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University of Amsterdam

Amsterdam Business School Thesis for the Master in International Finance

September 2018

I Would Like to Have My Money Back First! - The Liquidation Preference in Dutch Publicly-Sponsored Seed Venture Capital Contracting

Supervisor: Jeroen Ligterink

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2 ABSTRACT

This study analyses the determinants of the different types of liquidation preference contracting claims used by venture capital firms. Liquidation preferences are rights included in preferred shares. They reduce the downside risk for a venture capital firm and create the potential for an upside. I collected and analyzed the content of contract data from 353 investments made by 66 publicly-sponsored Dutch seed venture capital funds over the period 2005-2018. A liquidation preference occurs in 66% of all participations. A 1x multiple (including cumulative dividends) is most common (94%) as liquidation preference; multiples of 3 and higher are extremely rare in Dutch seed venture capital. I find that 71% of the liquidation preferences are participating however their share is declining in recent years. Overall, 93% of the participating liquidation preferences were not capped. Furthermore, I show that fund manager experience has a significant positive impact on the occurrence of a liquidation preference. I also show that

institutional venture capital firms are more likely (36%) to introduce a liquidation preference than informal or corporate venture capital firms. Finally, I show institutional venture capital firms are 56% more likely to introduce a participating liquidation preference than informal or corporate venture capital firms.

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Content

1. Introduction ... 4

2. Literature Review ... 7

2.1 Venture Capital & Preferred Shares ... 7

2.2 Venture Capital & Liquidation Preferences ... 9

2.2.1 1st Characteristic: The Multiple ... 10

2.2.2 2nd Characteristic: Simple vs. Participating ... 10

2.2.3 3rd Characteristic: The Cap ... 11

2.2.4 4th Characteristic: Seniority ... 11

2.3 Occurrence of Liquidation Preferences ... 12

2.4 Research Hypotheses ... 14

2.4.1 First Hypothesis: Type of Venture Capital Firm ... 14

2.4.2 Second Hypothesis: Level of Venture Capital Firm’s Experience ... 16

2.4.3 Third Hypothesis: Liquidity in the Venture Capital Market ... 16

3. Methodology ... 18

3.1 Design ... 18

3.2.1 Description of independent variables ... 19

3.2.2 Control variables: GDP and Sectoral Write-Offs ... 20

4. Data Description and Analysis ... 22

4.1 Data Set... 22

4.1.1 Type of Documents ... 22

4.1.2 Content Analysis Specifics ... 22

4.2 General statistics and results... 23

4.2.1 General Explorative Liquidation Preferences Statistics ... 23

4.2.2 Some Exotic Liquidation Preferences ... 24

4.2.3 Different Venture Capital Firms ... 25

4.2.4 Sectoral Differences ... 26

5. Regression Results ... 28

5.1 Results ... 28

5.1.1 Testing the 1st Set of Hypotheses: Venture Capital Firm Type ... 28

5.1.2 Testing the 2nd Set of Hypotheses: Venture Capital Firm Experience ... 29

5.1.3 Testing the 3rd Set of Hypotheses: Liquidity ... 31

5.2 Sample Biases ... 31

6. Conclusions ... 35

7. References ... 39

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4

1.

Introduction

It is January 28, 2019. On this cold Tuesday morning an elegant woman walks towards the entrance of a giant building at the Amsterdam Financial District. Her name is Robin and she is about to sign a contract with the venture capital firm BioTech Seed Capital. This firm is specialized in funding biotechnological start-ups. After years of running experiments in her lab Robin discovered a potential medicine to slow down Alzheimer’s disease. She now wants to bring the drug to the market. This development requires a lot of capital and BioTech Seed Capital is willing to provide her first funding. To structure the funding a term sheet was drafted. This term sheet contains various claims in favor of the venture capital firm.

When Robin enters the glass elevator of the building at the Gustav Mahler Avenue she realizes she still doubts one aspect of the term sheet. The venture capital firm insisted on introducing a liquidation preference, to ‘create the right incentives’ as they explained. She wonders: ‘What would the venture capital try to achieve by introducing this clause and what would other entrepreneurs agree on?’.

Robin’s story is not unique. With the rise of the entrepreneurial economy the role of venture capital firms has become more and more important in modern economies (Colombo, D.J. Cumming & Vismara, 2016). The finance provided by venture capital firms is considered ‘smart’ because venture capital firms also advice and monitor their participations (Sandberg & Hofer, 1987, Hellman & Puri, 2002). However, this advice comes at a price. Venture capital firms raise funds from investors, and generally the venture capital firm promises the investors a return on their investment within 6-8 years (Espenlaub, Khurshed, & Mohamed, 2015). Typically,

successful exits are matched with a high number of write-offs, especially in the seed capital phase (Wright, Lockett, Clarysse & Binks, 2006). This volatility in the portfolio’s proceeds and overall risks are even bigger for early stage venture investments such as university spin-offs (Wright, et al., 2006). Therefore, venture capital firms want to protect their downside and at the same time

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5 increase their potential upside when exiting investments. To do so, they make use of convertible preferred stock with attached, so called liquidation rights (Gardner, 1971).

The liquidation preference specifies the sequence and how much the holder of the liquidation preference gets paid out before others (Sahlman, 1990). These claims reduce the downside exposure by putting the holder first in line among equity holders when a company does not do well. Liquidation preferences can be invoked at pre-defined liquidation events. Also positive liquidation events (such as a trade-sale or a merger) allow the investor to invoke their liquidation preference.

Do Dutch venture capitalists use a liquidation preference often? The answer until now is ‘we don’t know’. There are a number of studies that focus on financial contracts showing liquidation preferences were used frequently in the United States (e.g. Kaplan & Strömberg, 2003, Gompers, Gornall, Kaplan & Strebulaev, 2016). However these studies were either based on old data sets (Kaplan & Strömberg, 2003) or were done via surveying (Gompers et al., 2016). In 2007, Kaplan, Martel and Strömberg did a broad study to investigate venture capital contracting terms and included some European (including 2 companies from The Netherlands) countries and found liquidation preferences occur less in venture capital deals outside the US (Kaplan et al., 2007). This analysis was also based on old data (from 1998 till 2001). Another study focus on Europe and show convertible preferred securities are less used in Europe than in the US yet it does not focus on liquidation preferences (Schwienbacher, 2008).

This paper makes an effort to close this gap of knowledge by describing in detail the occurrence of liquidation preferences in seed venture capital within a specific European country, The Netherlands. Using the proprietary data of a governmental investment program for seed venture capital firms, I explore the use of liquidation rights and I show what types of liquidation

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6 preference are used most frequently. I also explore how the occurrence of liquidation preferences differs over time, sectors, type of venture capital fund and the venture capital firms experience. Finally, this study uses regression analyses to show what kind of determinants can be identified influencing the type of liquidation preference that occurred in Dutch seed capital venture capital financing over the period 2005-2018.

This study uses qualitative content analysis and focuses on a specific non-American region within the European Union using previously non-disclosed data. It thereby builds upon the work of Kaplan & Strömberg (2003) and Gompers, et al. (2016) that focus on liquidation preferences in the US. This study aims to enhance the global academic knowledge on venture capital,

specifically on the use of the different types of preferred liquidation rights. As a consequence, the analysis of Schwienbacher (2008) is updated specifically for liquidation preferences for a specific European country. Moreover, my analysis reveals common practices in the governmental Dutch seed venture capital landscape influencing the future relationship between venture capital firms and portfolio companies and the relationships among venture capital firms themselves. My data description and empirical results are beneficial for both entrepreneurs, venture capital firms and their supportive eco-system such as lawyers and consultants in The Netherlands. Finally, my results are also relevant for other small knowledge-based European economies such as Austria, Belgium, Denmark or Sweden.

The rest of this paper is organized as follows. Section 2 describes a number of relevant studies, creates the context for this paper and introduces my three sets of hypotheses. Section 3 contains the methodology, section 4 a summary of the statistics. These statistics are the basis for the regression analyses testing three sets of hypotheses in Section 5. Section 6 concludes.

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2.

Literature

Review

In order to gain a better understanding of liquidation preferences and their role in venture capital contracting, I explore some theories of financial contracting. I will then describe the different forms of venture capital contracting such as preferred shares and the different types of

liquidation preferences. I will end this chapter by describing three sets of hypotheses based upon the literature.

2.1 Venture Capital & Preferred Shares

In 2003, Kaplan & Stromberg report that in 203 out of 213 examined US-based venture capital investment deals (from 1996 to 2000) preferred shares are used (Kaplan & Stromberg, 2003, p. 13). Why do venture capital firms use preferred shares? To answer this, I will describe the

literature related to financial contracting, cover the agency theory and I will give an example as an illustration.

The agency theory explains why and how to incentivize entrepreneurs to increase the value of a firm and reduce agency problems due to information asymmetry. The agency theory is an interdisciplinary theory about economical relationships where one party (referred to as the principal) delegates work to another party (the agent) (Eisenhardt, 1989). A contract is used as a metaphor to describe the relationship between the principal and the agent (Jensen & Meckling, 1976).

The set-up of the venture capital industry leads to information asymmetries between principals (the venture capital firms) and agents (the entrepreneur) (Hart, 2001, Schmidt, 2003). Kaplan and Strömberg describe three ways in which venture capital firms deal with these conflicts using: “sophisticated contracting, pre-investment screening, and post-investment monitoring and advising.” (Kaplan & Strömberg 2001, p. 429). Venture capital funds are unique in their design of sophisticated

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8 contracting (Schmidt, 2003). One aspect on this unique design is the use of preferred securities. The use of preferred securities has been widely documented (e.g. Gardner, 1971, Sahlman, 1990, Gompers, 1997). For example Kaplan & Stromberg (2003, p. 13) report that in 95% of the analyzed US-based venture capital investment deals preferred securities are used.

Preferred securities date back to the 19th century when this type of securities was introduced in

Maryland for the re-financing of five railroad and waterways companies (Fergusson, 1952, p. 448). This type of securities allows a venture capital firm to have: i) control rights, and ii) cash flow rights (Sahlman, 1990). Examples of control rights are: hiring/replacing the CEO, deciding on the sale of a company and recruiting crucial members of the company’s management team. Cash flow rights are dividend rights but also liquidation rights. Preferred liquidation rights (or liquidation preferences) are cash flow rights giving preferential positions to certain shareholders in a clearly defined event such as an acquisition by another company (Hoffman and Blakely, 1973).

The use of preferred shares can be best illustrated by a short example (inspired by Gompers & Sahlman, 2002, p.291). Imagine female inventor Robin again. She established her venture and sells 40% of her common shares to BioTech Seed Capital at a pre-money valuation of

EUR 2 million. BioTech Seed Capital invests EUR 800.00 and the company is now worth EUR 2.8 million. Now, the following day Robin receives a call from an old friend who now works at pharmaceutical firm ProDiagX. Her friend convinces Robin to sell the venture for a value of EUR 1.5 million. What happens with the proceeds? Robin makes a profit of EUR 0.9 million (60% of the EUR 1.5 million) and BioTech Seed Capital a loss of EUR 200.000. To avoid this situation BioTech Seed Capital could demand preferred shares instead of common shares that includes control rights and cash flow rights such as a liquidation preference. The inclusion of a so called ‘1x liquidation preference’ for example would have allowed the venture capital firm to

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9 receive EUR 0.8 million. Summarizing, the introduction of a liquidation preference reduces the venture capital firm’s downside risk (though it does not protect it completely) and allows for an upside potential also in case of minority shareholder position without any control rights.

2.2 Venture Capital & Liquidation Preferences

As illustrated in the ProDiagX example the introduction of a liquidation preference is always the result of negotiations between the entrepreneur and the venture capital firm (D. Cumming and Johan, 2006). These negotiations result in a term sheet and are later formalized in contracts (Kaplan & Strömberg, 2004). Quite often follow-up investments are structured as convertible loans. Convertible loans are often used since they require less documentation and decrease transaction time by avoiding a re-valuation of the start-up company. Coyle and Green (2014) analyzed contract innovation and interviewed leading venture capital attorneys on the types of venture finance securities. One of their observations is that prior to 2005 venture capital firms used convertible preferred equity. However, due to technological developments (most

significantly the rise of cloud computing) the costs of launching a technology company declined dramatically. This led to a change contracting, ‘investors in early-stage technology companies increasingly

turned to much simplified versions of traditional convertible preferred stock documents to structure their investments’

(Coyle & Green, 2014, p. 134). The introduction and increased use of convertible loans is also confirmed in an interview with a Dutch venture capital attorney.

Gompers et al. (2016, p.51) showed that liquidation preferences are a must for venture capital firms in designing the contract with the entrepreneur. This shows how important these rights are for venture capital firms. I will now describe four different characteristics of liquidation

preferences that can be used to construct a liquidation preference in the term sheets, namely: 1) the multiple, 2) simple vs. participating, 3) a cap, and 4) seniority. These characteristics can also

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10 be combined as building blocks for a liquidation preference. These four dimensions will now be further explained

2.2.1 1

st

Characteristic: The Multiple

The value of a liquidation preference is equal to the initial investment (and can include

cumulative dividends) (Fergusson, 1952, p. 459; Hoffman and Blakely, 1987). However, a larger value of the initial investment could be retrieved by using a liquidation preference. This is called a ‘multiple’. Essentially, it means that the holder of a ‘2x liquidation preference’ first receives twice the initial investment before any other holder of common shares receives a share of the proceeds, as is shown in figure 1. Generally speaking, using a liquidation preference with the value of the initial investment reduces the venture capital firm’s downside risk. However, a loss would still occur the in case of a write-off. Next to that, the inclusion of cumulative dividends or a multiple in the liquidation preference increases the minimum priority return (Leisen, 2012). Cumulative dividends effectively acts as a multiple is. To illustrate this: a cumulative dividend for an

investment period of 6-8 years with an annual a dividend rate of 8% could mean multiplying the initial investment with a 1.6 multiplier after only 6 years. Therefore, the effect of cumulative dividends is similar to the effect of a so-called multiple.

2.2.2 2

nd

Characteristic: Simple vs. Participating

The second characteristic allows the venture capital firm to retrieve primarily its initial investment back including dividends, and additionally it allows it to share in the remaining proceeds. This characteristics is called a participating liquidation preference. An example pay-out scheme is shown in figure 1c. This figure shows that the venture capital firm receives their initial investment back yet also directly participates in the remaining profits. This is called a ‘double dipping effect’ (Leisen, 2012, De Vries, Van Loon & Mol, 2016). To illustrate this please see figure 1c. Note that a participating liquidation preference is considered in the literature as

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11 of a participating liquidation preference is a non-participating liquidation preference and is logically called a ‘simple liquidation preference’.

2.2.3 3

rd

Characteristic: The Cap

A cap can be used in a participating liquidation preference as a limitation of the profits in the remaining proceeds. Therefore a cap actually limits the ‘double dipping effect’. Put differently, when the venture capital firm has introduced first a multiple followed by a participating

liquidation preference in the contracting terms, the entrepreneur can limit the profits received of the remaining proceeds by introducing a cap. As a consequence of the cap, the venture capital firm will only receive proceeds till the cap. Finally, because the venture capital can convert his preferred shares to common shares he has a choice. He can consider to convert his preferred shares into common shares, as the introduction of a cap could limit the upside potential for the venture capital firm when the entrepreneur’s company has a high market value (Fried and Ganor, 2006).

2.2.4 4

th

Characteristic: Seniority

The fourth characteristic for a liquidation preference is the seniority. This means that different venture capital firms with preferred shares have levels of seniority to evoke liquidation

preferences (Christopoulos, 2005). Typically, later investors invest more capital as the firm matures and thus become senior to seed investors. Receiving proceeds as a senior investor can be done in two ways. As the later investor has invested large(r) amounts of capital as opposed to seed investors, she can demand to annul the liquidation preferences of the seed investors. This practice can be beneficial of the entrepreneur as the amount of liquidation rights is reduced. However, when the later investor merely invokes his seniority this could lead to a serious accumulation of liquidation preferences leaving the entrepreneur with nothing on the table (Klausner & Venuto, 2013, Bengtsson & Sensoy, 2015). This practice has been confirmed in interview with leading Dutch venture capital attorneys. Note that an accumulation of liquidation

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12 preferences also creates an incentive for the entrepreneur create (more) value. Since this study focuses on investments in the seed phase I will not focus on this characteristic of liquidation preferences.

To visualize how the different characteristics figure 1 was created. This figure contains are four examples of pay-out structures between a venture capital firm and an entrepreneur. These examples illustrate how the different characteristics of the liquidation preference can influence a simplified possible pay-out structure. In this structure the venture capital firm holds 50% preferred shares and the entrepreneur holds common shares. Note that the venture capital firm uses preferred securities that are convertible. This means the venture capital firms will have the opportunity to convert their preferred shares to common shares if that would increase their pay-out.

2.3 Occurrence of Liquidation Preferences

The occurrence of the different characteristics of liquidation preference has been part of the quantitative analysis for several studies. First, a number of studies focused on financial contracts showed that liquidation preferences are used frequently in the United States. Kaplan &

Strömberg (2003) used data set covering the years 1992-1998. They examined in which way sophisticated contracting is used. This examination showed that preferred shares are used in 80% of the deals and that in 71% of the deals the liquidation rights presented a higher value than the initial investment. This mainly accomplished by the use of cumulative dividends in 44% of the deals or a participating liquidation preference in 40% of the deals (Kaplan & Strömberg, 2003, p. 288). As stated earlier, in 2016, Gompers et al. surveyed venture capital firms and found that US venture capital firms a liquidation preference is a must when negotiating contractual terms (Gompers, et al., 2016, p. 51). They also showed that participating liquidation preferences are used more frequently in the health sector than in the IT sector (Gompers, et al., 2016, p. 50).

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13 Finally, Smith (2005), explains that many American venture capital firms cap the participations rights (Smith, 2005, p. 347).

Other studies have looked at the use of US-style contracts and the liquidation preferences used in Europe. Kaplan et al. (2007) showed that liquidation preferences occur less in venture capital deals outside the US as compared to deals within the US (Kaplan et al., 2007, p. 282). However, this analysis was also based on an old data set (from before 1998 till 2001). Other studies focus in particular on European deals and have shown that convertible preferred securities are less used in European deals than in American deals. However, this study does not primarily focus on

liquidation preferences (Schwienbacher, 2008).

Finally, a number of studies mention some exotic types of liquidation preferences. First, Kaplan and Strömberg report one particular case in which the possibility to execute the liquidation preference (or its participating part) depended on the participation’s exit value. As a consequence, a high firm value resulted in an annulment of the liquidation (Kaplan & Strömberg, 2003, p. 286). Secondly, Woronoff and Rosen describe a so-called ‘catch-up’ for the venture’s management team, meaning a pay-out of their shares in such a way that a compensation is provided for the losses occurred due to the liquidation preferences evoked by the venture capital firm. This way, the asymmetry between the seed investors and the management team in proceeds is reduced (Woronoff & Rosen, 2005, p. 213).

Another source the occurrence of liquidation preferences are data sets published by several law firms. Examples are the Silicon Valley Venture Capital Survey of Fenwick & West (focusing on US deals) and Shibolet Trends in Legal Terms in Venture Financings in Israel. These surveys are used by different finance authors such as Hellmann (2006, p. 650) and Leisen (2012, p. 22). Next to that, also a number of legal authors referred to these statistics as being reliable and valid. For example Woronoff and Rosen used the Sillicon Valley Survey as source to show that in US venture capital deals the liquidation preferences is sometimes a multiple of the investment (Woronoff & Rosen

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14 (2005) p. 211). Coyle and Green use the same survey to show that the number of Series-A rounds did not increase as swiftly as the number of seed finances, thereby showing how the lower capital requirements for start-ups influences venture capital investment rounds (Coyle & Green, 2014, p. 159).

2.4 Research Hypotheses

The literature provides evidence that can be used to formulate hypotheses for the determinants of the occurrence of liquidation preferences. I will now describe the different hypotheses and explain how they are connected to literature. I will focus on 1) the type of venture capital firm, 2) the venture capital firm’s level of experience and 3) the liquidity of the venture capital market. I will also introduce two control variables.

2.4.1 First Hypothesis: Type of Venture Capital Firm

It has long been recognized that not all venture capital firms are the same (Robinson, 1987). Venture capital firms might have close ties to multinational companies, be affiliated with banks, be created by the government, or are cooperation of business angels pulling their resources together. Several classifications for different types of venture capital firms are found in the literature. For this study I used the classification of Landström (Landström, 2007). He distinguishes between informal venture capital firms, corporate venture capital firms and institutional venture capital firms (Landström, 2007). Landström characterizes institutional venture capital firms by their formal control in monitoring and their source of funding provided by sophisticated investors such as family offices (Landström, 2007). See table 1 for other

distinguishing characteristics of the different venture capital firm types. Other authors analyzed how different types of venture capital firms operate. The framework for my first set of

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15 I will begin with informal (business angels) venture capital firms. Landström classifies informal venture capital firms as funds where the investors mainly invest their own money. Van

Osnabrugge (2000) describes how informal investors are not under pressure to behave extremely professionally and may wish to control agency problems more through active involvement. The reason for this is that they normally invest a lot of their own money, instead of institutional firms that raise almost all the capital from outside limited partners (Van Osnabrugge, 2000). This view is supported by Politis (2008). He believes business angels (or informal investors) focus on mentoring instead of writing extensive contracts drafted by expensive law firms. Therefore, I expect informal venture capital firms to make less use of liquidation preferences than institutional venture capital firms.

The same type of reasoning was found for corporate venture capital firms. These investors have strong strategic motivations and require less financial incentives (Hellmann, 2002). Because they seek for both direct financial benefits and indirect strategic benefits, they will justify poor financial terms on the prerequisite that these terms are offset by the strategic benefits

(Dushnitsky & Lenox, 2006). This is confirmed by Masulis and Nahata (2009) who found that the overall strategic objectives corporate investors affect their beneficial contracting terms such as control rights.

Consequently, both informal and corporate venture capital firms are expected to use liquidation preferences less often. My first set of hypotheses is therefore:

H1a: Corporate or informal venture capital firms are less likely to use liquidation preferences than

institutional venture capital firms;

H1b: Corporate or informal venture capital firms are less likely to introduce a participating liquidation

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2.4.2 Second Hypothesis: Level of Venture Capital Firm’s Experience

Kaplan et al. (2007) have shown that more experienced non-US venture capital firms over the period of 1998 to 2001 implement US style contracts (such as large sizes of liquidation

preferences). This is supported by Hsu (2004). His analysis shows more experienced venture capital firms get better deals when negotiating with entrepreneurs. This is also in line from Timmons and Bygrave (1986) who state “[i]t is far more important whom you obtain funding from than

how much and at what price” (Timmons & Bygrave, 1986, p. 169). So, it appears that more

experienced venture capital firms are able to get better deals and use US-style contracts more often and hence might be expected to use liquidation preferences more often.

However Bengtsson and Sensoy (2011) find the contrary. They discover more experienced venture capital firms obtain weaker down-side protection (including liquidation preferences) in a ten times bigger data set than Kaplan et al. (2007) and with more recent data (mainly 2005-2007). They suggest more experienced venture capital firms focus on better ‘ex post’ monitoring and value-added abilities then on ‘ex ante’ legal terms.

Since the analysis by Bengsson and Sensoy is the most recent, I use their conclusions to formulate my second set of hypotheses. My second set of hypotheses is:

H2a: More experienced venture capital firms are less likely to use liquidation preferences than less

experienced venture capital firms;

H2b: More experienced venture capital firms are less likely to introduce a participating liquidation

preferences than less experienced venture capital firms.

2.4.3 Third Hypothesis: Liquidity in the Venture Capital Market

Increased liquidity results in increased bargaining power for entrepreneurs because the pool of potential venture capital firms grows (Hellmann, 1998). This could mean that entrepreneurs are able to get better deals in their term sheets because they can choose among more venture capital firms, obtain several draft term sheets and bargain the best deal including restricted liquidation

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17 preferences. This implies a negative relationship between liquidity and the occurrence of

liquidation preferences. This view was also confirmed in an interview with a Dutch venture capital attorney.

However, other authors reason differently. They argue that increased liquidity leads to increased valuations (Gompers & Lerner, 2000, Inderst & Müller, 2004). Increased valuations could lead to smaller equity stakes by venture capital firms. These can be compensated by using liquidation preferences (Kaemingk, 2002). My interview with a Dutch venture capital attorney confirmed the connected vessels of liquidation preferences and pre-money valuation. This would assume a positive relation instead of the negative relation with the occurrence of liquidation preferences. This implies that a study into the occurrence of liquidation preference should also look into the pre-money valuation because these are connected.

I believe the former authors are not wrong. On a case-by-case basis (micro level) it is true the pre-money valuation of venture and the use of liquidation preferences are often connected in term sheet negotiations (Heughebaert & Manigart, 2012). However, on a macro level Hellmann’s reasoning is more logical. Therefore, my third set of hypotheses is:

H3a: Increased liquidity of the Dutch seed venture capital market will reduce the likelihood of the

introduction of a liquidation preferences;

H3b: Increased liquidity of the Dutch seed venture capital market will reduce the likelihood of the

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3. Methodology

This chapter explains the methodology of this study. I will start with the design of the study and will include the different variables that I used.

3.1 Design

To test my hypothesis, I used the data of the Dutch seed venture capital database. I relied on content analysis to locate and describe the occurrence of the different types of liquidation preferences. Whenever a liquidation preference was located, I coded its occurrence and the type of liquidation preference using a binary coding system. The coding system used dummies to code the liquidation preferences, see table 2 for a more detailed description of this system.

The data obtained by the content analysis was used to build a model to test my three sets of hypotheses using multinomial logit regressions. For the three different sets of hypotheses, three models were built based on three different equations.

H1:!"#$%$&'&()(+&,-&.%(&#/ !"121"1/31)5 = 71+ 72∗ <-/. =)>1&+ 73∗ @A>1"&1/31&+

74∗ +&,-&.&()&+ 75∗ DE!&+ 76∗ G13(#"%' H"&(1 I22J&+ K(

H2: !"#$%$&'&()(!%"(&3&>%(&/L +&,-&.%(&#/ !"121"1/31)5 = 71+ 72∗ <-/. =)>1&+ 73∗ @A>1"&1/31&+ 74∗ +&,-&.&()&+ 75∗ DE!&+ 76∗ G13(#"%' H"&(1 I22J&+ K(

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19 H3: !"#$%$&'&()(M%>>1. !%"(&3&>%(&/L +&,-&.%(&#/ !"121"1/31)5= 7N+ 7O∗

<-/. =)>15+ 7P∗ @A>1"&1/315+ 7Q∗ +&,-&.&()5+ 7R∗ DE!5+ 7S∗

G13(#"%' H"&(1 I22J5+ KT

3.2.1 Description of independent variables

The first variable is the type of venture capital fund. I used a classification with three types: corporate, informal and institutional venture capital funds (Landström, 2007). To classify the funds into the three categories I relied on the seed capital database and the help of public officials. The seed capital database already classified two types of firms: informal venture capital firms (business angel syndicates) and financial venture capital firms (institutional venture capital firms). This matched two categories of the framework used by Landström (2007). The third category was identified with the help of the seed capital scheme public officials. By i) analyzing the different limited partners of the institutional venture capital firms and ii) classifying which were corporations, I was able to classify a number of corporate venture capital firms.

The second independent variable this study examines is the level of venture capital firm’s experience. Multiple proxies for this variable are found in literature, such as age of the venture capital firm, amount of committed capital, number of investments, relevant working experience or the number of previous investments (Lerner, 1994, Gompers, 1996, D. Cumming & Johan, 2006, Hsu, 2004, Kaplan et al., 2007, Sørensen, 2007, Bengtsson & Sensoy, 2011). Supported by the literature and for practical reasons (availability of relevant data to calculate the experience), I used the age of the venture capital firm as a proxy for the level of experience.

To calculate the age, I first examined if the seed capital fund was the venture capital firm’s first fund. If so, than the vintage year of the first fund was used to calculate the difference between the year of investment in the participation and the venture capital first fund’s vintage year. If not, then I used the vintage year of the seed capital venture fund.

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20 The third variable was liquidity, measured as investments made in The Netherlands by seed venture capital firms. The data for the liquidity level was acquired via the Invest Europe Yearbook Trend Report for The Netherlands. This data set is part of the European Data Cooperative and is self-reported by the venture capital community including the support of a number venture capital associations in Europe. The access to the data was kindly provided by the Dutch Private Equity and Venture Capital Association (Nederlandse Vereniging van

Participatiemaatschappijen). The levels for the liquidity of venture capital in the Netherlands were

obtained using the statistics for ‘Investments - Industry statistics (by country of private equity firm)’.

3.2.2 Control variables: GDP and Sectoral Write-Offs

This study used two control variables: GDP and sectoral write-offs. The rational to include these two control variables and how they could influence the use of liquidation preferences in venture capital will now follow.

Venture capital liquidity is pro-cyclical – it reacts strongly and positively to GDP growth (Romain & Van Pottelsberghe de la Potterie, 2004). This is supported by Hellmann (2006), he suggests there is a link between GDP and the use of higher multiples in liquidation preferences. According to Hellmann higher multiples were rare in the boom period (1997-2000), increased significantly in the post dot.com bubble era (2001-2002) and came down again in the period that followed (Hellmann, 2006, p. 669). I therefore used The Netherlands GDP as a control variable. Finally, I gather data for the GDP of The Netherlands.

The data for the Dutch GDP was obtained from the Statistics Netherlands. I created a dummy for the GDP by calculation the average GDP over the given time period and comparing it with the different annual GDP statistics.

Liquidation preferences are used for down-side protection (Bengtsson & Sensoy, 2011). Another control variable is therefore the riskiness of different venture capital sectors. It is a well-known

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21 fact that different industries have different systematic risk, or different have different beta’s. A beta measures the volatility of a particular stock compared to the market as a whole. However, calculating beta’s (as a proxy for risk) depends on the public information of prices and these are not available for venture capital. Hence, another way to determine the riskiness of the different sectors was necessary.

When venture capital firms write-off an investment they stop investing money and time in a particular ‘failed’ venture (D.J. Cumming and Macintosh, 2003). However, this does not mean the venture goes bankrupt. It just means the venture capital firm does not want to invest any of its valuable resources in it. I have therefore used the sectoral write-offs as a control variable. The data for the sectoral write-offs was acquired via the Invest Europe Yearbook Trend Report for The Netherlands. By combining the non-public data for sectoral des-investments including write-offs, a proxy was created for the riskiness for each sector from a seed venture capital firm’s perspective. The proxy I used was share of write-offs of the total des-investments.

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22

4. Data Description and Analysis

I will now describe the data used to test the different hypotheses. First, the process of data gathering via content analysis is described. Then, I will highlight the independent variables in the context of liquidation preferences. Finally, some sample biases are described.

4.1 Data Set

To obtain my data, I was able to use the database of Dutch Seed Capital governmental

investment program. This database creates a unique insight into the venture capital industry in The Netherlands and forms the basis of this study. The database contains the contracts of Dutch seed venture capital deals. Whenever an eligible seed venture capital firm decides to make an investment, the venture capital firm will make a capital call under the governmental seed capital loan agreement. Before a 50% payment – under the loan agreement – is released from the government-side, a number of documents are checked. Among these documents are the contracts used for the case studies in this study.

4.1.1 Type of Documents

During this analysis, I found that the liquidation preferences could be included in three different types of documents. If the seed venture capital firm was the first investor then the liquidation preferences is located in the shareholder purchase agreement. In case there are more investors, then the shareholder agreement contains the liquidation preferences. Finally, the participations’ notary deeds of the venture’s establishment (statutes) were sometimes used to make contractual arrangements including the liquidation preferences.

4.1.2 Content Analysis Specifics

The build-up of the case studies database was based on 66 seed capital venture capital funds. The different fund types for the 66 funds were: 6 corporate funds, 12 informal investors, and 48

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23 institutional funds. The investments in start-ups (participations) of the 66 funds yielded 353 case studies. These files had sufficient documentation for the content analysis and formed the case studies database.

4.2 General statistics and results

I will first focus on the whole data set’s statistics before diving into a number of specifics such as the occurrence of different types of liquidation preferences. I also show and explain specifics for sectoral differences, the level of experience of the venture capital firms, and the venture capital firm’s fund type (corporate, informal or institutional).

4.2.1 General Explorative Liquidation Preferences Statistics

Table 3 shows the total size of the data set in number of funds and observations and also shows how often different liquidation preference types occurred in the data set. I find that 66% of the seed capital case studies contained a liquidation preference. These findings are comparable with the occurrence of liquidation preferences in venture capital deals in Israel. However, it is

considerably higher than the prevalence of liquidation preferences in venture capital deals Silicon Valley, as is shown in figure 2. Figure 2 shows the occurrence of different types of liquidation preferences for Dutch seed venture capital and for US and Israel venture capital based upon the Fenwick & West and Shibolet’s Surveys.

Liquidation preferences can carry a multiple on the amount invested, creating upside potential if the multiple is higher than 1x. 94% out of the Dutch seed liquidation preferences carried a multiple of 1x, as is shown in table 3. Note that this is including cumulative dividends. This is roughly comparable to Kaplan and Strömberg (2003) who find a 1x multiple is used in the vast majority (71.1%) of investments. It also corresponds with lack of the multiples bigger than I found in samples of Silicon Valley and Israel, as is shown in figure 2.

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24 This study also looked at the amount of liquidation preferences that allowed for participation. I found that 71% of the liquidation preferences were participating, although their amount is declining from 2012 onwards (see figure 2).

Finally, I examined how often the participating liquidation preferences were capped. A cap increases the alignment between investors and entrepreneurs, yet only for higher exit values, as is shown in figure 1. As it turned out almost all (93%) participating liquidation preferences were not capped. This is contrary to Smith (2005), he suggests many venture capital firms cap the

participations rights. It is also quite different from the amounts of capped participating

liquidation preferences reported in Silicon Valley and Israel (both roughly 50-60%), as is shown in figure 2.

4.2.2 Some Exotic Liquidation Preferences

Although the majority of different types of liquidation preferences were rather straight forward, there were some liquidation preference with special characteristics. A number of exotic

liquidation preference structures are the following. First, in a number of cases the possibility to invoke the liquidation preference (or its participating part) was linked to the participation’s exit value. Above a certain hurdle (high valuation of the portfolio company) the holders of preferred shares can no longer invoke their liquidation preference. I consider the use of this restriction founder-friendly because it increases the possible proceeds for the founders. This finding is in line with Kaplan and Strömberg (2003), who also document this specific special structure in their study (Kaplan & Strömberg, 2003, p. 286). Secondly, sometimes the liquidation preference multiple is replaced with a time dependent IRR. Other special types were: one convertible loan with a liquidation preference; specified exit fees (for the management team of the venture or for the research institute where the venture’s innovation was discovered) were part of the liquidation preference in the sense that they carry seniority over the common shareholders. Additionally, there were a few cases where common shareholders also had a liquidation preference although

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25 the seniority of the liquidation preference lied with the preferred shareholders. Finally, a number of cases had a very founder-friendly catch-up for the participation’s management team, thereby reducing the asymmetry in proceeds pay-out between the seed capital investor and the

management team. The occurrence of this last term is also described by Woronoff and Rosen (Woronoff & Rosen, 2005).

4.2.3 Different Venture Capital Firms

Table 5 contains the descriptive statistics for a number of different classes, such as: level of experience of the venture capital firm, type of venture capital firm and sectoral differences. Venture capital firms with high experience (six years or more) used liquidation preferences more often, as is shown in table 5. This is in line with Kaplan et al. (2007) who showed that more experienced non-USA venture capital firms implement US style contracts (such as large sizes of liquidation preferences). My finding is also supported by Hsu (2004). His analysis showed more experienced venture capital firms get better deals when negotiating with entrepreneurs. Whether the level of experience significantly influences the occurrence of liquidation preference is tested as a hypothesis in section 5.

I will now go more into detail on the results for the three different types of venture capital firms: informal, corporate or institutional. I find institutional type of venture capital firms used

liquidation preference in 75% of the cases studied. This is more than informal funds (52%) and corporate funds (also 52%). This finding is in line with the literature for informal venture capital firms. Van Osnabrugge (2000) and Politis (2008) reason informal venture capital firms focus on mentoring instead of extensive contracting. The lower occurrence of liquidation preference for corporate venture funds is also in line with literature. Hellmann (2002), Dushnitsky & Lenox (2006) and Masulis & Nahata (2009) described and showed corporate investors focus on strategic benefits and less on their beneficial contracting terms.

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26

4.2.4 Sectoral Differences

Venture capital funds have different strategies and often focus on specific industries that match the track record of the members of general partners operating the fund. Hence, we might expect different utilization of liquidation preferences for different sectors. This has been shown for example by Gompers et al. (2016). They compared the prevalence of certain liquidation preference types in IT and healthcare industries.

Of the 353 cases I analyzed 44% of the cases were in IT, 26% Biotechnology & Healthcare and 12% Energy. The other cases mainly contained investments in food, transportation and high-tech. This is consistent with Kaplan and Strömberg (2003, p. 283) and Gompers et al. (2016, p. 42) who also find the greatest concentration of venture capital deals in information technology & software in their data set.

For IT (72%) the prevalence of a liquidation preference in my analysis is high. For Biotechnology & Healthcare (54%) and Energy (57%) it is considerably lower. This study finds 77% of the Energy cases had a participating liquidation preference. For IT (65%) and Biotechnology & Healthcare (68%) this was lower. The latter is in contrast with Gompers et al. (2016), that study finds participating liquidation preferences occur more in Healthcare (67%) than in IT (41%) (Gompers, et al. 2016, p. 50). An explanation for the reduced use of liquidation preferences in biotechnology & healthcare is that other forms such as staging are used to keep agency costs under control (Sahlman, 1990, Admati, 1994, Gompers, 1995). Due to the specific regulatory requirements (clinical-trails and approval by the governmental agencies like Food and Drug Administration or European Medicines Agency) the biotechnology sector uses staging via

milestones also to reduce risks (Kaplan & Strömberg, 2003). Finally, the only Dutch seed venture sector – within this data set – where the ‘founder-friendly’ capping of the participating

liquidation preference occurred (a few times) is IT. This might be explained by the increased bargaining power for entrepreneurs due to the number of venture capital firms where they

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27 choose from (Hellmann, 1998). Or it could be due to the awareness in the IT start-up community based on e.g. several tech-blogs that describe the use of non-capped participating liquidation preferences.1 Another explanation might simply be that IT founders are more used to use

software to model the pay-out schemes of the liquidation preference and limit the asymmetry by reaching a compromise with a cap on the participating part. This explanation was obtained by an interview with a two leading Dutch venture capital attorneys.

To conclude this part of chapter 3, I will briefly summarize. To analyze the determinants of the different types of venture capital liquidation preferences I collected and studied contract data on 353 investments made by 66 Dutch seed venture capital funds. I found a liquidation preference occurs in 66% of all participations. A 1x multiple was most common (94%) as liquidation

preference and multiples of 3 and higher were extremely rare. 71% of the liquidation preferences were participating yet declining in recent years. 93% of the participating liquidation preferences were not capped.

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28

5. Regression Results

5.1 Results

I will now describe the results of the multinomial logit regressions by testing my three different sets of hypotheses. These results show which determinants significantly influence the probability of the occurrence of different types of liquidation preferences. By back transforming the output of the regression I give economic context to these results.

5.1.1 Testing the 1

st

Set of Hypotheses: Venture Capital Firm Type

The first set of hypotheses tested, was:

H1a: Corporate or informal venture capital firms are less likely to use liquidation preferences than

institutional venture capital firms;

H1b: Corporate or informal venture capital firms are less likely to introduce a participating liquidation

preferences than institutional venture capital firms.

The empirical results of the multinomial logit regression are displayed in table 6. The results show that if the venture capital firm was an informal or corporate venture capital firm, the probability of the occurrence of a liquidation preference was significantly lower. Moreover, using back transformation, I have found that institutional venture capital firms have a 36% higher chance of introducing a liquidation preference, as is shown by the back transformation of Log odd to probability in table 7. The lower chance of a liquidation preference for informal investors (business angels) has already been predicted in the literature. Van Osnabrugge (2000) states business angels will focus on ‘ex post active’ involvement to control agency problems because they are not under a lot of pressure due to investing money of limited partners. This is supported by several other authors (Dushnitsky and Lenox, 2006, Politis, 2008, Masulis & Nahata 2009). For participating liquidation preference, I have discovered that the type of venture capital firm

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29 determines whether the liquidation preference is more likely to include a participation part. Institutional venture capital firms have a significantly higher probability (56%) to add a

participating part to their liquidation preference. This could be explained, again, by the increased focus of this type of venture capital firms on monetary benefits via ex ante contract claims instead of monitoring for informal venture capital firms (e.g. Van Osnabrugge, 2000, Politis, 2008).

The final regression is for the non-capped participating liquidation preferences. The results of the final regression were weak. This is not surprising since 93% of all participating liquidation

preferences had no cap, as is shown in table 5. The lack of caps on participating liquidation preferences is not in line with literature, nor in line with the US and Israel survey examples. For example, Smith (2005) argued venture capital firms normally cap their participating liquidation preference. Furthermore, the US and Israel venture capital survey found the use of a non-capped participating liquidation preferences was roughly 40-60% (Fenwick & West, 2004-2018, Shibolet, 2004-2017). My study shows that there is certainly a lack of caps in participating liquidation preferences.

5.1.2 Testing the 2

nd

Set of Hypotheses: Venture Capital Firm Experience

The second set of hypotheses tested, was:

H2a: More experienced venture capital firms are less likely to use liquidation preferences than less

experienced venture capital firms;

H2b: More experienced venture capital firms are less likely to introduce a participating liquidation

preferences than less experienced venture capital firms.

The second set of hypotheses must be rejected, as my study shows there is a significant higher probability that experienced venture capital firms frequently introduce a liquidation preference. By back transforming the log odds of the regression, I show the probability to introduce a

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30 liquidation preference increases with roughly 7% when venture capital firms had five years of experience opposed to firms with one year experience, see table 7. This means there is no evidence for my hypothesis which was based on recent literature for experienced US venture capital firms (Bengtsson & Sensoy, 2011). This study actually confirms prior literature (Kaplan & Strömberg, 2007, Hsu, 2004). This might be explained by the following reasoning.

Chronologically, in the first phase experienced US venture capital firms were known for using liquidation preferences (Kaplan & Strömberg, 2003). In the next phase, the prior trend of introducing liquidation preference was picked up by experienced non-US (including Dutch) venture capital firms (Kaplan & Strömberg, 2007). Finally, in the third phase, as is shown by Bengtsson & Sensoy (2011), and explained by Coyle & Green (2014), experienced US venture capital firms started to introduce less liquidation preferences. In other words, American venture capitalists can be seen as early adopters of liquidation preferences. However, unlike experienced US venture capital firms, Dutch seed venture capital firms did not reduce the use of liquidation preferences (Bengtsson & Sensoy, 2011). Root-cause of this observation could be found in the need of protecting themselves against senior investors’ liquidation preferences (Klausner & Venuto, 2013). A survey for Dutch venture capital firms could confirm this explanation and could reveal why experienced Dutch VCs are less reluctant to reduce the use of liquidation preferences.

For the participating liquidation preference, I have observed that in relation to the first

regression, the level of experience of the venture capital firm no longer significantly influences the outcome. Hence, I find no evidence for hypothesis H2b. Apparently, both experienced and inexperienced venture capital firms that use a liquidation preferences do not significantly differ from each other with regards to adding a participating part to the liquidation preference. The final regression for this hypothesis is for the non-capped participating liquidation preferences. This regression only showed weak results.

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31

5.1.3 Testing the 3

rd

Set of Hypotheses: Liquidity

The first set of hypotheses tested, was:

H3a: Increased liquidity of the Dutch seed venture capital market will reduce the likelihood of the

introduction of a liquidation preferences;

H3b: Increased liquidity of the Dutch seed venture capital market will reduce the likelihood of the

introduction of a participating liquidation preferences.

I find liquidity is insignificantly related to the probability of a liquidation preference and the probability of including a participating part in the liquidation preference.

5.2 Sample Biases

The data for this study was acquired using content analysis. Content analysis is a research method using a set of procedures (coding rules) to draw conclusions from a text (Weber, 1990, p. 9). According to Neuendorf content analysis tries to commit to the scientific method by attending to objectivity, reliability, validity and generalizability (Neuendorf, 2016). I will now reflect upon this study using these four criteria.

Optimally, content analysis is done without any biases by the investigator. Although all human inquiry is in a way subjective, I believe the content of contracting terms containing liquidation preferences were very straight forward. Beside any unforced errors, consequently I believe the analysis has been objective.

However, are the results also reliable? To test this another researcher should go to the seed capital scheme files at the governmental archives and re-do the whole analysis. In other words: the inter coder reliability should be calculated by re-doing the whole analysis and calculate the omissions (Lombard, Snyder-Duch & Bracken 2002). Again, besides any unforced errors, I

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32 believe my results are reliable. This is further supported by the use of well-specified decision rules which “may produce few discrepancies when used by relatively inexperienced coders” (Milne & Adler, 1999, p. 239). Hsieh & Shannon take this one step further and advise to work-out a coding scheme beforehand and discuss this with other researchers increasing the trustworthiness of a study (Hsieh & Shannon, 2005). I tried to use this advice and have completed a detailed coding scheme beforehand and discussed this with my supervisor and other graduation professionals for

feedback. Hsieh & Shannon further argue that also the validity of a study can be improved by well-defined coding rules that preferably built upon frameworks created by others to provide a universal benchmark (Hsieh & Shannon, 2005). To improve my reliability and validity I have added my coding scheme in the Annex.

Finally, the generalizability is the amount to which the conclusions based on a sample could be extrapolated to a whole community. This criteria influenced one of the choices I made for the research design. I choose to analyze all the case files that I could locate instead of taking a randomly selected sample of the Dutch seed capital database. Due to the high number of cases and comparability in outcome with the US and Israel data, I believe extrapolation for the whole Dutch seed venture capital industry is probably acceptable. In addition, my data is most probable also comparable to other West-European seed venture capital contracts. However, this

generalization is from an academic point of view a bridge too far because I did not create a random sample of West-European venture capital contracts. Interesting follow-up analysis might therefore be to cooperate with national promotional institutions in other West-European

countries to increase the generalizability. Finally, my results are based on the first investment rounds. The results might be different for further investment rounds when a company needs more capital and new investors enter.

In addition to these four types of important criteria connected to my content analysis, I believe my data sample might suffer from the following biases. First, the use of cumulative dividends as

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33 part of the liquidation preference was not singled out as a specific category in the research design. Additionally, it was not recognized as a category in the beforehand created and discussed coding scheme. Instead, the cumulative dividends were included in the categorization of the different multiples. This creates an important distortion in this study because cumulative dividends with a rate of for example 8.5% will accumulate in five years into a return of 150% which is comparable to a 1.5 multiplier. Therefore, failing to single out the dividends creates an important bias. Another bias might be due to the amount of all Dutch seed venture capital deals. Although my data set contains almost all cases of the Dutch governmental program the seed capital scheme, there have been much more types of seed investments over the period of 2005-2018. Private seed venture capital firms (including business angels and corporate venture capital firms) but also other publicly-created investors such as regional investment agencies (Regionale

Ontwikkelingsmaatschappijen) could be a source for further analysis.

In addition, some biases might be due to my classification rules. For example, a 1.5x liquidation preference was coded as a 1x liquidation preference. This might mathematically not be consistent, however I choose to be conservative - for the handful of cases concerned - when multiples were between the specified categories.

Another possible bias relates to the used external databases. For example the data for two independent variables ‘sectoral write-offs’ as well as the ‘liquidity’ are based upon data provided by the European private equity and venture capital community. These data are self-reporting and might therefore suffer from self-reporting biases.

The data for the venture capital’s firm experience might also be suffering from a number of biases. This variable was based upon the question whether or not a previous fund was established by the venture capital firm. To find out, I had to rely on a search on the internet. This method heavily relies on the information published by the venture capital funds. Therefore here might be

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34 self-reporting biases, as venture capital firms may have removed any references to unsuccessful funds. Another possibility for self-reporting biases to arise, is when the venture capital firm changes a vintage year to improve the IRR of earlier funds. This may influence the level of experience. These biases can be taken away when all venture capital firms are surveyed or when the application files for the governmental scheme are analyzed. Most probably these files would contain resumes and these would mention earlier created funds to establish track record.

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35

6. Conclusions

Using the database of the government Seed Venture Capital investment program I have built a database of 66 venture capital funds and 353 case studies. These files formed the case studies database and were used to explore the seed venture capital contacting landscape for liquidation preferences. Finally, a multinomial regression has been used to test three sets of hypotheses.

I explored the use of different types of liquidation preferences for the total data set as a whole and took a closer look by using four specific focuses, namely: sector, timeframe, level of

experience of the venture capital firm, and the type of venture capital firm, as is shown in table 3 and table 5. Table 3 shows that 66% of the cases contained a liquidation preference. And 71% of the liquidation preferences were participating. Of the participating liquidation preferences 93% were not capped and 5% were capped with 3x multiple of the initial investment. Table 5 shows that liquidation preferences are used more often in the IT sector than in the Biotechnology & Healthcare sector.

Another conclusion is that experienced venture capital firms introduce liquidation preferences more often than less experienced firms. And that institutional venture capital firms introduce liquidation preferences more often than corporate or informal venture capital firms. For a comparison of these results with the results of earlier studies from Kaplan & Strömberg (2003) and Gompers et. al (2016), please see table 8.

After having tested the three sets of hypotheses tested I came to the conclusion that there is evidence that the type of venture capital firm is an important determinant for the occurrence of a liquidation preference and subsequently an important indicator for an increased occurrence for a participating liquidation preference.

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36 significantly more likely to introduce a liquidation preference than corporate or informal venture capital firms do. I also conclude that institutional venture capital firms are also significantly more likely to add a participating right to their liquidation preference than corporate or informal venture capital firms do. By testing the second set of hypotheses, I have been able to conclude that there is evidence that the level of experience significantly influences the likelihood of a liquidation preference to be introduced.

Finally, testing the third set of hypotheses I can conclude I found no significant evidence for a positive of negative relation between the liquidity of the Dutch seed venture capital market.

By back transforming the regression outputs into probabilities, I am able to give economic meaning to these results by quantifying the probabilities. In the case of institutional venture capital firms there is a 36% higher chance that a liquidation preference is introduced as is opposed to the case of a corporate or informal venture capital firm. For institutional venture capital firms there is a 56% higher chance to introduce a participating liquidation preference than a corporate or informal venture capital firm. With regard to the venture capital firm’s level of experience the probability to introduce a liquidation preference increases by roughly 7% when firms have five years of experience as opposed to one year of experience.

There are two important limitations in this study that require further analysis. First, the use of cumulative dividends as part of a liquidation preference was not coded as a specific category but was included in the specific multiple of the liquidation preference. This causes distortions in the data, because compounding dividend rates e.g. of 10% for a number of years have the same effect as a higher multiple. Further analysis can provide more details on the occurrence of

different types of liquidation preferences by inserting dividends and the dividend rates as separate categories. Secondly, as was confirmed by venture capital attorneys, a liquidation preference is in

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37 practice a connected vessel with the pre-money valuation of a start-up company. A higher

valuation means a small(er) equity share for the venture capital firm. However, this can be compensated by a liquidation preference. Unfortunatley, I did not code the pre-money valuation as a specific category. Further studies on this topic combined with the data of this paper might put the results in a different perspective.

In addition to solving the limitation of this study, another possibility for further analysis is to explore ways to improve the generalizability. By including the archives of other (semi-

governmental organizations such as the Dutch Regional Development Agencies or adding the archives of private seed capital investors the generalizability will improve. Secondly, by adding data from West-European National Promotional Banks, this study could be scaled up to an Western-Europe focus.2 Another perspective to improve the generalizability is to discover in

what way the ex-ante defined legal terms are invoked in practice. For example, Broughman and Fried (2010 and 2013) have found that common shareholders (entrepreneurs) sometimes receive pay-outs before venture capital firms invoke their liquidation preference. By surveying Dutch seed venture capital managers one could find proof for these types of ‘incomplete contracts’. A survey could – as was mentioned before – also be used to find an explanation for the high levels of liquidation preferences in Dutch seed venture capital.

Another (more legal) perspective, that was obtained when interviewing a venture capital firm, might be to research when or when not a liquidation preference can or cannot be invoked by analyzing the definition of a liquidation event more in detail. Can an IPO be a liquidation event and what about other proceeds for example from a licensing deal with a multinational

corporation (frequently used in biotechnology)?

Finally, the impact of multiple investment rounds on the occurrences of liquidation preferences

2 For example: Danish Growth Fund (Vækstfonden) or the Flemisch Investment Company (Participatie Maatschappij

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38 could be of interest for further analysis. When a company is successful and is in need for fresh money, the venture’s management team and the new or last investor could be running the show, this can have implications for the earlier terms agreed on with seed venture capital firms. As stated earlier a successful management team might be able to erase all the liquidation preferences or at least limit the participating aspect.

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39

7. References

Admati, A. R., & Pfleiderer, P. (1994). Robust financial contracting and the role of venture capitalists. The Journal of Finance, 49, 371-402.

Bengtsson, O., & Sensoy, B. A. (2011). Investor abilities and financial contracting: Evidence from venture capital. Journal of Financial Intermediation, 20, 477-502.

Bengtsson, O., & Sensoy, B. A. (2015). Changing the nexus: the evolution and renegotiation of venture capital contracts. Journal of Financial and Quantitative Analysis, 50, 349-375.

Bhashyam, S. (November 8, 2013). All that glitters isn’t gold: Startup valuations & the liquidation preference overhang [Blog post]. Retrieved from: https://www.wework.com/creator/personal-profiles/glitters-isnt-gold-startup-valuations-liquidation-preference-overhang/.

BioGeneration Ventures (October 31, 2017). BGV Fund III reaches EUR 82 million in final close: Investments from Bristol-Myers Squibb and Johnson & Johnson Innovation – JJDC [Press Release]. Retrieved from: https://www.biogenerationventures.com/news-releases/bgv-fund-iii-

reaches-eur-82-million-final-close-investments-bristol-myers-squibb-johnson-johnson-innovation-jjdc/.

Broughman, B., & Fried, J. (2010). Renegotiation of cash flow rights in the sale of VC-backed firms. Journal of Financial Economics, 95, 384-399.

Broughman, B., & Fried, J. (2013). Carrots and Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups. Cornell Law Review, 98, 1319-1358.

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40 Christopoulos, N. (2005). Liquidation Preference in Private Equity. Ondernemersrecht, 15, 478-483.

Chudzinski, P. (November 23, 2016). Why Liquidation Preferences Can Make Your Startup Worse [Blog post]. Retrieved from: http://pawel.posthaven.com/why-liquidation-preferences-can-make-your-startup-worse.

Colombo, M. G., Cumming, D. J., & Vismara, S. (2016). Governmental venture capital for innovative young firms. The Journal of Technology Transfer, 41, 10-24.

Coyle, J. F., & Green, J. M. (2014). Contractual Innovation in Venture Capital. Hastings Law

Journal, 66, 133-189.

Cooper, I.A., & Carleton, W.T (1979). Dynamics of Borrower-lender Interaction: Partitioning Final Payoff in Venture Capital Finance. The Journal of Finance, 34, 517-529.

Cumming, D., & Johan, S. (2006). Is it the law or the lawyers? Investment covenants around the world. European Financial Management, 12, 535-574.

Cumming, D. J., & MacIntosh, J. G. (2003). A cross-country comparison of full and partial venture capital exits. Journal of Banking & Finance, 27(3), 511-548.

Dushnitsky, G., & Lenox, M. J. (2006). When does corporate venture capital investment create firm value?. Journal of Business Venturing, 21, 753-772.

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