Per Strömberg

Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses

We study the investment analyses of 67 portfolio investments by 11 venture capital (VC) firms. VCs consider the attractiveness and risks of the business, management, and deal terms as well as expected post-investment monitoring. We then consider the relation of the analyses to the contractual terms. Greater internal and external risks are associated with more VC cash flow rights, VC control rights; greater internal risk, also with more contingencies for the entrepreneur; and greater complexity, with less contingent compensation. Finally, expected VC monitoring and support are related to the contracts. We interpret these results in relation to financial contracting theories.

Financial Contracting Theory Meets The Real World: An Empirical Analysis Of Venture Capital Contracts

In this paper, we compare the characteristics of real world financial contracts to their counterparts in financial contracting theory. We do so by conducting a detailed study of actual contracts between venture capitalists (VCs) and entrepreneurs. We consider VCs to be the real world entities who most closely approximate the investors of theory. (1) The distinguishing characteristic of VC financings is that they allow VCs to separately allocate cash flow rights, voting rights, board rights, liquidation rights, and other control rights. We explicitly measure and report the allocation of these rights. (2) While convertible securities are used most frequently, VCs also implement a similar allocation of rights using combinations of multiple classes of common stock and straight preferred stock. (3) Cash flow rights, voting rights, control rights, and future financings are frequently contingent on observable measures of financial and non-financial performance. (4) If the company performs poorly, the VCs obtain full control. As company performance improves, the entrepreneur retains / obtains more control rights. If the company performs very well, the VCs retain their cash flow rights, but relinquish most of their control and liquidation rights. The entrepreneurs cash flow rights also increase with firm performance. (5) It is common for VCs to include non-compete and vesting provisions aimed at mitigating the potential hold-up problem between the entrepreneur and the investor. We interpret our results in relation to existing financial contracting theories. The contracts we observe are most consistent with the theoretical work of Aghion and Bolton (1992) and Dewatripont and Tirole (1994). They also are consistent with screening theories.

Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies

We study how firm characteristics evolve from early business plan to initial public offering (IPO) to public company for 50 venture capital (VC)-financed companies. Firm business lines remain remarkably stable while management turnover is substantial. Management turnover is positively related to alienable asset formation. We obtain similar results using all 2004 IPOs, suggesting that our main results are not specific to VC-backed firms or the time period. The results suggest that, at the margin, investors in start-ups should place more weight on the business (“the horse”) than on the management team (“the jockey”). The results also inform theories of the firm.

Conflicts of Interest and Market Illiquidity in Bankruptcy Auctions: Theory and Tests

I develop and estimate a model of cash auction bankruptcy using data on 205 Swedish firms. The results challenge arguments that cash auctions, as compared to reorganizations, are immune to conflicts of interest between claimholders but lead to inefficient liquidations. I show that a sale of the assets back to incumbent management is a common bankruptcy outcome. Sale-backs are more likely when they favor the bank at the expense of other creditors. On the other hand, inefficient liquidations are frequently avoided through sale-backs when markets are illiquid, that is, when industry indebtedness is high and the firm has few nonspecific assets. Copyright The American Finance Association 2000.

How Do Legal Differences and Learning Affect Financial Contracts

We analyze venture capital (VC) investments in twenty-three non-U.S. countries and compare them to VC investments in the U.S. We describe how the contracts allocate cash flow, board, liquidation, and other control rights. In univariate analyses, contracts differ across legal regimes. At the same time, however, more experienced VCs implement U.S.-style contracts regardless of legal regime. In most specifications, legal regime becomes insignificant controlling for VC sophistication. VCs who use U.S.-style contracts fail significantly less often. Financial contracting theories in the presence of fixed costs of learning, therefore, appear to explain contracts along a wide range of legal regimes.

Private Equity and Industry Performance

The growth of the private equity industry has spurred concerns about its potential impact on the economy more generally. This analysis looks across nations and industries to assess the impact of private equity on industry performance. Industries where PE funds have invested in the past five years have grown more quickly in terms of productivity and employment. There are few significant differences between industries with limited and high private equity activity. It is hard to find support for claims that economic activity in industries with private equity backing is more exposed to aggregate shocks. The results using lagged private equity investments suggest that the results are not driven by reverse causality. These patterns are not driven solely by common law nations such as the United Kingdom and United States, but also hold in Continental Europe.

Private Equity and the Resolution of Financial Distress

We examine the role private equity (PE) firms play in the resolution of financial distress using a sample of 2,151 firms that borrow in the leveraged loan market between 1997 and 2010. Controlling for leverage, PE-backed firms are no more likely to default than other leveraged loan borrowers. When firms do default, PE-backed firms restructure more often out of court, restructure faster, and are more likely to remain an independent going concern following the restructuring. PE owners are also more likely to retain control of the firm following the restructuring. The propensity for PE owners to infuse capital as firms approach distress is positively related to measures of the success of the restructuring. Overall, our results show that PE sponsors resolve distress in portfolio firms relatively efficiently.

Systemic Financial Crises: Maximizing the Value of Distressed Assets: Bankruptcy Law and the Efficient Reorganization of Firms

We argue that the main role of corporate bankruptcy is to mitigate bargaining frictions in financial distress. Bankruptcy law can improve ex post bargaining efficiency by (1) verifying assets and liabilities; (2) improving coordination among claimholders; (3) protecting third-party claimants; (4) maintaining asset value during bargaining; and (5) alleviating the impact of liquidity constraints among claimants and potential acquirers of the distressed firm’s assets. In improving ex post efficiency, however, bankruptcy law will also affect the bargaining power of the claimants, which may have unintended consequences on ex ante efficiency. We apply this framework to analyze bankruptcy systems in six representative countries. With the exception of the third-party protection, the U.S. Chapter 11 system goes the farthest in addressing ex post bargaining frictions. Other reorganization codes lack important key features, which seems to have discouraged the use of these codes, often in favor of reorganizing firms in the traditional liquidation-oriented chapter. We then turn to ex ante efficiency and argue that this issue can be best understood by looking at a context where private contracting works well and bankruptcy law is not needed. We propose that venture capital contracting is such an environment. Preliminary evidence suggests that venture capital reorganizations share many key features with the U.S. Chapter 11, with the exception that less power is given to equity-holders and other junior claimants. Since recent evidence suggests that the real impact of the equity-holder bias in Chapter 11 is small, however, we argue that it is unlikely that the U.S. system has significant ex ante inefficiencies. We conclude by discussing some lessons and limitations of our results for designing bankruptcy law in developing countries. * Division of International Finance, Board of Governors of the Federal Reserve System. Mailstop 19, 20th and C Streets NW, Washington, DC 20551. E-mail: david.c.smith@frb.gov. ** Graduate School of Business, University of Chicago, 1101 East 58th Street, Chicago, IL 60637. E-mail: per.stromberg@gsb.uchicago.edu. This paper was prepared for the World Bank conference on Systemic Financial Distress. The opinions expressed here do not necessarily reflect those of the Federal Reserve Board or its staff. We would like to thank our discussants Simeon Djankov and David Skeel for insightful input, Ulf Axelson, Douglas Baird, Luc Laeven, Steve Kaplan, Frederic Martel, Stefan Sundgren, and Arne Wittig for helpful discussions, and Guillermo Noguera for research assistance. We are grateful to Lynn Lopucki for providing us with his Chapter 11 data and Leora Klapper for sharing her international bankruptcy statistics.

The Economic and Social Impact of Private Equity in Europe: Summary of Research Findings

The private equity industry has found itself caught up in the prevailing political debate concerning the need for reform of financial services regulation. However, much of the debate about private equity tends to be based on hearsay or, at best, isolated examples, with little reference to the real impact of the industry on the European economic model. The purpose of this short research summary is to bring some clarity to the areas of the private equity model that have been most debated. The report presents the main features of the private equity model and summarises the empirical evidence relating to a number of economic and social impact questions.

What are Firms? Evolution from Early Business Plans to Public Companies

We study how firm characteristics evolve from early business plan to initial public offering (IPO) to public company for 50 venture capital (VC) financed companies. We describe the financial performance, line of business, point(s) of differentiation, non-human capital assets, growth strategy, top management, and ownership structure. The most striking finding is that firm business lines or ideas remain remarkably stable from business plan through public company. Within those business lines, non-human capital aspects of the businesses are more stable than human capital aspects. In the cross-section, firms with more alienable assets experience more managerial turnover suggesting that specific people becomes less critical as firms establish non-human assets. We obtain qualitatively similar results to those in our primary sample for all non-financial start-up IPOs in 2004 - both VC- and non-VC backed. This suggests that our main results are not specific to the presence of a VC or to the time period. We discuss how our results relate to theories of the firm and to VC investment decisions.