Contract Design Approach to Cash Flow Incentive Mechanisms

Abstract

This chapter offers a new explanation for the use of straight equity as the prevalent form of financing in German venture capital. Starting point of the analysis is the observation by Cumming and Walz (2004) that “[t]here is no single optimal form of venture finance”¹⁰⁹ despite the fact that theory claims that only convertible securities always optimally and endogenously allocate cash flow rights to the contracting parties and thereby induce them to exert ex-ante efficient efforts.¹¹⁰ As already formulated in the literature review in Chapter 3, the present work aims at investigating whether the incentive-compatible allocation of cash flow rights obtained with convertible securities can effectively be replicated by straight equity financing in combination with at least one cash flow-related covenant. The chosen contract design approach enables the author to analyze augmented venture capital contracting with a focus on the allocation of cash flow rights to the contracting parties. Augmented contracting considers the interaction of financing instruments and cash flow-related covenants as they are combined in venture capital contracts, and has so far rarely been examined. Control rights are not at the center of the analysis because their allocation can be carried out separately from the allocation of cash flow rights in venture capital.¹¹¹

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