 | Understanding the Economic Value of Legal Covenants in Investment Contracts:
A Real-Options Approach to Venture Equity Contracts
Authors
Didier
COSSIN - HEC-University of Lausanne, FAME and IMD
Benoît LELEUX
- IMD
Entela
SALIASI - HEC-University of Lausanne and FAME
Date
October
2002
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Abstract
Valuing
early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies.
This inability to come up with robust point estimates of value should not and does not lead to a breakdown
of market liquidity: instead, efforts are redirected towards the design of investment contracts which
materially skew the distribution of payoffs in favor of the venture investors. In effect, limitations
in valuation abilities are addressed by designing the investment contracts as baskets of real options
instead of linear payoff functions. This paper investigates four common features (covenants) of venture
capital investment contracts from a real option perspective, using both analytical solutions and numerical
analysis to draw inferences for a better understanding of contract features. The impact of the concept
for pricing issues, valuation negotiation and for contract design are considered. It is shown for example
how “contingent pre-contracting” for follow-up rounds is theoretically a better proposition than the
simple “rights of first refusal” commonly found in many contracts. We also provide for results (such
as timing of investments, length of rounds, choices of liquidation levels, conversion levels) that take
into account full interaction of the different features considered. We document some complex facts,
such as the concavity of the VC contract value depending on the amount invested at the different stages,
the actual share impact of the most common antidilution feature, some endogenous motivation for early
VC exits from otherwise performing companies, and stress overall the importance of a full analysis for
efficient contract negociation and understanding.
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