Governance Through Exit: Default Penalties and Walkaway Options in Venture Capital Partnership Agreements

Abstract

When investors sign venture capital partnership agreements, they do not immediately turn over the entire committed capital. Instead, they contribute capital in stages, as needed by the fund. Typically, investors have at least three years to decide whether to honor their commitment obligations fully. To discourage investor defaults, venture funds employ a complicated system of financial penalties. Since venture funds could have eliminated the default problem altogether by demanding the contribution of the entire amount upfront, the question arises: why do venture funds engage into this elaborate staging scheme?

I suggest that staged contributions are used as a governance tool: the threat of investor walkaway creates additional incentives for venture capitalists to perform well. The walkaway right, however, comes at a cost of undermining a fund's liquidity and threatening its ability to make investments in a timely fashion. Thus, my hypothesis predicts that the strength of investor walkaway right represents a tradeoff between governance concerns and liquidity concerns.

I test this hypothesis by studying venture capital partnership agreements. I find that the strength of investor walkaway right is strongly and positively related to several measures of expected agency costs. Venture funds where managerial compensation is riskier and more heavily tilted toward performance-based component make capital withdrawals more difficult. Larger venture funds (typically run by more prominent managers, who generate fewer mismanagement concerns) give investors weaker walkaway rights.

Keywords: venture capital, private equity, fundraising, governance, voice, exit

JEL Classification: D2, G2, G3, K00, K12, K22, L2