The Relationship Between Venture Capitalists and Managers in New Firms: Determinants of Contractual Covenants

Two types of opportunism, managerial and competitive, are described. Contractual covenants that control these types of opportunism are used when they are likely to occur, i.e., when there are obstacles to monitoring management behavior and when returns to starting new firms are large. These ideas are subjected to empirical test. The relationship between managers in new firms and venture capitalists is receiving increased attention in the literature (Norton and Tenenbaum 1990; Sahlman, 1988). The determinants and implications of several attributes of these relationships have been examined, including the percentage of a new firm's equity held by venture capitalists, the number of seats on the board controlled by venture capitalists, and the post‐funding activities of venture capitalists (e.g., helping the new firm raise additional capital, contacting customers, replacing management) (Barney, Busenitz, Fiet, and Moesel, 1989). While our understanding of the relationship between managers in new firms and venture capitalists is growing, one particularly important component of that relationship has yet to receive significant attention in the literature: the details of the formal contractual arrangement between managers in a new firm and venture capitalists. Often called the “terms and conditions” of the relationship between managers and venture capitalists, these contractual details specify the rights and obligations of both managers and venture capitalists throughout their entire relationship in a series of covenants (Fiet, 1991). Among other items, contractual covenants can specify limits on capital expenditures, limits on managerial salaries, limitations on raising additional outside capital, technology non‐disclosure agreements, and conditions for forcing a change in managing and liquidating the deal. The purpose of this paper is to understand the determinants of the formal contractual arrangements between managers in new firms and venture capitalists.