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Geography and Style in Private Equity Contracting: Evidence from the U.S. Venture Capital Market

This paper presents novel evidence that a geographically based style matters for the design of financial contracts, in addition to more traditional ingredients. We analyze cash flow contingencies included in 1,804 private equity contracts between U.S. venture capitalists (VCs) and U.S. startup companies. These contingencies affect both pricing and incentives. We document a pronounced “California effect”, namely, that California based entrepreneurs receive less harsh contract terms. We find a similar effect if the VC is located in California, or if a non-California VC had a large exposure to the California market. We further show that contracts are less harsh if the geographical distance between the VC and the company is shorter, which supports the view that geographical proximity can lower monitoring costs. However, the “California effect” remains large and significant even after we control for distance and other factors. Our findings cannot be explained by differences in state laws, bankruptcy and tax regimes, or by VCs substituting less harsh cash flow contingencies for harsher control rights or for more performance-based CEO compensation. In fact, California contracts are more entrepreneur-friendly in all these dimensions.