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During its comparably short 40-year history, the German venture capital market has developed into one of the largest and most important national venture capital markets in Europe. Smaller only than the British (EUR 3.958 bn), French (EUR 1.689 bn), and Spanish (EUR 1.295 bn) venture capital markets, it ranks fourth in terms of new investments with EUR 1.079 bn invested in 2004. As a result of this significant investment activity, venture capital is one of the fastest growing and most visible segments of the German economy, with new investments growing at an annual growth rate of 10.6% over the past ten years and representing 0.50%o of the German gross domestic product (GDP) in 2004. Venture capital investments are believed to substantially contribute to the German economy’s structural change because they are systematically employed to support“creative destruction” through innovation and growth.

This chapter introduces the reader to venture capital and contracting, thereby laying the conceptual foundations of venture capital investing and contracting. In a brief introduction to venture capital, it presents important definitions, explains the investment process, and portrays the German venture capital market and the prevailing legal environment. It then moves on to describe venture capital contracts, their legal documents and components. Finally, the augmented contracting approach underlying the subsequent theoretical and empirical analyses is defined.

This chapter presents a critical overview of theoretical and empirical literature on cash flow incentive mechanisms in venture capital contracting and identifies significant research gaps.

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

This chapter offers new insights into the real-world practices of contract negotiations and design between venture capital companies and their portfolio companies in the German venture capital market. Similar to the theoretical model in Chapter 4, its focus lies on the contractually defined allocation of cash flow rights to the contracting parties. It therefore adopts an approach in order to consider not only the cash flows resulting from financial instruments but also those determined by cash flow-related covenants. It additionally analyzes determinants of contract design, which relate to characteristics of the venture capital company. The separate allocation of control rights is also reported, despite the fact that control rights are not at the center of the analysis.

This chapter presents a synthesis of the above theoretical and empirical analyses on cash flow allocations in German augmented venture capital contracts in Chapters 4 and 5. It compares real-world practices with incentive considerations and derives implications for an improved venture capital contract design in the German market.

Venture capital relationships between venture capital companies and their portfolio companies are governed by contracts defining the financing terms as well as the contracting parties’ rights and duties throughout the investment period. The contracts’ coordinating function and their incentive-compatibility are particularly relevant in the venture capital setting where both parties are actively involved in the management of the portfolio company. Contracts and the design of their formal components, and , therefore play a central role in making the investment a success.