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Covenants in Venture Partnerships Analysis

This article examines the use of covenants in 140 venture capital partnership agreements. It tests two hypotheses: 1) that the extent of agency problems determines covenant use, and 2) that covenant use varies with supply and demand conditions in the venture capital industry. The authors find empirical evidence supporting both hypotheses. Specifically, they find that covenants are used more when agency problems are larger, and that covenant use has increased as demand for venture capital has grown in recent decades while supply of venture firms has remained relatively fixed.

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Avanish Nagar 23
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67 views15 pages

Covenants in Venture Partnerships Analysis

This article examines the use of covenants in 140 venture capital partnership agreements. It tests two hypotheses: 1) that the extent of agency problems determines covenant use, and 2) that covenant use varies with supply and demand conditions in the venture capital industry. The authors find empirical evidence supporting both hypotheses. Specifically, they find that covenants are used more when agency problems are larger, and that covenant use has increased as demand for venture capital has grown in recent decades while supply of venture firms has remained relatively fixed.

Uploaded by

Avanish Nagar 23
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd

The Use Of Covenants: An

Empirical Analysis Of Venture


Partnership Agreements
Author(s): Paul Gompers and Josh Lerner
Overview

 This article examines covenants in 140 partnership agreements establishing venture


capital funds
 Heterogenous Agreements
 Examine two complementary hypotheses
 H1: Extent of Agency problem determining covenants use.
 H2: Covenant use may reflect the supply and demand conditions in the venture capital
industry
 Regression to test the hypotheses
 Empirical evidence of Demand and Supply agreement
Introduction

 Covenants: A formal written agreement between two or more people or groups


of people which is recognized in law.
 Undertaken by a lender to reduce the risks by making it legally binding for the
borrower to:
• maintain a certain limit of a ratio
• a certain level of cash flow
• collect collateral in exchange for the breach of a covenant agreement

 Usefulness:
• For the borrowers: Ensure a stability in financial performance and trust
• For the lender: Security (Collateral), Control over the lending situation, Right to call off
an entire agreement in case of breach
Hypotheses

The usefulness of Covenants in VC and choosing the two hypotheses?

 H1: Negotiating and monitoring specific covenants is costly; contracting parties weigh the
potential costs and benefits of a particular covenant.

 H2: Utilization of covenants to variation supply and demand: In the short run, the supply of
venture capital is usually fixed, with a modest number of venture partnerships raising a
carefully limited size each year. With the developing startup ecosystem in the past 15 years,
demand for VC has increased. Covenants can ensure the rightful fees paid to Venture
capitalists, and restrictions on activities of the venture capitalists at their investors' expense
may be lifted.
The Venture Capital Industry

• Funds flowing into the venture capital


industry and the number of active venture
organizations increased dramatically during
the late 1970s and early 198.
• The increase in new capital contributions
outpaced growth in the number of active
organizations, suggesting that the short-run
supply of venture organizations may have
been fixed.
• The correlation coefficient between annual
observations of these two variables (both
expressed in constant 1992 dollars) from
1968 to 1992 is 0.48. This is significant at
the 2 percent confidence level.

The single most important factor accounting for the increase in money flowing into the venture capital sector was the 1979
amendment to the "prudent man" rule governing pension fund investments. Prior to that date, the Employee Retirement Income
Security Act of 1974 prohibited pension funds from investing substantial amounts of money in venture capital or other high-risk
asset classes
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