Fickle Investors, Reputation, and the Clientele Effect in Venture Capital Funds
8 Pages Posted: 4 Oct 2004
Date Written: October 2, 2004
This brief Symposium Essay comments on Professor Kate Litvak's Article, The Price of Stability: Default Penalties in Venture Capital Partnership Agreements. Litvak organizes her Article around the concept that it is helpful to characterize contract default penalties as put options. Using a sample of 37 venture fund agreements, Litvak sets the harshness of the default penalty as her dependent variable. She then runs regressions against several independent variables: fund size, fund number, fund vintage year, amount of carry, and so on. Litvak finds a relationship between fund governance and the harshness of default penalties. More precisely, she finds a relationship between her proxies for the need for contractual protections against agency costs and the size of one possible contractual protection: default penalties for failing to answer a capital call. As agency costs (and the need for contractual protections) decrease, contractual penalties increase. The threat of capital withdrawal, she concludes, is a useful contractual tool to reduce agency costs between investors and low-quality venture capitalists.
I argue in this Essay that while it is conceptually accurate to characterize contract default penalties as put options, it is not especially helpful to do so. Practical considerations force Litvak to exclude an important element from her model; the cost to an investor's reputation when it fails to heed a capital call. To draw any useful conclusions, Litvak should account not only for the nominal penalty written in the contract, but also the real world penalty of never being allowed to invest in venture capital again. The reputation cost varies depending on the clientele of the fund. Pension funds, university endowments, and other repeat players care deeply about their reputations, while some individuals and corporate investors might be indifferent. And so the variation in contract default penalties might, in fact, be more strongly predicted by a clientele effect that she does not, and for practical purposes, cannot measure. In my mind, then, Litvak fails to make a persuasive case that governance considerations really have the effect she suggests. Moreover, Litvak's theory does not seem to comport with recent real world experience: the lemming-like answering of VC capital calls following the NASDAQ crash of March 2000.
Keywords: clientele, venture capital, agency costs, reputation, options
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