Contract Theory On The Effect Of Venture Capital Project Evaluation In Stages

This paper lies at the crossroad of the venture capital and the real options literatures. Its purpose is to theoretically combine the venture capital financial contracts and the real options valuation method in a combined financial systems engineering framework. Based on this framework, a venture backed project investment example is investigated.Firstly, the literatures of venture capital financial contract theory and real options theory are reviewed. Secondly, the characteristics of venture capital investment and the information asymmetry problem between venture capitalists and entrepreneurs are researched. Thirdly, the important contract clauses including staged investment and using convertible preferred stock are introduced. Fourthly, option pricing methods and real option theory are reviewed. Then the combined financial framework of contracting theory and real option theory is designed. Because of the contract design in venture capital, venture capitalists can get some rights like continue investment rights, liquidity rights and other control rights, in fact, the contingent allocation of these rights could be considered as different types of real options, such as the expansion options, the delaying investment options or the abandoning options. Furthermore, the enterprise value will change. Finally, an example is studied based on the combined framework.It is reasonable that in staged investment, at the beginning, the venture capitalists should set some terms or targets with entrepreneurs. If these qualifications can be met at the end of the first round investment, the venture capitalist will continue the second round investment. However, if these qualifications can NOT be met, the venture capitalists will cancel the second round investment. How to establish these qualifications is the core issue of venture capital contracting. There are several kinds of qualifications to choose from, including profit target, growth target, and cash flow target. In fact the core qualification is the cash flow target. The case study shows this conclusion clearly.