How Do Financial Contracts Evolve for New Ventures

While previous research has characterized the key features of contracts between entrepreneurs and venture capitalists, little is known about how these contracts evolve over the life of new ventures. We overcome significant data challenges to compile a novel panel dataset of U.S. early-stage ventures that includes, for every company in our sample, the main financial and control rights offered to investors at each equity round. We also gather information on the characteristics of the investors and founders at each funding round. Regarding the terms associated with the first funding round, we find that in around 60% of early-stage ventures, the initial ‘Series A’ financing terms are very similar across companies. We refer to this as the default contract. Where deviations from this default contract occur, the terms are usually more investor-friendly. We then track how contractual terms evolve over funding rounds using a 3-direction classification. The ‘diagonal’ analysis compares the original share rights given to investors of each funding round at the time of the closing of each respective funding round. The ‘vertical’ dimension analyses how the rights of existing share classes are changed upon the introduction of new share classes at the closing of subsequent funding rounds. The ‘horizontal’ analysis compares the rights of all existing share classes at a given point in time. For successful companies, which have not suffered down-rounds, the default contract is often maintained across funding rounds. In such cases, we argue that post-money valuations can be a reasonable proxy for the economic value of the firm.