| dc.description.abstract | <P>In a private company setting corporate governance institutions can be viewed as responses to the contractual challenges of moral hazard, adverse selection and incompleteness of contracts. Thereupon, the attributes of corporate governance mechanisms are structured in a way that allows the corporate constituencies to deal with contractual design exigencies. Contract theory is thus a determinant of
corporate governance.
</P>
<P>VC-backed firms provide an explicit manifestation of this philosophy of design of corporate governance institutions. The financing practices that VC firms implement and the securities that they hold are carefully designed so as to allow the members of the firm to surmount the contractual obstacles. Staged investment (or staggered financing) is a screening mechanism that induces entrepreneurs to signal their
intrinsic motivation to the VC firm and thus allows the latter to tackle the adverse selection problem. Convertible preferred stock, the VCs’ investing vehicle of choice, allows the establishment of an incentive-compatible income stream, as it replicates the disciplining and agency cost-mitigating effects of paradigm debt while at the same time it eliminates the foremost agency cost of paradigm debt, the “asset substitution effect”. Consequently, with the “debtlike” security of convertible preferred stock VCs can cope efficiently with the problem of moral hazard. In addition to this, the typical covenants that are embedded in convertible preferred stock help to generate an optimal state-contingent allocation of control rights between the VC and the entrepreneur that is in alignment with the basic axioms of financial contracting theory. Thereupon, convertible preferred stock serves as a corporate governance mechanism that challenges the problem of the incompleteness of contracts.</P>
<P>Finally, given that the design of efficient corporate governance institutions in a VC setting requires a great deal of contracting flexibility, we look at the mandatory nature of European corporate laws and seek to ascertain whether they directly impede VC contracting. Although no such evidence is found, it is argued that the overall mandatory nature of European corporate laws compromises the contract innovation capacity of European lawyers, who, paralyzed by anchoring bias, do not invest in learning sophisticated VC financial and corporate governance design techniques that would let the VC industry in Europe flourish.</P> | en_US |
