Venture capital investment challenges in controlling agency costs and the role of convertible preferred equity. A UK law and policy reform perspective.

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VENTURE CAPITAL INVESTMENT CHALLENGES IN

CONTROLLING AGENCY COSTS AND THE ROLE OF

CONVERTIBLE PREFERRED EQUITY. A UK LAW AND POLICY

REFORM PERSPECTIVE.

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Name: Saun Amair

Student number: 12768804 Email: Saun.amair@gmail.com Course: LLM Law & Finance Thesis supervisor: Tawnee Hill Date of final submission: 17/07/2020 Words: 12,994

Abstract

Young, innovative, and high-potential ventures significantly contribute to economic growth and positive social externalities. Lacking historical records, agency mitigation controls, and aligned incentives, these ventures are limited in their capacity to attract external financing. Venture capital funds specialising in high-risk early-growth investments deploy a number of managerial practices to overcome agency costs and to ensure a profitable exit, including the use of convertible preferred equity to allocate control and cash flow rights. Aiming to increase the supply of equity to young and innovative ventures, United Kingdom (UK) policymakers have implemented various incentive regulations and schemes. This thesis examines and questions the validity of these initiatives as they can be misguided; often failing to confront what factors initially inhibits equity supply to start-ups.

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1 Introduction

Given the lack of transparency and historical track records available to attract early investors, start-ups and early-growth firms face external financing constraints which threaten their growth and survival (Colombo et al., 2014; Owen et al., 2019). A plethora of evidence reveals the value-inducing and cost-mitigating benefits for an entrepreneurial firm if they are financed by venture capital (VCs) funds through convertible preferred equity (CPE) financing (Sahlman, 1990; Bascha and Walz, 2001; Chiu, 2003; Schmidt 2003). This thesis highlights the role of VCs in controlling agency costs and funding innovative but high-risk early-growth firms in order to produce value-increasing outcomes. CPE is generally the preferred mode of financing, serving the interests of both entrepreneur and VC. Consequently, this thesis will explore how CPE helps VCs in mitigating agency costs and securing a profitable exit.

This thesis will examine policies and regulation from a UK perspective, a jurisdiction which warrants discussion as it has a thriving VC and PE market, ranking second on ‘The Venture Capital & Private Equity Country Attractiveness Index’ (Groh et al., 2018). The UK is also the ‘established centre’ in Europe for private equity and VC financing (Linthwaite, 2006). Specifically, the UK has several tax-incentives schemes and government venture capital (GVC) schemes to promote the growth of PE financing. With regards to the significance of the financing market and legislative environment, the UK necessitates consideration as ensuring the growth of innovative firms is pivotal in knowledge-based economies where start-ups are a source for economic growth, job creation, technological progression, productivity and transferring or capitalising knowledge (Lerner, 2010; Colombo et al., 2014). The UK is now ‘the largest and most active single regional market within Europe’ in terms of PE volume and value and has the largest VC market in Europe (BVCA, 2020). Nonetheless, the global leading VC market remains the US where in 2016 VC investments as a percentage of GDP were reported as 0.37%, whereas in comparison VC investments only amounted to 0.03% of GDP in the UK (OECD, 2017).

This thesis suggests that given the financial constraints in the start-up and early-growth sector, the prevailing equity gap cannot be resolved exclusively by the PE market (Colombo et al., 2019). The novelty of the PE industry and GVC schemes has generally meant research on the topic has been limited. This thesis will therefore examine and question

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4 whether UK regulation and schemes have catalysed VC funding and whether such initiatives have assisted in mitigating agency problems, a major source of financing constraints (Berglof, 1994). It concludes that VCs rely on their governance, managerial and operational role and the use of strategic CPE financing in order to overcome information asymmetries, a lack of inherent agency mitigation controls, and divided investee-investor incentives. Further, while a reduced disclosure regime, tax-incentive schemes and GVC schemes can be pivotal for new market entrants to experience growth and avoid immediate failure, they do not necessarily provide sufficient incentives for VCs to overcome costly and value-destroying agency and governance barriers, nor do they play a notable role in directly mitigating these barriers.

In consideration of the aforementioned preface, this thesis will answer the following research question:

A growing body of literature suggests innovative start-ups and private early-growth firms face a number of financing constraints due to agency costs. To what extent is a venture capital fund able to control agency costs and execute a profitable exit in the UK, and how does convertible preferred equity help to achieve this? Subsequently, does current UK law and policy further these objectives and if not, how should law and policy be reformed?

Defining various terms used in this thesis will help the reader grasp the specific intention of terminology. ‘Start-up’ is used to represent an unlisted, early-growth, highly innovative and high potential firm. More specifically, the start-ups discussed in this thesis have at least 2 of the following characteristics: i) a turnover not greater than £10.2 million; ii) a balance sheet total of not more than £5.1 million; and ii) it has not more than 50 employees (Section 382, Companies Act 2006). This thesis will exclude from the discussion therein ‘micro-entities’ as defined in Section 384A: i) a turnover not greater than £632,000; ii) a balance sheet total of not more than £316,000; and iii) it has not more than 10 employees. This thesis targets the period between start-ups seeking additional financing, investing in Research and Development (R&D), and market testing, up until the start-up is sold, floated, or liquidated.

Convertible Preferred Equity (CPE) is issued by a start-up in order to provide VCs with more senior rights than common equity. The preference is available in dividend payments and liquidation proceeds. The convertibility characteristic of CPE can allow the VC to convert at a pre-defined date, at VC discretion, or at the exit. Overall, CPE provides greater

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5 protection to investors than afforded in common equity. A main theme of the thesis examines these aspects in greater detail.

‘Dynamic capability’, a concept originating from a paper by Teece et al. (1997), defined this as ‘the firm’s ability to integrate, build and reconfigure internal and external competences to address rapidly changing environments’ as a source of wealth creation and competitive advantage. The thesis utilises a premise that ‘dynamic capabilities’ convey sources for wealth creation in innovative start-ups, particularly through effective governance, managerial and organisational mechanism.

The importance of VCs should not go unnoticed, as in addition to financing, they foster entrepreneurship and provide direct and indirect value-added assistance, from managerial decision making, connecting the firm with suppliers and customers, and providing performance incentives to the entrepreneur (Berglof, 1994; Colombo et al., 2019; Gompers and Lerner, 2001; Schmidt, 2003). In recent years, VCs have shifted away from early stage and risky investments, instead displaying a preference for less risky and later stage investments (Upton & Petty, 2010; Baldock, 2016; Colombo et al., 2019). VCs are generally regarded as having niche industry-specific knowledge and managerial abilities to overcome the high risk agency costs that are prevalent in early-growth and innovative companies (Owen et al., 2019) and use CPE to provide liquidation preference and to manage incentives through the preference and convertibility feature (Bratton, 2002). By understanding the degree to which CPE is a product of idiosyncratic features of start-ups and early growth companies (Sahlman, 1990; Bascha and Walz, 2001; Chiu, 2003), we are able to gauge a developed understanding on the variety of costs and risks the VC aims to minimise. These include facing a high degree of asymmetric information, conflicts of interest, and moral hazards. However, the shift of VC investments towards late-stage and more risk-averse companies may suggest inefficiencies rooted in the jurisdiction itself. It suggests the regulatory and policy climate has been inadequate in addressing agency problems that prevail in earlier-growth companies. Furthermore, it implies that UK law and policy should aim to ameliorate dynamic capabilities to entice and provide assurance to PE investors that an investment can provide a favourable return.

The Companies Act 2006 addresses mandated disclosure obligations for small companies, and this thesis will present an argument that thresholds to qualify for reduced disclosure are too low. Whilst tax-incentive mechanisms, including the Venture Capital Trust

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6 (VCT) scheme, the Enterprise Investment Scheme (EIS) and the Corporate Venturing Scheme (VCS) have endeavoured to lower direct costs of PE financing, they do not address the indirect agency costs which put the VC’s entire stake at risk. In addition to monetary ceilings, these schemes limit the VCs in their ability to effectively manage the investment by barring control, preference, or ownership in VCT-, EIS-, or VCS-backed firms. This hinders the start-ups ability to effectively pursue dynamic capabilities, as VC control in the investment is a significant source of value creation in terms of its managerial and operational support (Sahlman, 1990).

Equally important are the GVC schemes, namely the Enterprise Capital Funds (ECF) and the UK Investment Innovation Fund (UKIIF). The positive externalities of these GVC schemes are commendable, providing business development opportunities to early-growth firms by providing access to funding. Still, research illustrates that GVC schemes require private VC additionality, delivering the ‘managerial’ coaching that is necessary to mitigate agency costs and improve dynamic capabilities (Colombo et al., 2014). For successful GVC investments it is necessary to implement a support service network, including advisors, lawyers, and specialised accountants, in order to entice experienced private investors to underdeveloped VC markets (Lerner, 2010; Baldock, 2016). This thesis argues that UK policy and regulation have been inadequate in supporting endogenous dynamic capabilities, focusing on sound corporate governance, specifically the mitigation of agency costs as a source of profit for the VC fund. Incentivising investments through indirect tax breaks creates a supply-side bias (Avnimelech et al., 2010) without adequately controlling costs in the investee-VC relationship to promote long-term value creation. Acting alone, VCs and GVCs fall short of generating positive economic and social returns, whereas financial performance and innovation appear to triumph when VCs are GVC-backed (Cumming et al., 2013; Colombo et al., 2014). This thesis finds that to a significant extent the involvement of a VC and the use of CPE (as opposed to an institutional investor or a loan) is effective in mitigating agency costs and securing a profitable exit. However, the trend of VC investments towards late-stage companies suggests that deficiencies remain in the entrepreneur-VC relationship and these have not been adequately supported by UK law and policy.

Analysing a collection of academic research, this thesis provides a coherent collation of journals, legislation, and policy to address the research question. The majority of aforementioned journals contentions are based on empirical evidence, historical trends,

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7 interviews with fund managers and entrepreneurs, surveys, and financial and legal theory. In order to evaluate the tax-incentive schemes and GVC schemes, the Gov.UK website provides ample information. The Companies Act 2006 is also used in its current revised form with all changes known to be in force on or before 05 July 2020. Therefore, this thesis has adopted a functional approach which takes a focused jurisdictional analysis, examining legislation and policies introduced by the UK, given that the generally the most fruitful VC markets are characterised by government support (Owen et al., 2019). By using these sources, this legal and literature review will describe and evaluate the capabilities of the VC and CPE and ultimately provide recommendations on improved policy or regulation in the UK.

The remainder of the thesis is structured as follows: Chapter 2 introduces the investment challenges of minimising agency and cost barriers in start-ups and early-growth companies, while Chapter 3 explores how the VC and the use of CPE can overcome these challenges. Chapter 4 approaches these questions from a UK-specific perspective, examining UK legislation and government policy in light of the barriers to start-up financing. Chapter 5 suggests law reform recommendations. Chapter 6 provides a brief summary of the results and concludes the thesis.

2 What investment challenges does venture capitalism and UK law and policy

seek to overcome?

2.1 What is a venture capital fund?

VC funds invest in early-growth companies with high potential for capital appreciation by controlling a significant stake of ownership rights to exert value-increasing influences (Gorman and Sahlman, 1989; Ehrlich et al., 1994; Wijbenga et al., 2007). Early-growth firms - start-ups or firms at the ‘expansion stage’ - typically have plans to develop a product or have begun development, but have not yet commenced commercial sales (Cumming, 2005). Sahlman (1990) defines venture capital as ‘a professionally managed pool of capital that is invested in equity-linked securities of private ventures,’ finding that in a sample of 383 VC investments only 15% emerge as highly profitable. VC investments seek a trade-off between high risk and high potential, illustrated by the fact that even though 50% emerge moderately

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8 successful, the ‘moderately successful’ return is insufficient for the VC to continue the investment relationship (Schmidt, 2003). In any case, the term of a VC investment is generally short in order to direct earnings to other investments and to exhibit a reputable portfolio to encourage investors to back the VC fund (Gompers and Lerner, 1999; Bascha and Walz, 2001).

Support derived from VC investments have value-increasing outcomes for early but high-growth entrepreneurial firms, particularly when, as is usually the case in the VC industry, the VC has rich industry-specific knowledge (Gorman and Sahlman, 1989; Higashide & Birley, 2002). Support materialises in various forms, such as strategic advice, involvement in day-to-day operations, or connecting the entrepreneur with customers and suppliers (Sahlman, 1990; Hellman and Puri, 2002; Schmidt, 2003). In capital markets, PE investors generally have specialist knowledge and a competitive advantage can be created as a result of their governance skills firms (Bascha and Walz, 2001; Trester, 1998). This is not to say the entrepreneur effort is unimportant in creating value for the firm, in fact the VC is often extremely dependent on the entrepreneurs contribution in terms of researching, designing, developing, and marketing the product (Schmidt, 2003). This brief summary of a VC will be expanded on in greater depth throughout this thesis, demonstrating the model of VCs and why other investors, such as banks, typically do not or cannot invest in high-risk start-ups. Despite the suitability of VCs as the principal investor of a start-up, this thesis stipulates that the broadening equity gap (Colombo et al., 2014) for start-up finance suggests UK law and policy has not yet emerged at an idealistic standard. In order to reduce the equity gap, UK law and policy must endeavour to alleviate investment challenges faced by VC investors.

2.2 What agency problems exist between a venture capital fund and a start-up

or early growth firm?

2.2.1 Start-ups and early growth firms face a high degree of asymmetric information

Start-ups are private companies, defined in the Companies Act 2006 (hereinafter ‘CA 2006’) as ‘any company that is not a public company’ (Section 4(1)(a)) or one that does not ‘offer to the public any securities of the company’ (Section 755(1)(a)). The primary observation on a start-ups’ high degree of risk lies in the fact that information surrounding a

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9 start-ups’ financial, operational and asset information is highly asymmetric and uncertain (Bascha and Walz, 2001; Cumming, 2005), more than public companies that have been listed on the market for several years and qualify for mandated disclosure. Start-ups and early-growth companies have limited or non-available historical track records, making both present analysis and financial forecasts difficult (Gompers, 1995). As a result, the entrepreneur of a young firm is better informed about the firm’s investment prospects (Jia, 2015). As small companies they are also subject to reduced mandated financial disclosure (Section 382, 444 Companies Act 2006), examined in greater detail in Chapter 4.2. Furthermore, start-ups have likely not been incorporated for more than a year, and their product or lack thereof may be misleading representations of potential. This renders the pre-investment financial situation of the start-up difficult to assess or verify for the VC. In addition, screening and monitoring start-ups can be costly, complex, and inefficient (Huyghebaert and Gucht, 2007) and if these costs outweighs the potential future value of the firm, the VC may limit their funding or not provide it at all (Gompers, 1995; Marshal and Weetman, 2002; Owen et al., 2019). As a result of such difficulties in obtaining and monitoring information, start-ups will have difficulty attract financing. If a VC is able to overcome the costs of monitoring, it will conduct intensive due diligence prior to the investment and monitor them post-investment (Colombo et al., 2014). Nonetheless, these costs are an impediment to the VC in ensuring it receives a high return from its investments and overall there is a significant body of evidence stipulating information barriers in early-growth start-ups (Gompers, 1995; Colombo et al, 2014; Jia, 2015).

The initial growth of small business formation in the UK since the 1980s has been correlated with concerned legal debate on disclosure obligations, as smaller businesses face fewer information disclosure requirements given their high audit compliance costs (Hughes, 1997). Although the period that followed the global financial crisis witnessed a greater appreciation for transparency, specifically to measure credit risk (Welter et al., 2013), it is contestable as to what extent policy actually reflected this realisation. For example, Baldock (2016) suggests that following the global financial crisis (GFC) VCs in the UK tend to invest in expansion or late-stage small companies rather than early-growth firms, suggesting a preference for post-growth investments where the product or idea can be more accurately valuated. Yet if funds are being redirected to late-stage rather than early-stage firms, the ‘high-potential’ and ‘high-risk’ firms may never receive the opportunity to materialise their

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10 product or idea. Similarly, the VC will miss an opportunity to invest in a high future value company and to profit from a valuable exit.

It is not only financial information which is obscured in opaque information. Given that the entrepreneur’s effort is instrumental for firm value, the lack of information surrounding the entrepreneur as an individual is an impediment to valuing the firm as an investment opportunity. Since the moral hazard agency problems affect the selected choice of financing, optimistically or incompletely analysing the entrepreneur’s behaviour can lead to a suboptimal financing choice by VC. In order to assess the abilities of the entrepreneur, the VC needs to consider relevant behavioural characteristics, most importantly their risk preferences (Cumming, 2003), as excessive risk-taking can destroy value and underinvestment is a misallocation of resources. Hitherto, it is clear that the VC faces numerous informational impediments. A lack of insight in the investee company and its entrepreneur can lead to resource misallocation, an untimely exit, or a missed investment opportunity. Chapter 3 discusses how value-destructive diverging incentives can be mitigated by a VC and CPE structure through allocating cash flow and control rights, as well as how VCs and CPEs can overcome other informational barriers. Chapter 4 will examine whether and to what extent UK law and policy supports this endeavour.

2.2.2 High risks and moral hazards

Information asymmetry has been the common denominator for VCs investing in early-growth firms, an important consideration when determining how an entrepreneur can derive private benefits from investments, when such investment strategies do not correlate with the VCs return (Gompers, 1995). Addressing conflicts of interests and reducing private benefit extracts ensures value is kept in the company and therefore in the VCs stake. Chapter 3.3 explores how preferred equity shifts risk from the VC to the entrepreneur, essentially ‘smoking out’ low or negative net present value (NPV) projects and creating incentives for the entrepreneur to perform well (Sahlman, 1990), despite contrasting arguments that debt performs a similar function (Tester, 1998). Pervasive risks and hazards in start-ups and early-growth firms jeopardise the VC from obtaining a profitable exit, substantiating the argument that a greater law and policy role is necessitated.

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11 Start-ups face high agency costs and as such these early-growth firms are at significant risk of failing within their first few years. In addition to the risk of failing, large adverse selection and risk shifting incentives in early growth firms create moral hazard concerns which are exacerbated by costly due diligence in early stage companies and demonstrated by the associated and frequent failures in such markets (Cumming, 2003; Jia, 2015; Baldock, 2016). These moral hazard risks are high, primarily emerging from private benefits the entrepreneur can access due to the ‘malleable nature of their [the firms’] assets’ (Burchardt et al., 2016). VCs can have greater confidence if entrepreneurs invest in every positive NPV project (Myers and Majluf, 1984). However, where entrepreneurs have private information they may have incentives to invest in negative NPV projects, or investments with high private benefit but low shareholder return (Gompers, 1995). Ultimately, if the VC or law and policy are able to manage adverse selection and risk-shifting incentives, the fund can extract greater value from the exit. Chapter 3 develops these contentions by showing how CPE or VC contributions can mitigate high risks and moral hazards.

2.3 What barriers does a venture capital fund face in securing a profitable exit?

VCs face several impediments in securing a profitable exit which can further destroy the value of the investments. Conflicts of interest emerge between the entrepreneur and the VC when the firm is performing well and the VC chooses to divest, often because VCs are required to provide cash flows to the VC fund investors within a specific timescale (Burchardt et al., 2016). Both parties also require a degree of protection from an outsider taking over the firm. Berglof (1994) explains that the entrepreneur wants to be protected against an outsider who takes over the firm and does not compensate the entrepreneur for the firm-specific investments that they make in order to seize private benefits from the project. This is a disincentive for the entrepreneur to make those firm-specific investments. On the other hand, Berglof (1994) demonstrates that an outsider may siphon assets from the firm without paying its full market value, since valuation of new products or intangibles are hard to verify. In VC arrangements, an exit decision is an important concern from the start and often contracts will be contingent on an exit agreement, as selling the firm is a ‘verifiable event’ (Berglof, 1994). ‘Take me along’ clauses (shareholder with an agreed proportion of equity can require all other shareholders to accept a buy offer) is an example of a restriction which may be contracted into the articles of association. However, the characteristics of the

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12 buyer may change the entrepreneur and VC’s inclination to sell and consequently contractual contingency based on a sale event is insufficient to mitigate diverging incentives pre-exit (Berglof 1994; Lewis et al., 2014). As a result, the preferred mode of exit by the VC and entrepreneur often diverge. The VC seeks from its investee company a spike in profits and the ability to undergo a profitable exit (Chiu, 2003) while the entrepreneur tends to seek private benefits (Gompers, 1995). In contract, various scenarios are included in the structure to account for different possible exit strategies. Such a range of options can be disruptive for the start-up, especially as UK legislation does not have intervening powers to ameliorate the impact of harmful exits, simply because no regulatory frameworks exists to adjust the positions of parties (Chiu, 2003). As a result, the investor would prefer, in fact, to liquidate the investment on the secondary market. This suggests the PE market is not yet idealised.

Additionally, asymmetric information makes valuing the firm in part or as a whole more inaccurate, affecting efficient and profitable exit decisions (Bascha and Walz, 2001). This effect is magnified by the fact that both entrepreneur and VC have conflicts regarding the nature and time exit (Hellman, 2006; Arcot, 2014). Valuation is generally more accurately priced in a trade-sale than in an IPO, since in the trade-sale exit, bidding firms can perform due diligence and tend to operate in the same industry, unlike new shareholders in an IPO (Arcot, 2014). Therefore, for a firm with significant asymmetries of information, the value of the firm at the time of the exit can be more accurately ascertained through a trade sale as the optimal exit decision (Poulsen and Stegemoller, 2008). Compared to the entrepreneur who wants to protect their private benefits of control as both owner and manager, VCs generally prefer the trade-sale divestment in order to provide its VC investors with agreed cash flows (Burchardt et al., 2016) However, for a firm that is performing well, the VC can attract greater private reputational benefits from an IPO than a trade-sale, and in addition incentivises the entrepreneur to make an effort before the IPO in order for the entrepreneur to retain control post-IPO. Participating CPEs serve to resolve these mismatches of preferences as discussed in Chapter 3.6. In summary, both entrepreneur and VC may view the exit decisions with opposing interests which can affect their performance. CPE endeavours to align these interests yet preventing harmful exits and negative externalities should also be an objective of PE law and policy.

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3 How does the venture capitalist and convertible preferred equity enhance

value?

Ample data reveals the prevalent use of CPE in VC investments in entrepreneurial firms (Hellman, 2006; Burchardt et al., 2016) to design an optimal contract that can mitigate various moral hazard risks (Berglof, 1994; Burchardt et al., 2016). After introducing the concept of CPE versus alternative forms of financing, Chapter 3 discusses how cash flow and control rights are transferred to the VC in order to mitigate agency costs and secure a profitable exit. Chapter 3 then discusses other virtues of the VC fund and CPE which assist in reducing the costs of investing in a high-risk early-growth company. As mentioned in Chapter 2, in order to effectively finance young start-ups, the VC must address the issue of diverging incentives. The relationship must be structured in a manner which allows each party to advance the other’s interest, as in the normal state of the world a party is attempting to advance their own interests (Gorman and Sahlman, 1989). Convertible securities can be developed as ‘sophisticated contracting practices’ in order to settle such issues (Schmidt, 2003).

3.1 What advantage does convertible preferred equity have over other forms of

financing?

Common equity provides investors with dividends, reflecting ownership rights of a company. Generally, one share equals one vote, in addition to dividend entitlements. In a start-up company, common equity is generally held by the founders with the entrepreneurial vision.Common equity holders do not have special rights, such as preference in liquidation proceedings or anti-dilution provisions. Common equity is low priority, ranking below secured and unsecured creditors and preferred equity holders. Bascha and Walz (2001) contend that a lack of flexibility inherent in standard debt and/or equity makes optimum efficiency unfeasible. CPE allows the holder, in this case the VC, to convert its preferred equity to common equity. The conversion will usually take place at the IPO, acquisition, or trade-sale. Its initial preferred status provides preference in liquidation proceedings and dividends, above the common equity holders (i.e. the founders or entrepreneur). Before conversion, the preference resembles a debt-like claim given their liquidation preference, providing downside protection, and the fixed dividend payments akin to interest payments

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14 (Arcot, 2014). Alternatively, when CPE is converted into common equity, it can allow the VC to enjoy the upside potential of common stock (Marx, 1998). CPE may also take the form of participating CPE, entitling the holder to enjoy excess earnings with common shareholders (Arcot, 2014). In liquidation for example, this means the participating shareholder receives a pro rata share of the remaining amount to common shareholders, in addition to their liquidation preference. This dividend and liquidation preference is valuable to the investor, given the high degree of risk prevalent in start-ups. Therefore, it is apparent how the basic cash flow functions of CPE can benefit the VC in securing a profitable exit.

The choice of security financing for investments generally reflects the investors’ goals, in terms of their ability to cope with risk and their desired reward for bearing such risk. Financing decisions will be influenced by, inter alia, reducing agency costs, improving efficiency, and securing a profitable exit (Huygherbaert and Gutch, 2007). Convertible debt and convertible preferred equity are used most frequently in VC finance (Sahlman, 1990; Bascha and Walz, 2001; Chiu, 2003; Schmidt 2003). In fact, CPE materialises at almost 80% of all VC contracts (Kaplan and Stromberg, 2003). While the focus of this thesis is on CPE, lessons can nonetheless be learned from academic research on convertible debt as a similar mode of fixed-income security. Both convertible debt and preferred equity holder have a fixed monetary claim, the former in interest payments and payment of the principal amount, and the latter in accumulated dividends. Bascha and Walz 2001 note the main divergence between the two securities is in the event of default where debtholders become owners with authority to impose decisions such as mandating insolvency. Other literature does not consider the two as close alternatives with research indicating that the choice depends on the firm characteristics (Billingsley and Smith, 1996; Lee and Figlewicz, 1999). For example, convertible debt is used more frequently in firms with greater free cash flow, and the opposite is true for CPE (Jensen, 1986; Lee and Figlewicz, 1999). This is consistent with the thesis hypothesis that early-stage firms, with little free cash flow and large demands for capital (Cumming, 2005), are likely to select CPE. Furthermore, companies are more likely to use CPE financing when they are not profitable and cannot afford additional risk, or have high bankruptcy risks (Marsh, 1982; Lee and Figlewicz, 1999). This is consistent with an abundance of evidence indicating that VCs invest in high-risk companies (Sahlman, 1990; Huyghebaert and Gucht, 2007). On average firms issuing CPE are about seven times smaller than firms issuing convertible bonds (Abhyankar and Dunning, 1999) and there is an increase in convertible debt use over time (Cumming, 2005).

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15 Interestingly, Lee and Figlewicz (1999) state that convertible debt is selected in lieu of CPE by firms with greater ‘growth potential’ – a feature that can be characterised with start-ups VCs choose to invest in – to optimise investments and align shareholder and bondholder interests. Lee and Figlewicz follow the view that growth potential is determined by year-end Tobin’s q (Total Market Value of Firm / Total Asset Value of Firm) prior to security offering, and earnings-per-share in the 3-year period prior to the offering. Thus, ‘growth potential’ is defined in terms of historical data prior to the investor’s contribution in the firm. Comparatively, this thesis takes the view that growth potential is reflected in a high level of innovation and dynamic capabilities. For example, Kortum and Lerner (2000) examined a patenting rate over three decades in US VC industry investments of 7 to 1 compared with regular research and development. This represents a greater growth potential as a result of the investors operational and governance contribution. Given that limited financial information is available on start-ups – due to their young existence since incorporation – ‘growth potential’ would be examined from a product-focused and financial forecast perspective. There are also indications of the superiority of equity in terms of meeting growth needs for small businesses, compared to debt which has ‘practical limitations’, despite the fact that larger businesses tend to prefer debt finance for external financing as the pecking order theory postulates debt has lower costs of financing than equity (Chiu, 2003). This is because small firms require a quality of permanence in their financing in order to carry out research and development practices, a feature which does not resonate with debt financing. Alternatively, debt substitutes to equity financing can be unviable if the start-ups ability to provide collateral or guarantees to loan providers is insufficient, if their trading records are insufficient, or if the owners are unwilling to provide a private property guarantee in debt financing (Owen et al., 2019). Therefore, this thesis examines growth potential as an outcome of VC contribution and dynamic capability improvements throughout the start-ups’ financing stages in order to increase firm value and allow the VC to secure a profitable exit. It is also apparent that CPE in contrast to alternative forms of financing assists the VC in these efforts.

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3.2 How does convertible preferred equity transfer cash flow rights?

Hellman (2006) uses the delivery of cash flow rights as a pivotal characteristic in which VCs chooses CPE over other securities. These rights allow the VC to acquire some income even if the company’s success is marginal. In addition, VCs do not have to wait for explicit board authorisation to redeem dividends with CPE (Sahlman, 1990). Marx (1998) contests this and states dividend payments are the discretion of the directors. However, he also notes VCs managerial rights are acquired through investment usually contains a right to appoint one or more directors as a company officer, suggesting VCs can exercise a degree of control on the board. This is similarly supported by Gompers (1997) who shows that from a sample of 50 CPE VC investments, VCs typically hold enough seats to control the board of directors. Moreover, Sahlman explains that the ‘conversion ratio’ of CPE can be written in flexible terms. For example, a company that performs well may have a higher conversion price. The entrepreneur is essentially compensated since there is a lower likelihood the entrepreneurs ordinary shares will be diluted. From this rationale, management and the entrepreneurs have greater incentives to ensure the company performs well. Sahlman (1990) adds that entrepreneurs would be encouraged to build legitimate value, in lieu of overstated projections. This contention is supported by Bratton (2002), finding that stock ownership can be used as a performance incentive, whereby stock is vested in the entrepreneur when certain targets are met. This carries resemblance of a stock option-based incentive package, although Toms et al., (2015) notes that this incentive mechanism in addition to executive remuneration are ‘necessary but not sufficient conditions for competitive advantage and the creation of shareholder value’.

Furthermore, the VCs cash flow rights provide incentives to invest efficiently (Schmidt, 2003). The VC preference in liquidation ‘has the effect of raising the cost to [the entrepreneur] of poor performance’ (Bratton, 2002), as a risk-averse VC will intervene during poor performance, imposing intervention costs on the VC and loss of control for the entrepreneur (Marx, 1998). CPE therefore provides an incentive mechanism for the VC to intervene during poor performance and where the expected value of the project can be improved (Marx, 1998; Cumming, 2005). CPE is particularly effective as a VC incentive mechanism when the costs of capital currently exceed the firms’ earnings (Cumming, 2005). In order to at least secure a marginal share of profits, the entrepreneur must maximise firm

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17 value. The preferred nature of CPE in terms of fixed payments and liquidation preference can create a possibility similar to what is experienced in debt-overhang scenarios. If the VCs CPE ownership is too large, and profits are not substantial (as they likely won’t be), the entrepreneur may lose any incentive to optimise investment decision-making in the short term, since the profits would be directed to the VC fund instead. One may contend that cash-flow rights might reduce VC monitoring incentives since their cash cash-flow priority places them ahead of ordinary security holders, namely the entrepreneur. Monitoring can also be costly for the VC (Gompers, 1995). This is eased by the process of staging, which is periodically observing the performance of the firm and its investments with the ability to exit (Gompers, 1995). Ultimately, it is apparent that CPE can provide value-increasing incentives to both VC and entrepreneur, however its various limitations suggests that performance may benefit from law and policy intervention or guidance.

3.3 How does convertible preferred equity transfer control rights?

Literature has shown CPE can optimise both the VCs’ and the entrepreneurs’ incentive to provide effort in terms of efficient decision making and mitigation of agency problems in exit decisions (Cumming, 2005). By alleviating conflict of interest issues, inefficiencies can be reduced, and investment value can be improved (Sahlman, 1990; Berglof, 1994; Bascha and Walz, 2001). When an entrepreneur exercises its discretion there is evidence they value private benefits of control and will influence strategic business decisions in order to secure a private benefit (Cumming, 2005; Huygherbaert and Gutch, 2007). Under various conditions and firm characteristics, security design can optimally mitigate agency conflicts (Jensen and Meckling, 1976; Cumming, 2005). Start-ups backed by VC investment face a bilateral moral hazard problem since both the VC and entrepreneur have incentives to manage the firm. Evidence indicates bilateral moral hazard problems are pronounced in high-tech firms, with the result that such firms are 6.1% more likely to finance their operations with CPE (Cumming, 2005). Window-dressing – when the entrepreneur misrepresents the cash flow or company value to secure further investor financing – is similarly a distinctive feature in high-tech firms which attract the use of CPE (Cumming, 2005). The following paragraph illustrates how the VC and CPE uses control rights to overcome these information asymmetries and conflicts of interest.

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18 If we consider debt and its advantage of superior insolvency priority and avoiding tax charges on interest payments, why wouldn’t the VC offer a loan in lieu of equity? Preferred equity allows the VC to adopt key business decisions, replace executives and recruit new management, partake in strategic and operational planning, support day-to-day operations and even determine customer and supply chains (Gorman and Sahlman, 1989; Sahlman, 1990; Marx, 1998; Bratton, 2002). This is made possible by VC CPE investments which typically provide the VC with board control (Gompers, 1997). Having this degree of control and participation in start-up or early-growth company allows the VC to overcome information barriers through continuous monitoring (Marx, 1998). It is relevant to keep in mind that the VCs’ contribution must be sufficiently material in order to provide efficient investment decisions (Schmidt, 2003). However, this is an expensive endeavour for the VC fund, so it may decide to liquidate the company if unprofitable, or alternatively, bring an outside CEO with greater expertise to run the business in lieu of the entrepreneur (Schmidt, 2003). Consequently, we see the value of equity in providing the VC with managerial control during the investment tenure whilst debt attempts to exercise its control ex ante, embodied in a collection of covenants and small print. This is not to say that ex ante control rights are ineffective, but rather the allocation of control rights is inefficient when debt and/or equity are used in ‘simple contracts’ in terms of VC financing (Bascha and Walz, 2001), particularly when new information is constantly being revealed regarding the company’s value after project investments (Marx, 1998). There is also the obvious prospect that the start-up is confined to equity investors and may never ‘take off’ if limited to high interest charges as expected by bank caution investing in relatively risky companies (The Wilson Report, HMSO, 1979). Regardless, the nature CPE is one that provides both the VC and entrepreneur with implicit control, the VC with its preferred status and the entrepreneur if it successfully grows the value of the firm and is allowed to reacquire their stake in an IPO (Black and Gilson, 1998).

Additionally, VCs can attach covenants to the term of the investment, but the nature of equity makes resorting to covenant-backed remedies weaker than debt. For example, default on a debt obligation by the debtor entitles the debtholder to accelerate interest and principal payments. This power is generally not available for CPE, since dividends can be retracted. Other remedies to approximate such repayment may include a repurchase promise, but due to regulatory and equitable legal principles, are less reliable (Liberadzki and Liberadzki, 2019). In any case, if attached, the use of covenants is a means by which a VC

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19 may exercise control. In addition to making key decisions such as authorising material transactions and liquidation procedures, covenants allow the VC to exercise authority over the board and management (Gompers, 1997; Bascha and Walz 2001). By taking a seat on the board of directors, VCs can exercise managerial ownerships rights in addition to ‘important economic rights’ (Sahlman, 1990). However, since control covenants can be secured separately, Gompers contends that such control rights are separate from the convertible security itself, which has the primary function of cash flow rights, and those control rights can be achieved separately. Similarly, Berglof (1994) find debt and equity are complementary for settling control issues. Bascha and Walz 2001 agree to a certain extent, but also argue that combining cash flow and control rights provide a greater advantage. Alternatively, Cornelli and Yosha (1997) consider convertible debt to be most effective in aligning the entrepreneur’s incentives short-term outcomes, especially in staged financing. Finally, Marx (1998) finds than in an environment where the entrepreneur is wealth constrained and the VC is risk neutral, a debt-equity mix is optimal. The remainder of Chapter 3 displays how a CPE contract can incorporate features of a debt-equity mix, allowing the VC to overcome information barriers and mitigate risks in order to improve firm value.

If the CPE contract includes the right to put the security by redemption, as such agreements typically do (Sahlman, 1990), then this can act as a control mechanism by aligning the VC incentives with the entrepreneur’s to enhance the value of the firm. Additionally, VCs use staging finance through periodic capital flows in order to divest in investments that provide low returns in the start-up or expansion phase (Dahiya and Ray, 2011). Thus, there is a role for CPE in mitigating agency costs by providing monitoring incentives (Cumming, 2005) and ensuring the entrepreneur undertakes value-increasing projects (Burchardt et al., 2016), aligning their incentives with improving overall firm value. This control right is limited if the entrepreneur contracts a requirement of additional ‘outside’ financing at later stages of firm growth, as the entrepreneur does not want to face renegotiation hold-up problems which may arise by having a single ‘inside’ investor. Nor does the entrepreneur want to rely on a single supplier, as this may cause hold-up problems if that supplier exercises too much control in exit decisions (Cumming, 2003). The interdependence ensures the investors do not free ride on each other’s effort and they finance positive NPV decisions. It also ensures the insider VC does not engage in window-dressing, preventing over- or under-stating of capital requirements to outside investors and overcoming information asymmetries (Cumming, 2005; Burchardt s et al., 2016). Additionally, because of

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20 outside investors potentially diluting the entrepreneurs’ shareholdings, staging under convertible contracts mitigates excessive risk-taking (Burchardt et al., 2016). The limitation of this contention is that staging theory often presumes the VC has perfect information in comparison to outside investors (Burchardt et al., 2016). Though the VC will still face information barriers, this is periodically overcome through VC monitoring and due diligence at the point of re-financing decisions (Gompers, 1995; Marx, 1998). VC control rights are a valuable method of enhancing exit profits, but they are not absolute. This dichotomy demands law and policy intervention.

3.4 Direct contributions of the venture capitalist

Governance skills are pertinent at both entrepreneur management and investor level. Essentially, value is the result of ‘complementary resource mixes’, in that knowledge is shared between both entrepreneur and the VC (Toms et al., 2015). In addition to the improvement feedback VCs provide from their continuous monitoring, entrepreneurs also seek VC investments since VC are better suited than other private investors to attract a strong and experienced management team and to develop internal control systems used to create value (Ehrlich et al., 1994; Wijbenga, 2007). Furthermore, the entrepreneur can benefit from the VCs networking and operating expertise and can rely on significant VC involvement since the VC wants to ensure for its investors a positive return of cash flow (Ehrlich et al., 1994; Burchardt et al., 2016). To mitigate these risks, the VC will become more involved in the venture, as suggested by a correlation of greater VC involvement to decreased performance (Higashide & Birley, 2002). Thus, a synergistic relationship can help to avoid a mismatch of goals and expectations, which is attained by effort on both parties to analyse and agree with each other’s goals in the investment deal (Ehrlich et al., 1994). Gorman and Sahlman (1989) find the involvement time is positively associated with early-stage investments as compared to late-stage investments where the VCs will then provide 10 times as less contact with the firm. Amongst the aforementioned contributions, the VC also assists in preparing business strategy, monitoring operational and financial performance, and developing an investor group (Ehrlich et al., 1994; Wijbenga et al., 2007). In retrospect, VC support in start-ups and early-growth firms is favourable for firm value. Chapter 4.4 contends that public funding additionality in the UK currently lacks the value-enhancing expertise of private VCs.

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3.5 Executing a profitable exit

Structuring the exit can have agency-mitigating effects on the entrepreneur. The VC is able to build the exit strategy into the investment by agreeing ex-ante in the articles of association. This would include tag-along rights enabling the VC to have greater control on the exit process, for example its timing (Lewis et al., 2014). In addition to the VC, CPE can be used as both an incentive mechanism to ensure a profitable exit but also provide the VC with preferences in liquidation. Chapter 4 will review to what extent UK policy facilitates the VC in achieving a profitable exit.

CPE is valuable because of its insensitivity to the risk of underlying assets (Berglof, 1994). Berglof shows that in an ordinary scenario protecting assets in contracts is difficult, and consequently entrepreneurial incentives are not protected as incentives are derived from those assets. Given the use of CPE in allocating control in state-contingent scenarios, CPE can protect these incentives by contracting on ‘non-verifiable but observable information’ with the conversion option. Arcot (2014) demonstrates that in an IPO, a VC may choose to convert its participating CPE into common equity despite the fact its stake as a preferred shareholder is greater than its converted share in order to signal or ‘certify’ to investors the (higher) value of the venture. In this sense, the VC provides a verification and reputational role to other investors which is important given that practitioners and academics agree that VCs with higher reputations provide better managerial, coaching and networking services than low reputation VCs (Chemmanur et al., 2011). It also allows the VC to convert CPE, which is illiquid, into a more liquid form: cash (Sahlman, 1990). On the other hand, bidders and buyers in a trade-sale do not require such a signal since they are already relatively informed – they have access to the company’s book and likely specialise in the industry of the investee company, whereas in an IPO the investor relies on the intermediary and the prospectus. Given that the entrepreneur is more likely to retain control during an IPO than a trade-sale, there are ex ante incentives for the entrepreneur to maximise firm value and to be rewarded with control post-IPO. Despite the costs of IPOs to the VC, it is beneficial for firm value. In fact, empirical evidence shows the reputational effect and value certification of a VC-backed IPO lowers the costs of IPOs for VCs compared to offers that are not backed by VCs (Megginson and Weiss, 1991). In either scenario, in an IPO where the entrepreneur

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22 retains independence or in a trade-sale where the VC satisfies its financing constraints, holding CPE has potential to balance incentives by allocating cash flow rights, leading to revenue maximisation (Hellman, 2006).

4 What is the role of UK legislation and government initiatives in controlling

agency costs?

Previous chapters examined how the VC can apply an array of operational and managerial tools to overcome governance challenges in funding early-growth ventures, and similarly use CPE to align diverging investee-investor incentives. In light of recent trends, if VCs now display a preference for later-stage investments following the GFC (Upton & Petty, 2010; Baldock, 2016; Colombo et al., 2019) it can be contended that these value-inducing VC and CPE qualities are not always adequate to overcome the variety of risks and costs embedded in earlier-stage ventures. This suggests that UK regulation and policy should address these immediate hurdles in order to attract investments to early-growth yet high-potential ventures. Owen et al., (2019) find that few UK public venture capital schemes have actually been successful. These fail primarily because of an insufficient response to agency problems or dynamic capabilities, particularly information asymmetries and consequently a hindrance of a VC’s ability to conduct effective due diligence (Owen et al., 2019). To understand how the UK has approached information asymmetries, this chapter examines the UK Companies Act 2006 which provides a disclosure regime for small unlisted companies. Furthermore, this chapter investigates various policies which endeavour to promote PE financing and to provide opportunities for early-growth companies which face financial constraints. These policies include tax-incentive schemes and GVC schemes. Tax-incentive schemes incentivise VCs by way of tax relief, whereas GVC schemes use public and private sector co-funding in order to address the equity gap for small and medium enterprises (SMEs). While providing opportunity to financially constrained SMEs, this chapter explores how these do not necessarily overcome agency problems or provide the VC with a profitable exit.

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4.1 Does the Companies Act 2006 address informational agency problems?

The principal ‘legal dilemma’ which policymakers face in information disclosure is the trade-off between disproportionate administrative burdens and necessary financial transparency. On one hand the growth of start-ups and early growth companies is dependent on not incurring insurmountable costs which are better spent invested on R&D, and on the other hand it is proven that credit-resource allocation, economic development and economical certainty is improved by the amelioration of financial transparency (Welter et al., 2013). The paradox is furthered when considering disclosure may actually harm the small company from stakeholders such as competitors from seeking to appropriate or exploit informative sources of economic value which may ultimately threaten the growth of the start-up (Welter et al., 2013). Therefore, the aims of UK regulation must be put into perspective. Over the years, audit exemptions for private limited companies have periodically widened the scope for small companies seeking to apply for statutory annual audit exemption. For financial years beginning before October 2012, a company would qualify for the exemption if it had an annual turnover of no more than £6.5 million and assets worth no more than £3.26 million. Financial years from 1 October added an eligibility criterion of ’50 or fewer employees on average’, and only 2 of those 3 requirements were necessary to qualify for the exemption. 2016 experienced another increase in thresholds, raising turnover and asset value to no more than £10.2 million and £5.1 million respectively, whilst maintaining the employee threshold (Section 382 CA 2006; IFC International & BMG Research, 2017). Essentially, The Companies Act 1981 provided a ‘modified’ accounts regime. The Companies Act 1989 changed this to an ‘abbreviated’ accounts regime, and this was kept in the Companies Act 2006 (Welter et al., 2013). Then, for financial years beginning on or after 1 January 2016, ‘abbreviated’ accounts for small companies were abolished and replaced with ‘abridged’ accounts (Adrain, 2017a). Previously, abbreviated accounts were prepared in full and a shortened or abbreviated version was prepared for the Companies House. Now, only certain line items in the income statement and balance sheet must be included in the abridged accounts, with shareholder pre-approval (Adrain, 2017b). As a consequence, there are now 4 possible scenarios in accordance with Section 444 of the Companies Act 2006 which lists the filing obligations of companies subject to the small companies regime. Small companies may file i) unaudited and unabridged accounts; ii) audited and unabridged accounts; iii) unaudited and abridged accounts; iv) audited and abridged accounts. Small companies are able to

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24 exempt from annual reports the directors’ report and the income statement, although this is subject to a requirement of stating that the accounts were prepared with shareholder consent and in accordance with the small company’s regime. Regardless, the reduction in line items has a consequence a restriction in financial ratios required to observe the companies’ performance, naturally increasing agency costs.

There are a number of exceptions to this small company regime, namely under Section 384, the Section 382 exceptions regime do not apply if at any time during the financial year the company was, inter alia, a public company, an authorised insurance company, a banking company, a Markets in Financial Instruments Directive (MiFID) investment firm or an Undertaking for Collective Investment in Transferable Securities (UCITs). This issue can be addressed by UK regulation in the post-investment period. If the sole VC or any other investor in the same class has an individual or combined share ownership of not less than 10% they may still ask for an audit (Section 476 CA 2006). This request must be complied with, provided the request is in writing, sent to the company’s registered office, and sent a minimum of 1 month before the company’s financial year end (Gov.uk, 2020). The scale of the exemption is enormous when considering that in 2015 up to 90% of all UK registered exemptions likely exercised the audit exemption. Although the range of this percentage is from 62%, IFC International & BMG Research (2017) note the higher estimate is more robust. The report notes, as expected, the use of the exception is likely to grow over time as a result of increased thresholds. For example, the take-up of audit exemption as a result of the 2012 changes was between 60-85% (BIS, 2014), displaying a lower take-up of audit exemptions in the past. We can therefore conclude that the vast majority of small private companies opt for an audit exemption.

A significant finding for this thesis is that companies with shareholder, lenders or external investors were more likely to voluntary agree to a statutory audit in order to ‘satisfy and provide confidence to these external parties’ (IFC International & BMG Research, 2017). This is consistent with the idea that the VC exercises a considerable amount of control over the venture in order to compensate the fund for the high degree of risk it accepts. Therefore, given that VCs efficiently monitor its target and that VCs incentives are more aligned relative to public shareholders, a VC is able to confine asymmetric information agency costs by conducting due diligence at entry and exit points, consequently a source for knowledge sharing and value creation (Toms et al., 2007). Toms et al., further specify that insider

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rent-25 seeking accruals can be reduced as a result of due diligence and active monitoring, for example in the form of being regularly provided with managed accounts and surveying the covenants of loan providers. On one hand, increased disclosure obligations improves access to growth for start-ups and early growth companies by lowering the cost of capital from investors who price the greater risk into their financing (Garcia-Sanchez and Noguera-Gamez, 2017, Welter, 2017). However, on the other hand, reduced disclosures decreases credit flow from investors to the company as a result of business uncertainty (Welter, 2017). Although the risk remains that start-ups and early growth firms will choose not to voluntary disclose information, in practice the VCs with ‘control’ will mandate such disclosure as part of their financing agreement, particularly in staged-financing agreements (IFC International & BMG Research, 2017).

4.2 Do tax-incentive schemes address agency problems and ensure

profitability?

The development of the Enterprise Investment Scheme (EIS), the Venture Capital Trusts (VCT), and the Corporate Venturing Scheme (CVS) initiatives endeavoured to expand SME financing through income and capital gains tax reliefs. However, Hughes (1997) suggests that rather than funding ‘high-risk, high-tech, or innovative small business growth’, PE policy in the 1980s appeared to encourage low risk management buyouts, omitting from VC portfolios high-risk and high-potential companies, a source of innovation and economic growth (Lerner, 2010; Colombo et al., 2014). More recently, Avnimelech et al., (2010) find the results of UK policy development has still portrayed ‘a pervasive emphasis on monetary incentives and a strong supply-side bias, with little regard for capability generation at both the firm level and the industry level’. Similarly, Toms et al., (2015) associates the pre-1980s market with unsuccessful speculative company buying and selling, the post-1980s market with management buyouts, and early 2000s as reflecting ‘greater maturity of the industry’ up until the GFC. We do not imply that buyouts are market failures, in fact evidence from the first PE buy-out wave from 1980-90 and the second wave in 1996-2008 is characterised by increased profitability and efficiency. Toms et al. (2015) largely attribute this to value-increasing corporate governance measures. However, they note these buyouts target profitable companies in low-risk sectors, and not high-risk and innovative start-ups, which require funding in order to realise their value. This chapter argues whilst UK initiatives have

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26 emphasised monetary incentives in SME financing, this significant supply-side bias has neglected capability generation (Avnimelech et al., (2010)). Teece et al. (1997) includes in a firms’ dynamic capabilities effective governance processes that are a source for wealth creation and competitive advantage. PE in the form VC therefore has a strategic role to allow for value creation. This may embody, inter alia, aspects of innovation and R&D, financing positive NPV projects, sound corporate governance, and trading risk for high returns. By and large, characteristics of accountability and governance structures are significant for financial return (Toms et al., 2015). However, it is debatable whether the EIS, VCT and CVS schemes actually contribute to dynamic capabilities.

VCT funds, introduced in 1995, are publicly quoted and professionally managed funds providing returns to investors seeking above-average returns. Between 2018-2019, £731 million was invested into VCTs. The pool of risk is managed in the form of a diversified portfolio of qualifying companies, making it attractive for investors. For eligibility, the private equity company must have no more than £15 million in gross assets, no more than 250 employees, and a maximum of 7 years can elapse since the first commercial sale of that entity. VCTs provide an income tax relief on invested shares. In this case, 30% on investments up to £200,000 per tax year is tax credit to offset against an investors annual tax liability. The hold period is slightly longer than that of the EIS, mandating VCT shares are held for a minimum of 5 years to qualify for the income tax relief. However, there is no such period to qualify for capital gains relief. Although the VCT can be used for funds investing in preference shares, there are two important qualifying conditions: i) at least 10% of the total investment in a company must be in eligible shares (i.e. shares without preferential rights), and ii) the VCT cannot have control over the company (Lewis et al., 2014). The latter qualification marks a significant limitation of the VCT scheme. As noted in Chapter 3.3, both VC and CPE contracts are catalysts for value-added control, allowing the VC to overcome information barriers through control and continuous monitoring (Gompers, 1997; Marx, 1998). If the VCT cannot exercise control over the company, the VC is limited to the degree it can effectively provide value-added contributions.

Similarly, the EIS, a tax relief scheme introduced in 1994, offers income tax relief of 30% of the value of the investment, and capital gains relief for private investors in ‘EIS eligible startup or business’ in the form of disposal and deferral relief (HMRC, 2020). Tax relief can be applied to previous years as a carry-back. There are also inheritance tax reliefs of 100%

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27 when EIS shares are held for two years, applicable only to non-listed stocks. Amongst a range of anticipated requirements, there are a couple of notable constraints. Firstly, investors are eligible to invest in qualifying companies each tax year up to an amount of £1 million. Additionally, there is an obligation to hold the shares for a minimum of 3 years, harming the flexibility of VC divestment. The EIS does not apply to investors with an interest of >30%, and so this paper argues the EIS is insufficient in generating dynamic capabilities for a firm if the PE investor, namely a VC, cannot control aspects of the firm.

Finally, the CVS, introduced in 2000, provides tax benefits to qualifying companies, namely small and high-risk companies. Akin to VCTs and EIS, the CVS provides investment, deferral, and loss relief. However, these benefits apply to investment funds subscribing for ordinary shares baring the full risk of non-preference, and therefore are not applicable to funds subscribing to CPE. This limitation is noteworthy because VC funds aiming to manage risk with preferred equity when the firm is not performing well and with a convertibility option to enjoy the gains in exchange for its high-risk investments, are essentially barred from doing so, if they want to simultaneously enjoy capital gains tax relief. This further reinforces Avnimelech et al.’s contention that policy focuses too narrowly on immediate monetary incentives, side-lining long-term value enhancement and strategic growth. In fact, they note that despite greater PE investments in the UK, a small proportion of this funding is for technology-based VC-backed start-ups, suggesting, in part, insufficient investments incentives in the UK for high-risk and high-potential ventures.

In April 2008, the HMRC conducted a study ‘on the impact of Enterprise Investment Scheme and Venture Capital Trusts on company performance’. Although the results reflected positive associations with growth in fixed assets and employment, there was little correlation with greater gross profits or investments (although the study notes as a limitation that the latter result was derived from incomplete information). Those positive associations were also regarded as materially very small. The study points out these negative associations are to be viewed in context of young entrepreneurial companies. Therefore, a company’s growth in fixed assets or employment – its general capacity building – is an indicator of their future capabilities, and in the short-term is a more important consideration than productivity or profitability, which have positive relations with company age. In fact, young and innovative companies without market presence are likely to have relatively high costs and low margins. This is particularly true for companies with VCT investments, as HMRC found a positive

Venture capital investment challenges in controlling agency costs and the role of convertible preferred equity. A UK law and policy reform perspective.