Legal Conditions and Venture Capital Governance

1. Legal Conditions and Venture Capital Governance Cumming & Johan (2013, Chapter 13) 1

2. Introduction Evidence Conclusion Issues Addressed in this Chapter • What drives corporate governance structures in VC finance? • How do different legal and institutional frameworks in different countries affect international differences in corporate governance structures? • Three dimensions: • time from fundraising to deal origination • syndication and co-investment • board seats and security choice 2

3. Introduction Evidence Conclusion Prior work • Law and Finance • La Porta et al. (1997; 1998); Berkowitz et al. (2003) • Venture Capital meets Law and Finance • VC Contracts: • Gilson and Schizer (2003); Kapland Stromberg (203,2005); Lerner and Schoar (2005); Cumming and Johan (2006); • VC Exits: • Black and Gilson (1998); Schleifer /Wolfenzon (2002); Cumming et al. (2006 ); Bienz/Walz (2007) • Size of VC Markets • Jeng and Wells (2000); Armour and Cumming (2006 ) • Public policy • Keuchnigg/Nielsen (2001, 2003, 2004) • Datasets not large (200 or so observations) due to private nature of VC data 3

4. Introduction Evidence Conclusion New Insights in this Chapter • Complementary Elements of Legal Conditions and VC Governance Worldwide: • Screening • Syndication • Co-investment • Board Seats • Functional Definition of Security • Data • 3838 VC - backed companies • 39 countries, developed and developing, worldwide • Extensive confidential details not previously studied 4

5. Introduction Evidence Conclusion Law and Venture Capital Governance • Law quality facilitates • Deal screening time • Syndication • Effectiveness of boards • Law quality mitigates • Co-investment • Securities requiring periodic cash flows pre-exit • How to measure law quality • Legality (Berkowitz et al.’s weighted average of La Porta et al.’s indices) • Legal Origin versus Country Dummy Variables 5

6. Introduction Evidence Conclusion Data • 3838 VC - backed companies • 39 countries, developed and developing, worldwide • Source: CEPRES, Germany • Partnership among practitioners worldwide to improve data quality for decision making in private equity • Extensive confidential details not previously studied • Little expected sample bias • Good and poor performing investments • Exited and un-exited investments • Matches profile of VC investments across countries and across time 6

7. Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Time to Deal Origination • Time from starting the VC fund until the first-round lead investment • Not previously studied in any single or multiple country study • Hazard models • Legality index from 20 to 21 (e.g. France versus US) lowers the time until lead first investment by 12% • Legality index from 10 to 11 (e.g. Philippines versus Indonesia) lowers the time until lead first investment by 24% • Faster time to deal origination in common law countries by approx. 30% 7

8. Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Time to Deal Origination 8

9. Table 13.4 Industry, Year, Country, VC firm dummies included 9

10. Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Syndication and Co-Investment • Syndication • Typically ‘Good’ • Decision making, value-added, 2 heads better than 1 • Legality 20 to 21: increases the probability of syndication by 3.8% • Legality 10 to 11: increases the probability of syndication by 5.5% • Legal origin ambiguous effect • Co-Investment • Typically ‘Bad’ • One VC fund bails out bad investments of prior VC fund from the same VC organization • Legality 20 to 21: reduces probability of co-investment by 1.8% • Legality 10 to 11: reduces the probability of co-investment by 3.5% • Legal origin ambiguous effect 10

11. Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Syndication and Co-Investment 11

12. Table 13.5 Industry, Year, Country, VC firm dummies included 12

13. Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Board Seats and Functional Security • Board seats • VC board representation more important than that of other investors (Gompers and Lerner 1999 MIT Press) • Legality 20 to 21: increases the probability of board seats by 4.2% • Legality 10 to 11: increases the probability of board seats by 8.1% • Functional security • Security mandates periodic cash flows paid back to the investor prior to an exit event • Not previously considered in any VC study for single and/or multiple countries • Legality ambiguous effect • English legal origin approx 16% less likely to require periodic cash flows 13

14. Introduction Evidence Conclusion 1. Deal Origination 2. Syndication and Co-Investment 3. Board Seats and Functional Definition of Security Board Seats and Functional Security 14

15. Table 13.6 Industry, Year, Country, VC firm dummies included 15

16. Introduction Evidence Conclusion Robustness Checks • Country dummy variables for English, US, France, German versus legal origin • Alternative explanatory variables • Market conditions, e.g., MSCI, VC capital in market • VC fund characteristics • Entrepreneurial firm characteristics • Transaction characteristics • Exclusion of certain countries – e.g., exclude developed countries • Exclusion of different years – e.g., exclude all years prior to 1995 16

17. Introduction Evidence Conclusion Related Evidence • Chapter 22 • Better legal standards  higher VC/PE returns • Better legal and accounting standards  less likely to observe inflated values of unexited investees reported to institutional investors prior to exit • Based on data from 39 countries around the world • >5000 transactions 17

18. Introduction Evidence Conclusion Concluding Remarks • Law quality facilitates • Deal screening time • Syndication • Effectiveness of boards • Law quality mitigates • Co-investment • Securities requiring periodic cash flows pre-exit (in conjunction with high-tech investment) • Legality has a more pronounced effect on emerging markets • Effective VC investment will continue to lag behind in emerging countries whilst legal quality remains deficient 18