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Smart Money

Influence of Venture Capitalists on High Potential Companies

Fingerle, Christian

Entrepreneurial and Financial Studies, Vol. 7

(2005)

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Abstract

While it has become widely acknowledged that high potential companies are a vital force in securing innovation and social prosperity, the manifold influence of venture capitalists on these companies has called for the development of a theoretical framework. This study makes a comprehensive enquiry into the nature of venture capitalists’ contribution to the development of their portfolio companies and discusses their involvement in managerial processes. Three in-depth case studies on German high potential companies complement the theoretical findings and allow a detailed insight into the reality of venture capital financing. As a result, this book provides valuable knowledge for scholars, entrepreneurs, investors and venture capitalists.

Table of Contents

Section Title Page Action Price
Foreword V
Acknowledgments VII
Table of Contents IX
Table of Figures XV
Table of Abbreviations XIX
Table of Interview Partners XXI
1 Introduction 1
1.1 Relevance of Smart Money 1
1.2 Aims of Analysis 4
1.3 Research Approach and Dataset 6
1.4 Structure of Analysis 10
2 Characteristics of High Potential Companies 13
2.1 Introductory Remarks 13
2.2 Fundamentals of the Resource-based View 13
2.2.1 Resources in Strategic Management Research 13
2.2.2 Resources and Competitive Advantage 17
2.2.3 A Comprehensive Resource-based View 19
2.3 Resource Profile of High Potential Companies 24
2.3.1 Resource Needs in Stage Models 24
2.3.2 Resource Categorization 26
2.3.3 Technological Resources 27
2.3.4 Financial Resources 28
2.3.5 Managerial Resources 31
2.3.6 Personnel Resources 33
2.3.7 Physical Resources 34
2.3.8 Organizational Resources 34
2.3.9 Reputational Resources 35
2.3.10 Social Resources 37
2.4 Mechanisms to Fill the Resource Gap 38
2.5 Return and Risks of Investments in High PotentialCompanies 39
2.5.1 Investment Decision Trade-Off 39
2.5.2 High Expected Return 40
2.5.3 High Risks 44
2.5.3.1 Liability of Newness 44
2.5.3.2 Liability of Smallness 45
2.5.3.3 Uncertainty of Supply 45
2.5.3.4 Uncertainty of Demand 46
2.5.3.5 Competitive Uncertainty 47
2.5.3.6 Dependency on Founders 47
3 Business Model of Venture Capital Firms 49
3.1 Introductory Remarks 49
3.2 Definition of Business Model Concept 49
3.3 Customers of Venture Capital Firms 51
3.4 Value Creation Architecture of Venture Capital Firms 54
3.4.1 Organizational Structure 54
3.4.2 Personnel Structure 59
3.4.3 Refinancing Process 62
3.4.3.1 Overview 62
3.4.3.2 Fundraising Process 63
3.4.3.3 Investor Relations Process 66
3.4.3.4 Distribution of Returns Process 68
3.4.4 Investment Process 69
3.4.4.1 Overview 69
3.4.4.2 Investment Origination 70
3.4.4.3 Investment Due Diligence 73
3.4.4.4 Investment Structuring 77
3.4.4.5 Investment Development 81
3.4.4.6 Investment Exit 82
3.5 Customer Value Proposition of Venture Capital Firms 87
3.5.1 Enhancement of Performance of Portfolio Companies 87
3.5.2 Enhancement of Asset Allocation of Investors 90
3.6 Profit Model of Venture Capital Firms 99
3.6.1 Management Fee 99
3.6.2 Participation in Value Creation 100
4 Venture Capitalists’ Influence through Contractual Agreements 103
4.1 Introductory Remarks 103
4.2 Deal-specific Risks for Venture Capital Firms 103
4.2.1 Risk of False Investment Decision 103
4.2.2 Risk of Managerial Opportunism 104
4.2.3 Risk of Competitive Opportunism 107
4.2.4 Risk of Unfavorable Decision-Taking 108
4.2.5 Risk of Exit Obstruction 109
4.3 Influence through Contractual Provisions 110
4.3.1 Information Rights 110
4.3.2 Conversion Rights 111
4.3.3 Control Rights 113
4.3.3.1 Voting Rights 113
4.3.3.2 Veto Rights 114
4.3.3.3 Supervisory Board Representation Right 115
4.3.4 Management Covenants 117
4.3.4.1 Affirmative Covenants 117
4.3.4.2 Non-Compete Clause 118
4.3.4.3 Vesting 119
4.3.4.4 Representations and Warranties 120
4.3.5 Milestone Agreements 121
4.3.5.1 Milestones 121
4.3.5.2 Earn-out 122
4.3.5.3 Ratchets 123
4.3.5.4 Management Dismissal 123
4.3.5.5 Staging 124
4.3.6 Cash Flow Rights 126
4.3.6.1 Dividend Preference 126
4.3.6.2 Liquidation Preference 127
4.3.6.3 Anti-Dilution Protection 128
4.3.7 Preemptive Rights 130
4.3.7.1 Right of First Refusal 130
4.3.7.2 Right of First Offer 131
4.3.8 Disinvestment Rights 132
4.3.8.1 Tag-Along Right 132
4.3.8.2 Drag-Along Right 133
4.3.8.3 Redemption Right 133
4.3.8.4 Registration Rights 134
4.3.8.5 Cancellation Right 135
4.3.9 Summary 137
4.4 Loss of Formal Autonomy through Venture Capital Firms 138
5 Venture Capitalists’ Influence through Provision of Resources 141
5.1 Introductory Remarks 141
5.2 Content of Resource Provision 141
5.2.1 Activities of Venture Capital Firms 141
5.2.2 Certification through Venture Capital Firms 144
5.2.3 Resource-Based View on Activities of Venture Capital Firms 145
5.2.3.1 Redefining Activities as Resources 145
5.2.3.2 Direct vs. Indirect Resource Provision 147
5.3 Determinants of Resource Provision 148
5.3.1 Differences in Intensity of Resource Provision 148
5.3.2 Size of Investment 151
5.3.3 Performance of Portfolio Company 153
5.3.4 Stage of Portfolio Company 156
5.3.5 Technology Intensity of Portfolio Company 156
5.3.6 Venture Capitalists’ Incentives for Resource Provision 157
5.3.7 Syndication 158
5.4 Loss of Real Autonomy through Venture Capital Firms 159
5.4.1 Sources of Venture Capital Firm’s Power 159
5.4.2 Loss of Real Autonomy by Levels of Management 160
5.4.3 Loss of Real Autonomy by Levels of Decision-taking 164
5.4.4 Benefit of a Loss of Autonomy 167
6 Case Study Bullith Batteries AG 169
6.1 Case Description 169
6.1.1 Preliminary Remark 169
6.1.2 Development before First Round Financing 169
6.1.3 First Round Financing 174
6.1.4 Further Development until Second Round Financing 176
6.1.5 Second Round Financing 184
6.1.6 Further Development 186
6.2 Case Analysis 187
6.2.1 Gi Ventures’ Influence through Contracting 187
6.2.1.1 Investment Agreement Structure 187
6.2.1.2 Influence on Deal-specific Risks 191
6.2.1.3 Influence on Management’s Formal Autonomy 192
6.2.2 Gi Ventures’ Influence through Resource Provision 193
6.2.2.1 Influence on Resource Pool 193
6.2.2.2 Influence on Management’s Real Autonomy 197
7 Case Study GPC Biotech AG 201
7.1 Case Description 201
7.1.1 Development before First Round Financing 201
7.1.2 First Round Financing 203
7.1.3 Development until Second Round Financing 206
7.1.4 Second Round Financing 213
7.1.5 Further Development and MPM Capital’s and TVM’s Exit 215
7.2 Case Analysis 219
7.2.1 MPM Capital’s and TVM’s Influence through Contracting 219
7.2.1.1 Preliminary Remark 219
7.2.1.2 Investment Agreement Structure 219
7.2.1.3 Influence on Deal-specific Risks 223
7.2.1.4 Influence on Management’s Formal Autonomy 224
7.2.2 MPM Capital’s and TVM’s Influence through Resource Provision 226
7.2.2.1 Influence on Resource Pool 226
7.2.2.2 Influence on Management’s Real Autonomy 230
8 Case Study varetis AG 235
8.1 Case Description 235
8.1.1 Development before First Round Financing 235
8.1.2 First Round Financing 238
8.1.3 Development until Second Round Financing 241
8.1.4 Second Round Financing 245
8.1.5 Further Development and BayBG’s Exit 247
8.2 Case Analysis 251
8.2.1 BayBG’s Influence through Contracting 251
8.2.1.1 Investment Agreement Structure 251
8.2.1.2 Influence on Deal-specific Risks 256
8.2.1.3 Influence on Management’s Formal Autonomy 258
8.2.2 BayBG’s Influence through Resource Provision 259
8.2.2.1 Influence on Resource Pool 259
8.2.2.2 Influence on Management’s Real Autonomy 263
9 Comparative Case Study Analysis 267
9.1 Venture Capitalists’ Influence through ContractualAgreements 267
9.1.1 Contracting Negotiations 267
9.1.2 Content of Investment Agreements 268
9.1.3 Portfolio Companies’ Loss of Formal Autonomy 269
9.2 Venture Capitalists’ Influence through Resource Provision 271
9.2.1 Direct Resource Provision 271
9.2.2 Indirect Resource Provision 274
9.2.3 Dynamic Aspects of Resource Provision 278
9.2.4 Venture Capitalists’ Influence on Competitive Advantage 279
9.2.5 Portfolio Companies’ Loss of Real Autonomy 281
10 Conclusion and Further Implications 285
10.1 Conclusion 285
10.2 Implications for Researchers and Practitioners 288
11 References 293