Jersey
NM - New Mexico
NV - Nevada
NY - New York*OH - Ohio
OK - Oklahoma
OR - Oregon*
PA - Pennsylvania
SD - South Dakota

Frequency
4
885
16
6
3
6
6
3
2
1
4
1
7
4
3
4
3
9
8
4
1
7
80
6
1
17
6
1

Percentage
0.27
59.44
1.07
0.4
0.2
0.4
0.4
0.2
0.13
0.07
0.27
0.07
0.47
0.27
0.2
0.27
0.2
0.6
0.54
0.27
0.07
0.47
5.37
0.4
0.07
1.14
0.4
0.07

2017]VENTURE CAPITAL CONTRACT DESIGN

169

TX - Texas*
UT - Utah*
VA - Virginia
VT - Vermont
WA - Washington*
Foreign*

140
9.4
18
1.21
7
0.47
3
0.2
189
12.69
34
2.28
Total
1,489
100
* These locations are included in the regression analyses because they
represent more than 1% of the total sample.
Lead Investor Type
Investor TypeAngel
Strategic/Corporate
Venture CapitalUnknown
Total

Frequency
483
132
810
64
1,489

Percentage
32.44
8.87
54.40
4.30
100

Prior Round
Prior Round
None/Common
Seed
A
B
C
D
E
F or higher
Unknown
Total

Frequency
425
17
182
129
84
43
18
17
574
1,489

Percentage
28.54
1.14
12.22
8.66
5.64
2.89
1.21
1.14
38.55
100

170

FORDHAM JOURNAL
OF CORPORATE & FINANCIAL LAW[Vol. XXIII

Average One-Year Treasury Rate (%)

Maturity
MaturityLess than six months
Between six months and one year
One year
Greater than one year
Total

Frequency
59
170
345
480
1,054

Percentage
5.60
16.13
32.73
45.54
100

Conversion
Conversion
No
Yes
Total

Frequency
56
1,030
1,086

Percentage
5.16
94.84
100

Conversion DiscountConversion DiscountNo
Yes

Frequency
330
658

Percentage
33.40
66.60

2017]VENTURE CAPITAL CONTRACT DESIGN
Total

171

988

100

Frequency
520
65
585

Percentage
88.89
11.11
100

Increasing Discount
Increasing Discount
No
Yes
Total

Conversion Cap
Conversion Cap
No
Yes
Total

Frequency
528
321
849

Percentage
62.19
37.81
100

Warrants
Warrants
No
Yes
Total

Frequency
973
484
1,457

Percentage
66.78
33.22
100

CollateralCollateral
No
Yes
Total

Frequency
1,128
361
1,489

Percentage
75.76
24.24
100

Subordination
Subordination
No
Yes
Total

Frequency
703
373
1,076

Percentage
65.33
34.67
100

172

FORDHAM JOURNAL
OF CORPORATE & FINANCIAL LAW[Vol. XXIII

Repayment Multiple
Repayment Multiple
No
Yes
Total

Frequency
877
185
1,062

Percentage
82.58
17.42
100

Staged Financing
Staged Financing
No
Yes
Total

Frequency
1,408
81
1,489

Percentage
94.56
5.44
100

Numerical Variables
Variable

Observations

Mean

Min.

Max.

6.87

Standard
Deviation
3.03

Interest
Rate (%)
AmountRaised($M2015)
Discount
Rate (%)
Repayment
Multiple
Size

1,071

0.01

30

1,488

2.75

8.9

0.01

190.23

638

26.55

19.08

0.90

90

177

2.43

2.59

0.50

25