a decision analytic proposal for a self

Transcription

A DECISION ANALYTIC PROPOSAL FOR A SELF-GOVERNING
CONTRACTUAL SYSTEM
A DISSERTATION
SUBMITTED TO THE DEPARTMENT OF MANAGEMENT
SCIENCE AND ENGINEERING
AND THE COMMITTEE ON GRADUATE STUDIES
OF STANFORD UNIVERSITY
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS
FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY
Muhammad Al Dawood
November 2014
© 2014 by Muhammad Nasser A Aldawood. All Rights Reserved.
Re-distributed by Stanford University under license with the author.
This work is licensed under a Creative Commons AttributionNoncommercial 3.0 United States License.
http://creativecommons.org/licenses/by-nc/3.0/us/
This dissertation is online at: http://purl.stanford.edu/sr801gf3647
ii
I certify that I have read this dissertation and that, in my opinion, it is fully adequate
in scope and quality as a dissertation for the degree of Doctor of Philosophy.
Ronald Howard, Primary Adviser
Blake Johnson
John Weyant
Approved for the Stanford University Committee on Graduate Studies.
Patricia J. Gumport, Vice Provost for Graduate Education
This signature page was generated electronically upon submission of this dissertation in
electronic format. An original signed hard copy of the signature page is on file in
University Archives.
iii
Abstract
Contracts are the medium facilitating the exchange of goods and services between
persons in a free economy. This research was motivated by the observation that decision makers commonly view contracts as costly and ambiguous. I argue that the legal
system handling of contracts is the primary reason for the increasing cost of contracting. Therefore, in this research, I propose a solution in the form of an alternative
contractual system that allows contracts to be managed by private institutions in a
competitive market. I call this system the self-governing contractual system.
A contract in this system is defined as a transfer of the titles to properties depending on different future possibilities. I discuss the process of developing contracts
and the dynamic of managing them in this system. I also discuss the competitive
market for contract management, where private firms compete to provide the service
of managing contracts.
As part of this research, I also develop the contract flowchart as a visualization tool
for contracts to help contracting parties communicate, design and negotiate contracts
more effectively. I conclude this dissertation with the study of venture investment
contract design problem. I take the perspective of a venture capitalist trying to choose
the best contract for a given investment opportunity.
iv
Acknowledgement
My time as a doctoral student was enjoyable and rewarding and I thank God for that.
I had the opportunity to develop personally and intellectually. I am grateful for a
host of incredible individuals who have helped me along the way. I first thank my
teachers at and before Stanford. When I was a teenager, I read The Muqaddimah by
Ibn Khaldun, a 14th century historiographer and historian. This book has a great
influence on me. The following passage from The Muqaddimah explains my experience
as an advisee of professor Ronald Howard and as a student of many great professors
at Stanford including my thesis committee members, professor Blake Johnson, John
Weyant and George Triantis.
A scholar’s education is greatly improved by traveling in quest of knowledge and meeting the authoritative teachers (of his time). The reason for
this is that human beings obtain their knowledge and character qualities
and all their opinions and virtues either through study, instruction, and
lectures, or through imitation of a teacher and personal contact with him.
The only difference here is that habits acquired through personal contact
with a teacher are more strongly and firmly rooted. Thus, the greater the
number of authoritative teachers, the more deeply rooted is the habit one
acquires.
I am very thankful to my friends in the Decision Analysis Working Group and
the department of Management Science and Engineering. Also, I am very grateful to
the amazing friends I came to know in the Muslim, Arab and Saudi communities at
Stanford. My memories with all will stay forever.
v
Finally, I am most appreciative of and indebted to my family. My parents, Nasser
and Hussa, are the inspiration of my life. May Allah have mercy upon them as they
brought me up, when I was, small. I am forever grateful and tankful to my lovely
wife, Reem, for her continuous support and kindness and for bringing our son, Nasser,
who brought joy and happiness to our life. I am also very appreciative to my amazing
siblings: Abdullah, Sara, Nouf, Abdulaziz, Fatima, Abdulrahman, and Hanoof.
vi
Contents
Abstract
iv
Acknowledgement
v
List of Tables
x
List of Figures
xi
1 Introduction
1
1.1
Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
1.1.1
Trade, Specialization and Productivity . . . . . . . . . . . . .
1
1.1.2
Contracts and Trade . . . . . . . . . . . . . . . . . . . . . . .
3
1.2
Dissertation Overview . . . . . . . . . . . . . . . . . . . . . . . . . .
5
1.3
Review of Legal Contractual Systems . . . . . . . . . . . . . . . . . .
5
1.3.1
Legal Definition of a Contract . . . . . . . . . . . . . . . . . .
7
1.3.2
Contractors’ View of a Contract . . . . . . . . . . . . . . . . .
7
1.4
Review of Contract Economics . . . . . . . . . . . . . . . . . . . . . .
8
1.5
Review of Negotiation Analysis . . . . . . . . . . . . . . . . . . . . .
11
2 The Self-Governing Contractual System
13
2.1
Definition of a Contract . . . . . . . . . . . . . . . . . . . . . . . . .
13
2.2
The Contract Table . . . . . . . . . . . . . . . . . . . . . . . . . . . .
14
2.3
The Elements and Dynamics of the Self-Governing Contractual System 15
2.3.1
The Contracting Parties . . . . . . . . . . . . . . . . . . . . .
vii
15
2.3.2
The Resolver . . . . . . . . . . . . . . . . . . . . . . . . . . .
16
2.3.3
The Escrow Agent . . . . . . . . . . . . . . . . . . . . . . . .
16
2.4
Building the Contract Table . . . . . . . . . . . . . . . . . . . . . . .
16
2.5
Example: Employment Contract . . . . . . . . . . . . . . . . . . . . .
18
2.6
Example: Loan Contract . . . . . . . . . . . . . . . . . . . . . . . . .
20
2.7
The Self-Governing Contractual System and the Law . . . . . . . . .
22
3 The Contract Management Market
24
3.1
Contracts as Products . . . . . . . . . . . . . . . . . . . . . . . . . .
25
3.2
Innovation in Contract Design . . . . . . . . . . . . . . . . . . . . . .
26
3.3
Insurance and Surety Bonds . . . . . . . . . . . . . . . . . . . . . . .
26
4 Visualizing Contracts
4.1
4.2
4.3
28
The Contract Flowchart . . . . . . . . . . . . . . . . . . . . . . . . .
28
4.1.1
The Building Blocks of the Contract Flowchart . . . . . . . .
29
4.1.2
Example: Employment Contract . . . . . . . . . . . . . . . . .
30
Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
30
4.2.1
Contract Design and Negotiation System . . . . . . . . . . . .
30
4.2.2
Contract Management System . . . . . . . . . . . . . . . . . .
32
Venture Capital Investment Contracts
. . . . . . . . . . . . . . . . .
33
4.3.1
Convertible Note Contracts . . . . . . . . . . . . . . . . . . .
33
4.3.2
Series-A Investment Contracts . . . . . . . . . . . . . . . . . .
34
5 Design of Venture Capital Contracts
5.1
5.2
5.3
37
Decision Analysis Process . . . . . . . . . . . . . . . . . . . . . . . .
38
5.1.1
Formulation phase . . . . . . . . . . . . . . . . . . . . . . . .
38
5.1.2
Evaluation phase . . . . . . . . . . . . . . . . . . . . . . . . .
39
5.1.3
Appraisal phase . . . . . . . . . . . . . . . . . . . . . . . . . .
40
Background on Venture Capital Investment . . . . . . . . . . . . . . .
40
5.2.1
Venture Capital Business Model . . . . . . . . . . . . . . . . .
40
5.2.2
Dynamics of Contract Negotiation . . . . . . . . . . . . . . . .
41
Formulation of the Venture Capital Contract Design Problem
viii
. . . .
42
5.3.1
Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . .
43
5.3.2
The Decision Diagram . . . . . . . . . . . . . . . . . . . . . .
45
5.3.3
Assessment Procedures for the Negotiation Uncertainties . . .
48
5.4
Evaluating the Decision . . . . . . . . . . . . . . . . . . . . . . . . .
53
5.5
Appraising the Analysis . . . . . . . . . . . . . . . . . . . . . . . . .
54
5.6
General Discussion about Contract Design . . . . . . . . . . . . . . .
57
6 Conclusion
58
6.1
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
58
6.2
Areas for Future Research . . . . . . . . . . . . . . . . . . . . . . . .
59
7 Bibliography
61
ix
List of Tables
2.1
The Contract Table . . . . . . . . . . . . . . . . . . . . . . . . . . . .
14
2.2
An Example Contract Table . . . . . . . . . . . . . . . . . . . . . . .
19
2.3
The Contract Table for the Employment Contract (1) . . . . . . . . .
19
2.4
The Contract Table for the Employment Contract (2) . . . . . . . . .
20
2.5
The Contract Table for Loan Contract . . . . . . . . . . . . . . . . .
21
2.6
The Contract Table for Credit Line Contract
. . . . . . . . . . . . .
21
5.1
Issues in Startup Investments . . . . . . . . . . . . . . . . . . . . . .
42
5.2
Partial Contract (CT=1)
. . . . . . . . . . . . . . . . . . . . . . . .
44
5.3
Partial Contract (CT=2) . . . . . . . . . . . . . . . . . . . . . . . . .
44
x
List of Figures
2.1
Possibility Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
18
4.1
Contract Flowchart of the Employment Contract . . . . . . . . . . .
31
4.2
Flowchart for convertible note contract . . . . . . . . . . . . . . . . .
35
4.3
Flowchart for Series A Investment Contract . . . . . . . . . . . . . .
36
5.1
Decision Analysis Process . . . . . . . . . . . . . . . . . . . . . . . .
38
5.2
Stages in the Venture Capital Investment Process . . . . . . . . . . .
41
5.3
Decision Diagram for Venture Capital Contract Design Problem . . .
46
5.4
Probability distribution on the discounted long-term exit value of the
startup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
47
5.5
Probability distribution on dilution given exist value
. . . . . . . . .
48
5.6
Zone of Possible Agreement . . . . . . . . . . . . . . . . . . . . . . .
49
5.7
Uncertainty about the Counterpart’s indifference point . . . . . . . .
50
5.8
{X = x|Agreement, CT, &}: Probability distribution on the pre-money
valuation given agreement and given the proposed contract . . . . . .
5.9
52
Cumulative Distribution Function (CDF): {X ≤ x|&} the probability
that the net value to the venture capitalist is less than or equal to x.
The X axis is truncated at $350M. . . . . . . . . . . . . . . . . . . .
5.10 Expected Value of the Venture Capitalist’s Alternatives
. . . . . . .
53
54
5.11 Sensitivity analysis to the probability that the board will accept the
acquisition offer
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
xi
55
5.12 Sensitivity analysis to the probability that the board will accept the
acquisition offer
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
xii
56
Chapter 1
Introduction
“O you who have believed, fulfill [all] contracts.”
Chapter 5, verse 1, the Holy Quran
1.1
Motivation
Trade provides substantial benefits to society. A contract is the mechanism that
enables trade between persons. This dissertation was motivated by the observation
that contracting can be costly. The high cost of contracting hinders trading activities
in the economy. I aspire to provide a practical solution for this problem.
1.1.1
Trade, Specialization and Productivity
In his inquiry into the nature and causes of the wealth of nations, Adam Smith [1]
concluded that the greatest improvements in the productive power of labor lie in the
division of labor. He described in detail the mechanisms that lead workers to be more
productive when specializing in a certain task. First, workers gain specialized knowledge of the particular task and therefore become more skilled at it. Second, division
of labor saves workers time that can be lost from switching between different tasks.
1
CHAPTER 1. INTRODUCTION
2
Finally, focusing on a specific task leads to innovation in the methods and machines
employed in the task; technological innovation will therefore make the task easier and
result in increased productivity. Moreover, Smith pointed out that division of labor
requires dividing production into separate tasks such that a worker can specialize in
a subset of these tasks. Further, George Stigler [2] suggested that the specialization
of individuals and firms should move together; the increase in productivity from the
specialization of an individual should lead to greater firm specialization.
After establishing the relationship between the division of labor and productivity,
Smith discussed the conditions that enable the division of labor. He made the proposition that the division of labor is limited by the extent of the market; or equivalently,
the division of labor is governed by the possibility of trade. Smith states: “As it is
the power of exchanging that gives occasion to the division of labour, so the extent of
this division must always be limited by the extent of that power, or, in other words,
by the extent of the market. When the market is very small, no person can have
any encouragement to dedicate himself entirely to one employment . . . .” [1] Smith
specifically made the conjecture that the extent of the market is determined by the
transportation cost and noted that communities inhabiting lands along sea-coasts exhibit higher level of division of labor and consequently tend to be more productive,
“As by means of water-carriage a more extensive market is opened to every sort of
industry than what land-carriage alone can afford it, so it is upon the sea-coast and
along the banks of navigable rivers, that industry of every kind naturally begins to
subdivide and improve itself . . . ” [1]
Furthermore, Hendrik Houthakker [3] developed Smith’s proposition about transportation conditions and proposed that the level of division of labor is generally
determined by transaction cost; where transportation cost is a special kind of transaction cost. An exchange between parties in different locations might be prevented
by the high transportation cost. Similarly, the exchange between parties in the same
location might be prevented by other transaction costs like search, negotiation and
contracting costs. In other words, the value of specialization could be outweighed by
the cost of transaction, which leads to lower level of division of labor than potentially
possible in some industries.
1.1.2
3
Contracts and Trade
A trade can be immediate, where the trading parties make the exchange on the
spot, or future-oriented, where the exchange is finalized in the future. A contract is
the medium facilitating future-oriented trade. It is the agreement that governs the
relationship between the trading parties over the course of their engagement.
This dissertation was motivated by the observation that decision makers commonly view contracts as ambiguous and dealing with them as risky, tedious and timeconsuming task. In other words, decision makers see a high transaction cost from
contracting. Following Smith’s and Houthakker’s line of thinking, higher contracting cost limits the extent of the market and consequently the level of specialization
and productivity in an industry. The points below summarize responses obtained in
personal interviews with decision makers and legal professionals about their views of
contracts.
1. The language used in contracts is difficult to understand.
Contracts contain concepts and legalese language that decision makers often
find obscure and intimidating. Law students are taught that the audience for
their writing consists of judges, arbitrators, and lawyers. As a result, we see
that contracts are usually written in a language that the contracting parties
usually find ambiguous [4].
2. Contracts are very long.
Contracts are not only long but they lack a clear structure that can help the
reader focus on a specific isolated part. In most contracts, the reader has to
go through the whole document in order to determine the obligation associated
with a specific event. Thus, decision makers usually find it difficult to distinguish the important from the less important parts of the contract. The length
of the contract is driven by various factors such as the number of events covered in the contract, the preciseness of the definition of terms, and the writing
skill of the contract drafter. Trying to simplify lengthy contracts, many contract drafters have adopted a practice of writing a contract with an addendum,
4
which provides a summary of the important items of the contract 1 , a definition
section, and sometimes multiple appendixes. This can be helpful but it does
not provide a fundamental solution.
3. The impact of an adjustment in a contract is not obvious.
Decision makers might feel reluctant to make changes in a given contract because
they don’t exactly know the extent of the impact of that change.
4. Comparing different contracts is very challenging.
This is a difficult task even for lawyers. In a personal interview, an attorney
at one of the most prestigious law firms in the Silicon Valley mentioned that
comparing different contracts is one of the most time consuming activities at
their firm. For a time-constrained decision maker, comparing different contracts
can be an impossible task.
5. Contracts might contain hidden obligations.
Many individuals feel afraid of signing contracts because they are afraid of being
deceived. In other words, they are afraid that the contract contains hidden
obligations. Therefore, they need a legal specialist to protect them from such
cases.
6. Some contracts might lead to legal troubles.
There are many legal constraints on contractual agreements. For example,
an employment contract in which the employer pays the employee below the
minimum wage is illegal and the employer is subject to a legal penalty. Decision
makers are not usually aware of all the laws governing contractual transactions
and therefore need a legal specialist to point out potential legal problems. In
many occasions, the purpose of contract has become the avoidance of legal
trouble as opposed to the creation of value in a transaction. This is specially
true for medical and employment contracts.
1
An example for that is the term sheet designed to summarize venture investment contracts.
5
7. Enforceability of contracts is governed by a set of complicated rules. Therefore,
the outcome of litigation can be highly uncertain.
Enforceability rules specify characteristics of an agreement which makes it enforceable by law. Different jurisdictions usually have different enforceability
rules. Decision makers do not possess the knowledge about the enforceability rules and their relative importance. Focusing on the enforceability aspect
of a contract has often overshadowed the true purpose of a contract, which is
enabling or improving the value of a transaction.
1.2
Dissertation Overview
In the remainder of this chapter, I review legal contractual systems and the literature on contract economics and negotiation analysis. The subsequent chapters are
organized as follows. In chapter 2, I describe an alternative contractual system I call
the self-governing contractual system. The system is designed to be simple, intuitive and operable by private entities in a competitive market. In chapter 3, I briefly
discuss the contract management market. In chapter 4, I borrow a commonly used
engineering tool, the flowchart, to provide a visual representation of contracts. The
contract flowchart represents contracts as a process of resolving events and transferring properties between contracting parties. In chapter 5, I apply decision analysis to
the design of venture capital investment contracts. Chapter 6 concludes by providing
a summary and a guideline for future research.
1.3
Review of Legal Contractual Systems
A legal contractual system is an embedded system within general legal and enforcement systems developed and managed by the government of a specific jurisdiction.
This review is mainly about the legal contractual system in the United States with
the understanding that different states have different systems.
Like other legal contractual systems, the legal contractual system in the United
States was not specifically designed at a certain point in time. Rather, it has evolved
6
over time and has been influenced by various legal theories 2 . Legal contractual
systems rely on the use of force or the threat of using force for the execution of
contracts, and legal theories tell us when the use of legal force against an individual
is morally justified [6]. The following are the most commonly applied classes of legal
theories [6]:
• Will theories suggest that commitments are enforceable because the promisor
has ”willed” to be bound by his commitment. The use of force against a
promisor who fails to make his commitment is morally justified because the
promisor has willingly accepted that possibility.
• Reliance theories explain enforcement as an effort to protect a promisee’s
reliance on the promises made by the promisor. A reliance theory suggests
that a person should be liable for his assertive behavior if it harms others the
same way that a person is liable in tort law for the negative consequences of his
actions.
• Efficiency theories state that the objective of enforcement is the maximization
of some concept of social wealth or welfare. An efficiency theory asserts that any
rule governing the enforcement of contracts should be judged by the relationship
between its aggregate benefits and its aggregate cost. This is the common view
within the school of law and economics.
• Fairness theories justify enforcement if the substance of a transaction is fair.
Fairness theory assumes that the substance of the contract can be objectively
evaluated.
• The Bargain Theory of Consideration focuses on the way contracting parties reached the agreement as opposed to examining the state of the contracting
parties or the substance of the agreement. The theory suggests that a promise
2
See Schwartz,, Alan, and Robert E. Scott,. Contract Theory and the Limits of Contract Law.
Center for Studies in Law, Economics, and Public Policy Working Papers. (2003). Schwartz and
Scott write ”Contract law has neither a complete descriptive theory, explaining what the law is, nor
a complete normative theory, explaining what the law should be . . . ” [5]
7
should be enforceable if there is a valuable consideration bargained for in exchange of the promise.
1.3.1
Legal Definition of a Contract
A contract is a special kind of agreement; it is an enforceable agreement. If an
agreement meets the criteria given in the definition of a contract, the force of law can
be used to enforce the contract. A widely acceptable definition of a contract is derived
from the bargain theory of consideration and the reliance theory, it is as follows:
A contract is formed in any transaction in which one or both parties make
a legally enforceable promise. A promise is a commitment or undertaking
that a given event will or will not occur in the future and may be express
or implied from conduct or language and conduct. A promise is legally
enforceable where it (i) was made as part of a bargain for valid consideration, (ii) reasonably induced the promisee to rely on the promise to his
detriment, or (iii) is deemed enforceable by a statute despite the lack of
consideration. [7]
1.3.2
Contractors’ View of a Contract
What does entering a contract entail for a contracting party? What happens if a
contracting party does not satisfy the commitment? The answer depends on the kind
of commitment. Contract law categorizes obligations in a contract into an obligation
to give or an obligation to do (or not do) 3 .
The obligation to give is an obligation to transfer the ownership of a property to
another person. This obligation is enforced literally only if the property is shown to
be unique like a piece of land or if remedies are inadequate as in the case of a unique
work of art.
3
See Louisiana civil code, art 1756 ”An obligation is a legal relationship whereby a person, called
the obligor, is bound to render a performance in favor of another, called the obligee. Performance
may consist of giving, doing, or not doing something.”
8
The obligation to do is an obligation to perform a specific action, such as an
obligation to sing at a wedding or paint someone’s house. Courts almost always refrain
from enforcing an obligation to do a specific action. Instead, courts assign remedies,
usually in the form of money 4 . Enforcing the obligation to do is problematic for
legal contractual systems for various reasons: It can be very costly to supervise the
performance, it is often counterproductive as in the case of a singer being forced to
sing, and, more importantly, forcing a person to provide a service to another person
can be considered a case of forced labor or a form of slavery [10].
The obligation not to do is an obligation to refrain from doing a certain action.
Courts generally do not enforce such performance either and assign damages instead
but there have been cases of courts ordering a person to refrain from doing a certain
action like seeking employment with a competitor in an employment contract with a
non-compete clause 5 .
1.4
Review of Contract Economics
Contract theory or contract economics is a field of study within economics concerned
with understanding how people choose the form of their economic interactions. The
theory has had a significant influence on many fields such as microeconomics [12],
macroeconomic, public policy, operations management [13], law, organizational design
[14], sociology [15] . . . etc.
Brousseau and Glachant [16] suggest that the development of contract economics
came as a direct result of the dissatisfaction with the Walrasian market theory. The
4
In the United States, see Barnett, Randy E. Contract Remedies and Inalienable Rights. Social
Philosophy and Policy 4, no. 1 (1986): 179. [8]. Barnett writes ” specific performance has traditionally been unavailable to enforce contracts for the provision of personal services, even if these services
can be shown to be unique and damages therefore are in fact inadequate.”
This is generally true in most modern states: In European states countries with civil legal systems,
see Lando, Henrik, and Caspar Rose. The Myth of Specific Performance in Civil Law Countries.
American Law & Economics Association Annual Meetings (2004). [9], the authors write ”specific
performance of an action is, roughly speaking, not enforced in Denmark, weakly enforced in France,
and though enforced in Germany, only rarely sought”. They conclude that specific performance is
largely irrelevant as a remedy for the non-performance of an action in civil law countries.
5
See, Yorio, Edward, and Steve Thel. Contract Enforcement: Specific Performance and Injunctions. Aspen Publishers Online, 2011. [11]
9
Walrasian model is based on the idea that a decentralized economy can be characterized by equilibrium prices that balance supply and demand. The model, however,
failed to explain the fact that, in practice, people exchange goods and services outside
the equilibrium and in a bilateral context. Based on this dissatisfaction with the Walrasian theory, economists tried to search for alternative models, which led to the birth
of contract economics in the 1970s. Foundational work in this field was conducted
by economists like Akerlof, Arrow, Stiglitz, Williamson and others. Brousseau and
Glachant [16] wrote:
New analytical tools were sought to explain how economic agents determine the properties, quantities, and prices of the resources they trade
in face-to-face encounters. If these agents are subject to transaction costs,
if they can benefit from informational advantages, or if there are situations
in which irreversible investments must be made, then it is reasonable to
expect that one will not see the same goods traded at the same price and
under the same rules as on a Walrasian market.
The field of contract theory has evolved into three main schools: incentive theory
(IT), incomplete contract theory (ICT), and transaction costs theory (TCT). These
schools emphasize different problems based on differences in their underlying assumptions. Incentive theory focuses on compensation schemes, incomplete contract theory
concentrates on the renegotiation provisions, and transaction costs theory studies the
allocation of decision and coercion rights between contracting parties.
The central concern in incentive theory (IT) is that contracting parties do not have
the same information on certain variables. The canonical situation in the incentive
theory is the one in which an under-informed party, the principal, designs an incentive scheme to induce the informed party, the agent, to either disclose information
(adverse-selection model) or adopt a desired behavior (moral-hazard model). In the
adverse selection model, the informed party cannot influence the variable on which
there is asymmetric information, while in the moral hazard model, the informed party
can influence the variable. The solution concept to the adverse selection problem is
the design of a menu of contracts, so that the principal can infer the agent’s private
10
information from his selection. The solution concept to the moral hazard problem is
the design of a payment scheme that combines a fixed base pay and a variable pay
based on the observed result.
Conversely, the main issue in incomplete contract theory (ICT) is the institutional
or the verification aspect. It suggests that complete contracting is impossible when no
third party, a judge or a governing institution, can verify the real value of some central
variables in the contract. It suggests by extension that contracting on unverifiable
variables is useless. The central issue therefore becomes finding an alternative to verification that ensures efficient coordination. The canonical situation in the incomplete
contract theory is contracting over two periods. During the first period, contracting
parties realize non-verifiable investments; during the second period, the parties conduct the trade. The characteristics of the trade, such as price and quantity, are the
only verifiable variables. The issue is that once the level of non-verifiable investments
and other uncertainties are observed during the first period, the contracted level of
trade is no longer optimal and therefore the contracting parties should renegotiate
that level, but another problem arises because the contracting parties anticipate this
renegotiation stage and therefore hold up on investment. The solution concept is to
limit the scope of the renegotiation in order to provide an incentive to each party to
invest optimally during the first stage.
The central question in the transaction cost theory (TCT) is similar to that of
the incomplete contract theory (ICT). It suggests that complete contracting is impossible because contracting parties cannot fully describe their contractual problem
and that no judge or governing institution is perfect. The contracting parties should
therefore accept incomplete contracts and seek other alternatives to ensure coordination. The solution concept in this theory considers methods like assigning decision
rights, controlling the costs of breaking the agreement using deposits or irreversible
investments and designing private conflict resolution mechanisms. However, the most
essential solution is based on the idea that contracting parties will fall back on collective provisions originating from the institutional framework. This framework frees
contracting parties from having to invent all necessary provisions and ensures the
performance of contractual obligations. The design of institutions is one of the major
11
area of application for the transaction cost theory.
In contrast with the other theories, transaction cost theory (TCT) is based on
the assumption of bounded rationality of all the contracting parties and of the judge
who represents the governing institution. The concept of bounded rationality coined
by Simon means that individuals have limited abilities to structure and reason about
their contractual problems.
In addition to differences in their underlying questions and assumptions, the aforementioned schools of contract theory also differ in their research methods. Incentive
theory (IT) and incomplete contract theory (ICT) are more hypothetical and deductive. Researchers following these theories develop a formal view of the contractual
situation using very generic models based on specific hypotheses about the contracting
parties. On the other hand, transaction cost theory is more inductive: researchers
following this theory generally rely on empirical work to infer theories about how
individuals choose to contract.
1.5
Review of Negotiation Analysis
Contracts are usually established via negotiation. In contract design, we need to take
negotiation dynamics and strategy into account. Raiffa [17] distinguishes among four
different perspectives in negotiation research.
1. Symmetrically descriptive research: the objective of a descriptive research is to
understand the behavior of negotiators, without having any interest in prescribing how they should behave.
2. Symmetrically prescriptive research: the objective of a symmetrically perspective research is to examine what perfectly rational people should do in competitive, interactive situations; and advice is given symmetrically to all parties
about how to play a certain game.
3. Asymmetrically prescriptive / descriptive research: the objective of asymmetric
research is to advise one party given a descriptive model of the other parties in
the negotiation.
12
4. Externally prescriptive or descriptive research: the objective of an externally
descriptive research is to describe the behavior of third parties intervening in
the negotiation; and the objective of an externally prescriptive research is to
describe what third parties should do when supporting negotiation.
When discussing venture capital contract design, I adopt most of the features
characterizing the negotiation analytic approach as defined by Sebenius [18], namely:
• Subjective perspective: Negotiation analysts assume that parties in the negotiation have their own preferences and beliefs. Also, one side is not bound to
regard the other side as rational.
• Sensitivity to ”value left on the table: Negotiation analysts would devote a
considerable effort to helping parties ”expand the pie” through problem solving,
creativity, and identification of differences and/or compatibility of interests.
• A focus away from equilibrium analysis and toward perceptions of the zone of
possible agreement: Negotiation analysts typically focus on subjective perceptions of the so-called ”zone of possible agreement”.
• Asymmetrically prescriptive / descriptive orientation: Negotiation analysts make
prescriptive advice to one party given a behavioral description of the other parties.
The remainder of this dissertation is organized as outlined in section 1.2.
Chapter 2
The Self-Governing Contractual
System
“Righteousness is good character, and sin is that which revolves in your heart and
which you do not want people to know.”
Prophet Muhammad peace be upon him
The self-governing contractual system is a system that allows contracts to be
managed by private institutions in a competitive market. I call it a self-governing
system because, as opposed to the legal contractual system, all outcomes of the
contract must be pre-determined by the contracting parties themselves at the time of
establishing the contract. The simplicity of the system and the competitive nature of
the market should drive down the cost of contracting and make contracts an easy-touse managerial instrument. The self-governing contractual system can only operate
in a legal system that protects property rights.
2.1
Definition of a Contract
In the self-governing contractual system, a contract is defined as an agreement between
two or more persons that details transfers of properties in different future possibilities.
13
CHAPTER 2. THE SELF-GOVERNING CONTRACTUAL SYSTEM
2.2
14
The Contract Table
A contract in the self-governing contractual system is a deterministic function that
maps different future possibilities to an operation of property transfer between contracting parties. This function can be represented as a table I call the contract table.
The contract table, shown in Table 2.1, specifies how different properties will be transferred between the contracting parties, person X and person Y, depending different
future possibilities.
Table 2.1: The Contract Table
Property 1
t0 ≤ t ≤ t1
X→Y
units
X→Y
units
Property 2
t0 ≤ t ≤ t1
0
0
X→Y
units
Possibility n
0
0
X→Y
units
0
Possibility N
0
Y→X
units
0
0
Possibilities
Possibility 1
Possibility 2
0
Property q
t1 ≤ t ≤ t2
Y→X
units
Property Q
t = t3
0
The rows, columns and cells of the contract table have the following characteristics:
• The rows constitute a set of mutually exclusive and collectively exhaustive possibilities (scenarios) represented along the time dimension by all the distinctions
(events) included in the contract. Each possibility is a future eventuality from
the beginning to the end of the life of the contract. The contract ends when all
the events included in the contract are resolved.
• The columns show the property kinds supplied by the contracting parties to
be transferred between them according to this contract. The time dimension
beneath each property kind shows the time frame within which this property is
supposed to be transferred during the life of the contract.
15
The reason for showing the time dimension is that different property transfers
in one future scenario need not happen at the end of the life of the contract.
In the contract presented in table 2.1, the first transfer in “possibility 1” will
take place in time (t0 ≤ t ≤ t1), and the second transfer will take place in
time (t1 ≤ t ≤ t2). Because each possibility is a future eventuality from the
beginning to the end of the life of the contract, the set of events leading to the
first transfer is a subset of the events representing “possibility 1.”
• A cell in the contract table shows the transfer of the title to a given property
given a particular future possibility. The transfer can be a function of an event
1
. The title to a property is the ownership of the property 2 , which is evidenced
by a deed, other appropriate documents, or by the possession of the property.
Moreover, the direction of the arrow indicates the direction of the ownership
transfer. The units beneath the arrow are the number of units of this property
kind. A zero in a cell means that there is no transfer of the corresponding
property given the corresponding future possibility.
2.3
The Elements and Dynamics of the Self-Governing
Contractual System
The self-governing contractual system operates as a controlled interaction between
contracting parties, a Resolver and an escrow agent.
2.3.1
The Contracting Parties
The contracting parties agree on the contract table and assign a Resolver and an
escrow agent. The agreement between the contracting parties is manifested by their
1
Events usually make the rows of the table, but if the event is a continuous variable, the transfer
is written as a function of the event.
2
. . . “the ownership of real property or personal property, which stands against the right of anyone
else to claim the property. In real property, title is evidenced by a deed, judgment of distribution
from an estate or other appropriate document recorded in the public records of the county. Title to
personal property is generally shown by possession particularly when no proof or strong evidence
exists showing that the property belongs to another . . . ” see dictionary.law.com
16
submission of the evidence of titles to the properties included in the contract to the
escrow agent.
2.3.2
The Resolver
The Resolver is an impartial person officially appointed by the contracting parties to
determine which possibility has taken place. The Resolver instructs the escrow agent
to distribute properties according to a specific row of the contract table. Having a
Resolver eliminates the possibility of disputes between the contracting parties since
the outcome of events is a decision made by the Resolver without awaiting agreement
or disagreement between the contracting parties. The Resolver might in fact be a
computer that can sense how events took place and instructs for transfers as specified
in the contract table.
2.3.3
The Escrow Agent
The escrow agent receives the evidence of the titles to the properties included in the
contract and then makes the distribution according to one of the rows in the contract
table as ruled by the assigned Resolver. If the contracting party who is supposed to
transfer a specific property does not have the title to that property at the time of
the establishment of the contract, then the escrow cannot be used for this property.
The solution is that the contract includes the event that the transfer of this property
occurs in the future and that the transferor should supply another agreed-on currently
owned property to the escrow to account for the contingency that the transfer of the
original property may not happen.
2.4
Building the Contract Table
To build the rows of the table, the contracting parties need to identify the distinctions to be included in the contract. A distinction is a division of eventuality into
states; the number of states is the number of degrees of a distinction. The contracting
17
parties and the Resolver should work together to define distinctions to ensure common understanding. The Resolver has the incentive to be involved in the definition
process because s/he is the person making the observations. The contracting parties
and the Resolver decide how much time and effort they need to spend in defining
distinctions to reflect the cost of drafting, the cost of observation, and the amount of
transfer conditioned on this distinction. The following are the guidelines for choosing
distinctions (events) in the self-governing contractual system:
1. A contracting party’s action of doing or not doing something should be considered an event (distinction).
2. Contracting parties can choose to include non-action distinctions such as “the
price of oil,” “the cost of production,” “the default of the company,” . . . etc.
3. If the title to a property intended to be transferred as part of the contract
cannot be supplied to the escrow account at the time of the establishment of
the contract, then the contract should include the distinction “the event that
the possession of the specified property has been transferred”.
For example, let us assume that the contracting parties have identified two distinctions, A and B; A has two degrees and B has three degrees. They can now build
a possibility tree, like the one in Figure 2.1. The distinctions should be ordered according to the time of resolution: A is resolved before B. An arbitrary order can be
chosen if there is no strict order of resolution. Each path through the tree represents
one elemental possibility; this tree has six. A compound possibility is a distinction
represented by a collection of elemental possibilities. For example, A1B2+A1B3 and
A2B1+A2B2 are compound possibilities. A row of the table can take an elemental
or compound possibility as shown in table 2.2.
After that, the contracting parties need to specify the properties to be transferred
as part of this contract and then specify the amount and direction of transfer in each
cell of the table. A zero value is given to a cell if no transfer is intended for the
corresponding property in the corresponding possibility.
18
Figure 2.1: Possibility Tree
2.5
Example: Employment Contract
Consider an agreement between John, a painter, and Sara, a real estate developer,
for the painting of Sara’s new commercial building. John and Sara agreed to use
the self-governing contractual system and so they assigned a Resolver and an escrow
agent.
In this agreement, John agreed to paint Sara’s building according to a given
specification by a given date. When constructing the contract table for this agreement,
the action of painting the house should be considered a distinction. The contracting
parties and the Resolver should work together to define this distinction and its degrees.
Each possibility makes one row of the table. Further, Sara and John decided to only
use money as an exchanged property; money therefore will take the single column of
this table.
Finally, John and Sara should specify the amounts of payment in each cell of the
table and then supply these amounts to the escrow agent. The resulting contract
19
Table 2.2: An Example Contract Table
Possibilities
A1B1
A1B2+A1B3
Property 1
t0 ≤ t ≤ t1
X→Y
units
X→Y
units
A2B1+A2B2
0
A2B3
0
Property 2
t0 ≤ t ≤ t1
0
Property 3
t1 ≤ t ≤ t2
Y→X
units
0
0
Y→X
units
Y→X
units
X→Y
units
0
table is shown in Table 2.3. The contractual system will then start running. In the
specified time of resolution of the painting event, the Resolver will check the state of
house and rule a specific outcome, a row of the table, and then instruct the escrow
agent to distribute the properties according to that row of the contract table.
Table 2.3: The Contract Table for the Employment Contract (1)
Possibilities
John performs the painting job according to the given
specification by the date T1
John does not perform the painting job according to the
given specification by the date T1
Money
Sara → John
$ 100K
John → Sara
$ 30K
A different contract can be constructed if the contracting parties choose to include another distinctions. For instance, John estimates that the cost of painting the
building by the deadline will be high if the weather is rainy, so he asks to be paid
more in the case of a rainy weather. Sara, the Resolver and the escrow agent agree to
include the weather distinction. The resulting contract table is shown in Table 2.4.
The operation of the contractual system is the same, but in this case Sara will need
to supply the maximum of his potential payment to the escrow account. Also, the
Resolver will need to check two events instead of one.
20
Table 2.4: The Contract Table for the Employment Contract (2)
Money
Possibilities
specification by the given date AND the weather is sunny
specification by the given date AND the weather is rainy
John does not perform the painting job according to the
given specification by the given date
2.6
Sara → John
$ 90K
Sara → John
$ 120K
John → Sara
$ 30K
Example: Loan Contract
Consider a loan agreement between Jane, the lender, and David, the borrower. In
this contract, Jane agreed to give David $100K in date T1; in exchange David agreed
to give Jane back a $110K by date T2. The contracting parties agreed to use the
self-governing contractual system, so they assigned a Resolver and an escrow agent.
The issue is that David does not own the property that he intends to give in
the future, so he cannot supply that property to the escrow account. To meet the
contractual system’s requirement, the contract should include the distinction “David
pays $110K by T2”. Jane and David agree that Jane should get David’s house if he
does not pay the $110K by date T2. In this case, David needs to supply the title
to his house to the escrow account. The resulting contract table is shown in Table
2.5. The contract table shows that there are two possible sets of exchange in the
contractual relationship between David and Jane. Each is shown in one of the rows
of the contract table. The time dimension in the table shows that the first transfer
will take place on time T1 and the second will happen on or before time T2.
The contractual system will then start running. On date T1, the Resolver will
instruct the escrow agent to transfer $100K to David. Then, if David pays $110k by
date T2 to the escrow account, the Resolver will instruct the escrow agent to apply
row 1 of the table, the $110K will be directly transferred to Jane and the title of the
house will return to David. Otherwise, the Resolver will instruct the escrow agent to
21
Table 2.5: The Contract Table for Loan Contract
Possibilities
David repays by T2
David does not repay by T2
Money
t = T1
Jane → David
$100K
Jane → David
$100K
Money
T1 < t < T2
David → Jane
$ 110K
House
t = T2
0
David → Jane
0
apply row 2 of the contract table, the title of the house will go to Jane.
Moreover, consider the situation in which David likes to have the option but
not the obligation to secure a loan within a specific time window, T 0 < t < T 1, a
credit line contract. Table 2.6 shows an example contract. In this contract, a new
distinction, David’s request of the loan before T1, is included. Because Jane has to
submit the $100K by T0, she asks for $3K fee if David does not request the loan.
Table 2.6: The Contract Table for Credit Line Contract
Possibilities
David requests the loan
AND David repays by T2
David requests the loan
AND David does not repay
by T2
David does not request the
loan
Money
T0 ≤ t ≤ T1
Jane → David
$ 100K
Money
T1 ≤ t < T2
David → Jane
$ 110K
House
t = T2
Jane → David
$ 100K
0
David → Jane
David → Jane
$ 3K
0
0
0
2.7
22
The Self-Governing Contractual System and
the Law
This section examines the extent to which the self-governing contractual system can
operate independently of the legal system. If the contracting parties voluntarily agree
to the contract as evidenced by the contracting parties’ submission of the titles to the
properties that might be transferred as part of the contract to the escrow account, is
it possible for courts to overrule the the Resolver’s decisions or change the agreed-on
property transfers?
The main motivation behind the self-governing contractual system is to free contracting parties from dealing with contract law and the court system and establish a
market place for contract management. If courts can intervene in the system, then
contracting parties will still need to write contracts addressed to the court and the
self-governing contractual system will be of little or no value. Therefore, it is essential
for our purposes to study the relationship between the the self-governing contractual
system and the law.
Fortunately, it appears that the the self-governing contractual system can work
independently. The Resolver may legally function as an arbitrator. Arbitration is
an alternative dispute resolution mechanism; contracting parties can decide on using
arbitration instead of courts to manage their disputes. In other words, arbitration can
be viewed as a private court system whose ruling is generally enforced by law. Most
arbitrators are former judges or lawyers who operate their arbitration business in a
similar way to courts. The role of a Resolver in the self-governing contractual system
is different from that of an arbitrator. The Resolver has to approve the contract
before it is established. Also, the Resolver decides the outcome of events without
hearing arguments from contracting parties. Despite their differences, a Resolver and
an arbitrator can be viewed as equivalent from a legal perspective.
Historically, courts have had the ultimate authority in the sense that a contracting
party can appeal arbitrators’ decisions to the court. Recently, however, arbitration
has been gaining more independence. Commenting on the recent supreme court
decision in Nitro-Lift Technologies, L.L.C. v. Howard, 568 U.S. (2012), Devin Slack,
23
Jim McQuade of ORRICK law group writes [19]:
In a strong rebuke, the Supreme Court found that, by assuming the role
of the arbitrator and evaluating the validity of the noncompetition agreements, the Oklahoma court violated a basic principle of the Federal Arbitration Act, which requires federal and state courts to rigorously enforce
written arbitration agreements except in certain limited circumstances.
The Supreme Court reiterated that a courts only function in this context
is to determine whether the arbitration clause is valid.
Michael Droke of Dorsey & Whitney LLP discussed the recent supreme court
arbitration cases in an interview [20]
In the past few years there has been a rash of arbitration decisions coming from the U.S. Supreme Court. The court has decided five cases, and
all “have swung strongly in favor of enforcing arbitration clauses in contracts,” . . . These decisions have changed the law, particularly in California, where the courts have been hostile to arbitration agreements, he
continued. The high court has ruled that the Federal Arbitration Act
(FAA) can pre-empt state law and lead to the enforcement of arbitration
clauses. These agreements allow the employer to choose the forum and
the decision-maker in these often hotly contested cases.
In short, to the best of my knowledge, it is possible to establish the self-governing
contractual system as an independent system in the United States using arbitration
as a legal entity. Still, this question deserves further analysis. The situation in other
countries also requires an separate investigation. That is an area of future research
beyond the scope of this dissertation.
Chapter 3
The Contract Management Market
“Absence of understanding does not warrant absence of existence.”
Ibn Sina (Avicenna) (b. 980)
The Resolver and the escrow agent in the self-governing contractual system operate
as intermediaries between the contracting parties. The Resolver is an impartial person
officially appointed by the contracting parties to determine the outcome of future
events. The escrow agent secures the evidence of the titles to the properties included
in the contract and makes the agreed-on transfer of property in a future possibility
that was determined by the Resolver. Consider a contract management firm that
provides the intermediary services of a Resolver and of an escrow agent and consider
a competitive market in which such firms operate. The objective of this chapter is to
briefly shed light on the economics of the contract management market.
As discussed in the previous chapter, the dynamic of contracting in the selfgoverning contractual system is fundamentally different from that in the legal system.
Legally, persons can enter into a contract drafted by themselves or their agents and
litigate or arbitrate in the case of a dispute. On the contrary, in the self-governing
contractual system, the contracting parties and the contract management firm need
to agree on the contract before it is established. Also, the contracting parties need to
24
CHAPTER 3. THE CONTRACT MANAGEMENT MARKET
25
agree to the contract management firm’s fee structure, which can vary from one contract to another. Moreover, it is important to emphasize that the role of the contract
management firm is not to listen to arguments and settle disputes; rather, its role is
to decide the outcome of future events and make the agreed-on property transfer.
3.1
Contracts as Products
We can view a contract as a product produced by the contract management firm and
consumed by the contracting parties for a specific fee. The cost of producing a contract
includes the cost of drafting the contract and the cost of managing it, determining
the outcome of events included in the contract and escrowing and transferring titles
to assets. The contract management firm’s objective is to maximize profit. The profit
can be increased by selling contracts at higher prices or by producing them at lower
cost. Also, at a positive margin, profit can be improved by selling more contracts.
Furthermore, the long term survival of a contract management business relies
heavily on reputation; that is the contracting parties’ belief that the firm will determine the outcome of events accurately. The reputation aspect and the fact that the
cost of resolving events is internalized in the fees charged by the contract management
firm should have a great impact on the types of events included in the contract and
on the quality of contract writing 1 .
Various technological innovations will help drive down the cost of producing
contracts in the self-governing contractual system. First, digitizing titles of assets
will ease the process of transferring titles by eliminating the frictions associated
with escrowing and transferring physical titles. Second, the development of cryptocurrencies, which include the multi-signature feature, should provide a cheaper alternative to escrow. Finally, advanced sensors can replace the need for human judgement
1
Please refer to Triantis, George, and Albert Choi. Strategic Vagueness in Contract Design: The
Case of Corporate Acquisitions. Yale Law Journal (2010) [21]. In this paper, Choi and Triantis
reviewed related work and provided a framework for explaining vagueness of contract. They argue
that given a costly litigation, a vague language in a contract can be used as a screen, a mechanism
to reveal the one party’s private information. Such incentive will be eliminated in the self-governing
contractual system since the contract management firm will insist in clearly written contracts to
protect its reputation and lower the cost of resolving future events.
26
in determining the outcome of events. The observability of future events is usually a
major issue affecting the cost and consequently the design of contracts.
3.2
Innovation in Contract Design
Innovation in contracts, the production of new and valuable contracts, is an important
way for contract management firms to improve their profitability. The incentives
driving innovation in a contract management firm and in a future exchange are similar.
A future exchange produces contracts and connect buyers and sellers of the contract
for a specific fee 2 . Exchanges retain financial and legal expertise to develop new
contracts and have been very active at doing so [22]. Therefore, we can expect
the same from contract management firms. Innovation has been lacking in contracts
produced by law firms and addressed to the court system, mainly because of litigation
and judicial uncertainty [22].
3.3
Insurance and Surety Bonds
In the self-governing contractual system, contracting parties are required to submit
the evidence of titles to the properties to the escrow account at the time of signing
the contract. In many cases, this can be very costly for the contracting parties.
A solution currently employed in practice is the use surety bonds. A third party,
typically an insurance company, guarantees to pay a certain amount to the obligee
if the the principal fails to meet a specific obligation. The principal will have to
reimburse the insurance company for its payment. The obligee trusts the insurance
company’s solvency and reputation and therefore accepts a contract that does not
include a collateral. The difference between an insurance policy and a surety bond
is that the insurance policy does not require the principle to reimburse the insurance
company. The application of the self-governing contractual system will expand the
2
The major differences between a contract management firm and a future exchange is that a
future exchange relies on cash settlements and use future spot prices as the events that trigger
transfer.
27
market size of the surety bonds and insurance policies. Insurance companies should
find the clear structure of contracts an opportunity for introducing new products.
Chapter 4
Visualizing Contracts
“Everything should be made as simple as possible, but not simpler.”
Albert Einstein (b. 1879)
Contracts determine the transfer of property between contracting parties depending on mutually exclusive and collectively exhaustive future possibilities. In practice,
contracts often include many distinctions and represent a long term relationship between contracting parties. Such contracts can be difficult to construct and communicate using the contract table. This chapter is concerned with the development of
a computer-based visualization tool, the contract flowchart, to support the processes
of designing, negotiating and managing contracts.
4.1
The Contract Flowchart
A flowchart is a type of diagrams commonly used to represent algorithms and engineering processes. A contract is a transfer of property between contracting parties
in different future possibilities. We can represent a contract as a process of resolving
events over time and transferring properties between the contracting parties. The
contract flowchart communicates the information contained in the contract table but
28
CHAPTER 4. VISUALIZING CONTRACTS
29
does not show the full information at once. The contract flowchart has some important features:
1. Each event (distinction) is displayed individually along the time dimension. A
contract flowchart represents each event in the contract as a step in the process
so the reader does not have to think of multiple events at the same time. This
allows readers to focus on and adjust a specific part of the contract while clearly
recognizing how this part fits within the whole.
2. The time line shows clearly the different dates of property transfer. This is
important because property transfers can take place at different points of time
in a given future scenario. The flowchart orders events according to their time
of resolution. If the order of resolution time is not known for a set of events,
they will be placed in a parallel process.
3. The definition and degrees of an event (distinction) is displayed clearly. The
definitions of distinctions in most contracts are not standardized and therefore
contracting parties have to clarify and maybe negotiate the definitions of different distinctions. As a computer-based visualization, the definition of an event
can be displayed by pointing at that event in the flowchart.
4. Compared to the contract table, contract flowchart does not grow in size fast
as we add more distinctions.
4.1.1
The Building Blocks of the Contract Flowchart
The following is description of the different boxes in the flowchart diagram.
• A rounded rectangle is an instruction to start or end the contract. By each
rounded rectangle box, the time line displays the start or the end date of the
contract.
• A rectangle is an instruction to resolve an event. By pointing at the box, the
reader can view the definition and the degrees of the event (distinction).
30
• A diamond is also an instruction to observe an event. It must be used for special
type of discrete events that produce asymmetry in the process; the set of events
to be resolved in the future is different given different outcome of this event.
• A parallelogram displays the property transfer specified by the contract. This
transfer is a function of some or all the preceding observations, rectangle and
diamond boxes. If the transfer takes place before the end of the contract, the
time line should display the latest time this transfer should be made by.
4.1.2
Example: Employment Contract
Consider the employment contract shown in chapter 2 in Table 2.4 between John, a
painter, and Sara, a real estate developer, for the painting of Sara’s new commercial
building. The contract has two discrete events: the weather condition and the state
of the building’s painting. The flowchart visualization of the contract is shown in
Figure 4.1.
The starting and end dates of this contract is displayed on the time line. The two
distinctions are represented with a rectangle because they do not lead to asymmetry
in the process. An important feature of the flowchart visualization is that the reader
can point at an event on the diagram to read its definition and degrees. Also, as
shown in Figure 4.1b, the reader can input the outcome of the two events from the
drop-down menu, the system would then output the resulting property transfer in
the parallelogram. This method is very helpful with continuous variables or discrete
variables with large number of degrees.
4.2
4.2.1
Applications
Contract Design and Negotiation System
The contract flowchart visualization tool can serve as a platform for contract design
and negotiation. Contracting parties and the contract management firm can design
and negotiate contracts on this platform.
31
(a) The user can point at a distinction to read its definition.
(b) The user can point at events and select their outcome to display the resulting property
transfer.
Figure 4.1: Contract Flowchart of the Employment Contract
32
Users can construct contracts using the system by defining events (distinctions),
ordering them on the time line according to their time of resolution, and specifying
property transfer in the mutually exclusive and collectively exhaustive joint possibilities. For example, the employment contract in Figure 4.1 can be constructed on the
system by first defining the two distinctions, the weather condition and the state of
the building’s painting. The users would then be asked to define the degrees of each
distinction. They would also be asked to order the events according to the time of
resolution. In this case, the weather condition should be resolved right before the
state of the building painting. The system would then build the joint possibility tree
internally and ask the users to specify property transfer for each possibility, effectively
creating the contract table in the background.
In a negotiation setting, the system can include a functionality that helps contracting parties reach an agreement that increases the total value created. For instance,
instead of negotiating the amount of property transfer in a given possibility, the parties can negotiate property transfers in multiple future possibilities by inputing their
indifference curves. The system can then suggest a set of transfers that maximizes
the total value created.
4.2.2
Contract Management System
A contract determines the relationship between companies, sometimes over an extended amount of time. The contract flowchart can be used as the basis for a contract management system, which gives companies the ability to manage concurrent
contractual relationships and visualize the flow of cash and other assets from multiple
contracts. Also, the system can allow companies to generate periodic statements of
current assets and the range of future assets. In this world, management of contracts
belongs to the corporate financial department as opposed to the legal department.
4.3
33
Venture Capital Investment Contracts
I consider venture capital investment contracts to illustrate the usefulness of the
flowchart visualization tool. Venture capital investment is essential for the development of new and innovative businesses. Investment contracts govern the exchange
between a venture capitalist and a startup company. In this exchange, the startup
company receives capital from investors in exchange for different amounts of cash
and/or shares in the company depending on different future possibilities. Many variations of venture capital investment contracts have been developed over time to satisfy
the varying interests of investors and entrepreneurs. I use two common types of venture capital investment contracts, convertible notes and series-A investment contracts,
to demonstrate the flowchart visualization tool.
4.3.1
Convertible Note Contracts
A convertible note contract is commonly used for investments in early stage startups,
when the negotiation time is generally short. Figure 4.2 shows an example convertible note contract in the flowchart representation 1 . According to this contract, the
capital is to be transferred from the investor to the startup only if certain “Closing
Conditions” are met; the closing conditions in convertible note contracts are typically
simple and non-negotiable 2 . In exchange of the capital, the investor will receive a
number of common or preferred shares depending on the “conversion event”: qualified financing, IPO or change of control, or maturity date. If the startup “defaults”
before a conversion event, the investor will receive a specific amount of the remaining
asset.
As shown in Figure 4.2, a computer-based implementation of the flowchart allows
contract readers to point at the distinction boxes, rectangles and diamonds, to read
the definition of these distinctions and at the transfer box, parallelograms, to read the
1
This contract flowchart is a built based on a convertible note contract available on UpCounsel’s
website.
2
The conditions include issues like that the company has valid registration and that the investor
is accredited . . . .
34
transfer functions. The flowchart representation of this contract was received positively by investors and entrepreneurs in usability test interviews. Contracting parties
can easily recognize the flexibility of generating variations of the same contract by
changing the definitions of the different distinctions or by changing the transfer functions. Also, comparing existing contracts should no longer be a burden on contracting
parties; one can first check the structure of the contract flowchart and then the definitions of distinctions and transfer functions.
4.3.2
Series-A Investment Contracts
As a startup company grows, it goes through rounds or series of financing. These
series are ordered alphabetically: series-A, series-B . . . etc, and in many occasions, a
seed financing precedes these financing rounds. Figure 4.3 shows an example series-A
investments contract in the flowchart representation 3 . According to this contract, the
capital is to be transferred from the investor to the startup only if certain “Closing
Conditions” are met; the closing conditions in series-A contracts are often negotiated
extensively. An important condition required by most investors is the adjustment of
the company’s charter, which might include configuring the board of directors and
assigning decision rights, such that investors will have control over some corporate
decisions like the valuation of the next round’s of financing, the sale of the company,
etc.
Also according to this contract, the investor will receive a number of common
shares depending on “the number of additional shares issued”, “the amount of dividends authorized” and the “conversion event”: liquidation, IPO, or acquisition. The
investor has the option to“convert” and receive common stock at a determined price
before a “conversion event”. In short, the contract is used to divide the company’s
rewards in different future possibilities between the founders and the investors and
also to assign decision rights that sets the future direction of the company.
3
This contract flowchart is built based on the Foundry Group’ standard contract documents.
Figure 4.2: Flowchart for convertible note contract
35
Figure 4.3: Flowchart for Series A Investment Contract
36
Chapter 5
Design of Venture Capital
Contracts
“I prefer true but imperfect knowledge, even if it leaves much undetermined and unpredictable, to a pretense of exact knowledge that is likely to be false.”
Friedrich A. von Hayek (b. 1899)
The objective of this chapter is to help make contracts more accessible to decision
makers by illustrating a framework for valuing and designing contracts. In this subject, I take an asymmetrically prescriptive-descriptive approach [17]; I study contract
valuation and design as a decision analyst supporting a decision maker given a descriptive view of the counterparty(s) in the contract. A contract details the transfer
of valuable properties between contracting parties depending on different future possibilities. Contract design is making a decision on the specifications of the contract,
i.e., deciding on the future possibilities and the property transfer in these possibilities.
A future possibility can be a combination of decisions made by the decision maker,
actions taken by the counterparty(s) or events outside their control.
I apply decision analysis to the contract design problem. Given the peculiarity of
different contractual settings, I focus on the study of a specific contract design problem, that of venture capital investment contracts. This analysis should, nevertheless,
37
CHAPTER 5. DESIGN OF VENTURE CAPITAL CONTRACTS
38
be insightful to the study of other contractual settings.
5.1
Decision Analysis Process
Decision analysis prescribes a process that “ transform an opaque decision problems
into transparent decision problems by a sequence of transparent steps” [24]. It is
a common misconception to think that decision analysis process is limited to the
construction and analysis of formal mathematical models. Decision analysis process should be viewed as a continuous conversation between a decision maker and
a decision analyst aimed at guiding the decision maker toward clarity of action; the
mathematical model is only a subset of the process. The process, illustrated in Figure
5.1, consists of three phases: formulation, evaluation and appraisal 1 .
Figure 5.1: Decision Analysis Process
5.1.1
Formulation phase
The first step in the decision analysis cycle is to fit the decision situation to a formal
model called the “decision basis”. The decision basis has three parts: alternatives,
relevant information or uncertainties, and preferences. An important step leading to
the development of the formal model is an issue raising session where the decision
analyst, the decision maker and other stakeholders or experts come up with issues
1
I provide a short summary here. For further readings on the subject, refer to Mcnamee, Peter,
and John Celona. Decision Analysis for the Professional. SmartOrg, Inc., 2008. [25] and Howard,
Ronald A. Decision Analysis: Practice and Promise. Management Science 34, no. 6 (June 1, 1988)
[24].
39
relevant to the decision situation. The decision analyst can then lead a process to
formalize the issues into the decision bases using various framing tools.
Alternatives are the courses of action that the decision maker is considering at a
specific epoch of time. A decision maker might theoretically come up with a large
number of alternatives. The formulation phase prompts the decision maker to limit
his/her scope to the most meaningful set of alternatives. Decision hierarchy is a
useful tool for this purpose; it asks the decision maker to determine which decisions
should be taken as given, which ones should be analyzed now, and which ones should
be examined later. The strategy table is another tool used for narrowing the set of
alternatives.
The second part of the decision basis is information; the factors affecting the decision maker’s value in the future, for which the decision maker possesses incomplete
knowledge. If the decision maker has full knowledge of the future outcome of these
factors, the decision problem becomes a trivial one and a matter of preference among
the alternatives. The main difficulty in decision making arises from decision makers’
lack of knowledge about the future. Decision diagrams provide a graphical representation of the various uncertainties and decisions considered in the analysis and how
they affect one another as well as the decision maker’s value [26]. The last decision
basis element is the decision maker’s preferences; values and attitudes toward risk
and time.
5.1.2
Evaluation phase
In this phase, the decision basis is evaluated by a computational process to produce
the recommended alternative. The mathematical analysis can be divided into deterministic and probabilistic stages. In the deterministic stage, the decision analyst
builds a model which includes the alternatives and uncertainties determined in the
formulation phase. Then, the decision analyst can perform a deterministic sensitivity analysis to find the set of uncertainties with the highest impact. The decision
analyst can then start the probabilistic stage by eliciting the necessary probability
distributions. After that, the analyst produces the probability distribution over the
40
value measure and calculates the certain equivalent of each alternative. The best
alternative is the one that has the highest certain equivalent.
5.1.3
Appraisal phase
After identifying the best alternative in the evaluation phase, the analysis is appraised to gain more insights about the decision problem. This phase might reveal
some shortcomings of the analysis which call for further refinement of the formulation of problem. Specifically, sensitivity analysis can help the decision maker identify
conditions under which a different alternative should be chosen, value of information
analysis can help the decision maker determines if it is worth gathering more information before making the decision, and finally value of control analysis might suggest
improving the decision situation by exercising influence over some variables.
5.2
5.2.1
Background on Venture Capital Investment
Venture Capital Business Model
Venture capitalists are generally investors in technologically driven startups. Such
startups have a high probability of failure, but can yield a very high payoff if successful. Venture capitalists apply a staged investment process illustrated in Figure
5.2 2 . A large number of potential investments go through the filtration funnel and
only a few reach the contract negotiation stage. Venture capitalists spend less time
analyzing investments early in the funnel and more time in the due diligence and
negotiation stages.
2
The staged investment process is common among venture capitalists. This figure was obtained
during an interview with Clint Korver, a partner at ULU ventures.
41
Figure 5.2: Stages in the Venture Capital Investment Process
5.2.2
Dynamics of Contract Negotiation
A contract is established by an agreement of all contracting parties. An agreement
is usually reached via negotiation. Understanding the negotiation dynamic is essential for the contract design exercise. The dynamic of contract negotiation typically
differ in different settings. In venture capital contract negotiation, the most common
dynamic is as follows:
1. The VC proposes a partial contract, a contract with some negotiable items.
2. The negotiation happens on these specific items only.
3. If an agreement is not reached on these specific items, the deal falls apart and
VC walks away. There is no further negotiation.
While allowing for some interaction with the entrepreneurs, this negotiation dynamic sets the right negotiation time required for each deal.
5.3
42
Formulation of the Venture Capital Contract
Design Problem
I consider a decision analyst advising a venture capitalist on the design of an investment contract in a startup company. This investment opportunity has gone through
the early meetings and the due diligence process. The first step in formulating the
contract design problem is to determine the issues that the venture capitalist should
consider in an investment decision. A venture capitalist can develop and maintain a
checklist of issues that can arise in startup investments and use it as a guideline when
designing investment contracts. Table 5.1 shows an example checklist obtained from
surveying some venture capital investment contracts and from interviewing venture
capitalists.
Table 5.1: Issues in Startup Investments
Issues
Market size
Founders’ ability to develop the product
Founders’ ability to manage the startup’s
financials
Founders’ ability to grow the startup
Dilution
Early low-price acquisition
Changes in regulations
Legal cases against the startup
Others
Relevant in this
Deal?
Yes
Yes
Can be solved by
the contract?
No
No
Yes
No
Yes
Yes
Yes
Not really
Not really
No
No
Yes
No
Yes
The venture capitalists and the founders of the startup have already agreed to the
following about this investment opportunity:
• The company requires a $ 5M investment.
• The self-governing contractual system will be used for this deal.
43
• The venture capitalist will not try to form a syndicate for this deal.
5.3.1
Alternatives
At this point of time, the venture capitalist has two decisions to make. First, he should
decide whether to enter the contract negotiation stage or walk away from the deal.
Entering the negotiation is an option but not an obligation to invest in this startup.
The option price is mainly in the form of time and effort. The exercise price is the
investment amount, $5M. The underlying uncertainty of this non-contractual option is
the results of the negotiation 3 . The alternative of not acquiring this non-contractual
option is spending the time and effort in pursuing other investment opportunities; the
venture capitalist estimates the value of this alternative to be $17M 4 . So, the venture
capitalist won’t enter the negotiation unless he believes that the certain equivalent of
doing so is greater than or equal to $17M.
Given the venture capitalist’s decision to enter the negotiation, he needs to choose
the partial contract to propose for the negotiation. In a dialog between the venture
capitalist and the decision analyst, working with the checklist in Table 5.1 and taking
into consideration the investment market conditions, the venture capitalist and the
decision analyst come up with two alternative partial contracts shown in table 5.2 and
5.3. Both contracts have one negotiable item, X, which is the pre-money valuation of
the company; equivalently the number of shares or the percentage ownership awarded
to the venture capitalist at the time of investment 5 .
The first alternative in Table 5.2 can be thought of as “plain vanilla” standard
3
For further discussion on the subject of options, see Howard, Ronald. Options (May 1995). [27].
For the use of options in negotiation, see Skaf, Mazen. The Use of Financial Engineering and Real
Options in the Design of Negotiated Agreements. Stanford University, Stanford, CA, 1999. [28]
4
Venture capitalists face a capacity constraint problem, they can only focus their attention on a
limited number of deals. Deciding to negotiate a contract means that venture capitalist’s available
capacity is reduced by one. Assuming the exponential or linear u-curves, $17M is the value of
having this unit of capacity going forward. This problem is commonly known as dynamic stochastic
knapsack problem. For further discussion on this problem in the context of venture capital investment
decisions, refer to Almojel, Ibrahim Saad. Valuation of Fleeting Opportunities, 2010. [29]
5
These two alternative contracts are simple version of the widely used contracts discussed in
the previous chapter, which are contingent on more events. In the convertible notes and Series-A
contracts, the number of shares awarded to the investor is a function of different future events.
44
contract. The venture capitalist thinks that the company has a high standard governance system and a good management team and this proposed contract does not
ask for any changes. The second alternative in Table 5.3 is designed in response to
the following pieces of information that the venture capitalist learned during the due
diligence process.
Table 5.2: Partial Contract (CT=1)
Possibilities
The following closing conditions are
true on the closing date
• Representation of the company
Money
Common Stock
Investor → Company
$1M
Company → Investor
X
0
0
• Representation of the investor
Not True
Table 5.3: Partial Contract (CT=2)
Possibilities
The following closing conditions are
true on the closing date
Money
Common Stock
Investor → Company
$1M
Company → Investor
X
0
0
• Representation of the company
• Representation of the investor
• The charter of the company is
amended to reflect the following:
The investor can veto any sale or
merger of the company.
Not True
• The company has characteristics that make it a potential target for acquisition.
45
In fact, the venture capitalist learned through his network that a specific firm
might be interested in making an acquisition offer for an amount around $30M
within the next few months.
• The venture capitalist conducted research on the founder of the company to
understand if he would agree to sell the company at such a valuation. He
learned that the founder is a visionary entrepreneur and a great manager but
he is not originally from the area; he came to attend graduate school at Stanford
and stayed after that. He reportedly told his friends many times that he would
love to cash out one day and go back to his family.
In a dialog with the decision analyst, the venture capitalist states that the choice
among the available alternatives is not obvious because of various uncertainties,
namely, the outcome of the negotiation, the likelihood of an acquisition offer and
whether the board would approve it, the future value of the startup if it is not acquired, and the dilution. In order to determine the best alternative, the decision
analyst develops a decision diagram to connect the factors affecting the venture capitalist’s decision situation.
5.3.2
The Decision Diagram
The decision diagram in Figure 5.3 shows the various decisions and uncertainties and
the relationship between them in the venture capitalist’s decision situation. The ovals
represent the uncertainties and the rectangles represent the decisions. An arrow between two uncertainties indicates a possible probabilistic relevance between them, an
arrow from an uncertainty to a decision indicates that the outcome of the uncertainty
will be known before the decision and an arrow from a decision to an uncertainty
indicates that the probability distribution of the uncertainty is a function of the decision. The value node is a deterministic function of the distinctions pointing to it.
The following is description of the distinctions shown in the diagram.
• Acquisition offer: The venture capitalist believes that there is 80% probability
that the company will receive an acquisition offer in the next six months for an
46
Figure 5.3: Decision Diagram for Venture Capital Contract Design Problem
amount around $30M.
• Approval of an acquisition offer: Given that the startup receives an acquisition offer, the probability that the board of directors would accept the offer is
40%.
• The veto decision: If the startup receives an acquisition offer and the board
approves it, the second contract (Table 5.3 ) gives the investor the power to veto
the board’s decision. The first contract (Table 5.2 ) does not give the venture
capitalist this power.
• Long term exit value: If the startup is not acquired, the venture capitalist
estimates that the startup needs about five years to be ready for an exit. The
startup has had early stage success; its main product is working and has attracted some visionary customers. Yet, the future is still very uncertain. The
47
decision analyst and the venture capitalist develop a model to estimate the
probability distribution of the future value of the startup; Figure 5.4 shows the
probability distribution on the long term exit value of the startup 6 . Further,
the decision diagram shows that the venture capitalist believes that given his
background knowledge, the long term exit value of the startup is irrelevant to
whether the startup receives an acquisition offer within the next six months or
not.
Figure 5.4: Probability distribution on the discounted long-term exit value of the
startup
• Dilution: Dilution is an important factor affecting the venture capitalist’s
return. The venture capitalist’s percentage ownership of the firm is his percentage ownership at the time of investment multiplied by the dilution factor,
0 < d < 1. If the startup is successful, it will likely raise more capital in the
future and therefore create more dilution, hence the relevance between the exit
value and the dilution events. Figure 5.5 shows the conditional probability distributions of dilution given two different levels of the long-term exit value of the
6
This probability distribution was derived from a model developed by Clint Korver. The model
is a generic decision diagram to value startup investment opportunities at ULU ventures.
48
startup.
(a) Given ”Home run” exit
(b) Given ”OK” exit
Figure 5.5: Probability distribution on dilution given exist value
• Negotiated pre-money valuation: The event that the agreed upon premoney valuation of the startup will be X = x. The venture capitalist can
directly express his belief about this distinction, but this could be a difficult
exercise which might potentially lead to inaccurate results. In the next section,
I devise a longer but more intuitive assessment procedure using the zone of
possible agreement (ZOPA) concept. An important feature of this procedure is
that it forces decision makers to think deeply about the negotiation dynamics
and strategies. This assessment procedure requires the introduction of a new
distinction, “Agreement reached?”, the event that the two parties will reach an
agreement given that the venture capitalist proposed a specific partial contract
to the negotiation.
5.3.3
Assessment Procedures for the Negotiation Uncertainties
The decision analyst starts by asking the venture capitalist to think of the zone of
possible agreement for the negotiable item, the pre-money valuation of the company,
shown in Figure 5.6. H is the highest valuation that the venture capitalist is willing
49
to accept, the pre-money valuation that would make the venture capitalist indifferent between accepting the deal and walking away from the negotiation. The certain
equivalent of the deal at this point is equal to that of the BATNA, the best alternative to a negotiated agreement. The venture capitalist estimates his BATNA to be
$15M. Further, L is the lowest valuation that the founder would accept. At point
L, the founder is indifferent between accepting the deal and walking away from the
negotiation. ZOPA exists if H ≥ L, the blue region of the graph.
ZOPA
L
H
Pre-Money Valuation
Figure 5.6: Zone of Possible Agreement
Assessment of the Probability of Agreement
In order to find the probability of agreement given each alternative partial contract,
the decision analyst goes through the following process:
1. Calculate the indifference point H. This point can be calculated on the decision
diagram in Figure 5.3 using a simple algorithm: change the value of the negotiable item “pre-money valuation” until the certain equivalent of the deal given
agreement equals the certain equivalent of the deal given no agreement, the
certain equivalent of BATNA. The venture capitalist need not engage in this
step. The result is H(CT=1)= $27M and H(CT=2)=$36.7M; the maximum
pre-money valuation that the venture capitalist is willing to accept with the
first contract is $27M but he is willing to accept up to $36.7 with the second
contract.
2. Assess the probability distribution on L, {L | CT, & }. What valuation point
does the venture capitalist think that the founder would be indifferent between
50
walking away and accepting the deal for each of the alternative partial contract?
Here, the venture capitalist needs to take the perspective of the founder and
think of his indifference point. He won’t likely know the point exactly but can
express his belief in the form of a probability distribution. Figure 5.7 shows the
assessments of this distinction given the two alternative partial contracts. The
venture capitalist thinks that the founder will probably demand higher valuation
of the startup if the second contract is proposed. The venture capitalist arrives
at these probability distributions by thinking about the status of the funding
market and the possible competing offers, his reputation compared to other
investors, the founder’s personality, etc. Further, given the uncertainty about
L, we see that ZOPA is not actually known, there is ZOPA for each value of L.
{L|CT = 1, &} ∼ N (20, 5)
{L|CT = 2, &} ∼ N (25, 5)
H(CT = 1) = $27M
Pre-Money Valuation
H(CT = 2) = $36.7M
Figure 5.7: Uncertainty about the Counterpart’s indifference point
3. Assess the probability of agreement given that H and L are known, {Agreement |
L, & }. It might be obvious that if L ≥ H, the probability of agreement is zero.
But even if H ≥ L, contracting parties may not manage to reach an agreement.
The venture capitalist believes that there is 10% probability that the parties
will not reach agreement even if there is some area of possible agreement.
(
{Agreement|L, &} =
0.9
0
if H ≥ L
otherwise
51
4. Derive the probability of agreement given the proposed contract. This can be
calculated from the probability distributions given in the previous two steps.
Z
{Agreement|L, CT, &} ∗ {L|CT, &}
{Agreement|CT, &} =
(5.1)
L
The result is that {Agreement | CT=1, & } = 83% and {Agreement | CT=2,
& } = 89%. So, it is more likely to reach an agreement if the venture capitalist
proposes the second contract.
Assessment of the Probability Distribution on the Pre-Money Valuation
Given Agreement
If we know that an agreement is reached, what would be the agreed on pre-money
valuation of the company? To find the probability distribution on this variable, the
decision analyst needs to make one additional probability assessment and a calculation
step as outlined below.
1. Assess the probability distribution { X=x | Agreement, CT , L, &}. The venture
capitalist thinks that regardless of the type of the contract being negotiated,
the outcome of negotiation will be uniformly distributed in the zone of possible
agreement. In other words, the outcome of the negotiation could be any point
between H and L 7 .
(
{X = x|Agreement, CT, L, &} =
1
H−L
0
if L ≤ x < H
otherwise
2. Derive the probability of { X=x | Agreement, CT, &} using the following equation. All the distributions in the equation are already known from the previous
7
This assessment reflects the negotiator’s ability to manage the negotiation. For example, a more
experienced negotiator might believe that the outcome of the negotiation will be more skewed to his
favor.
52
steps.
Z
{X = x|Agreement, CT, &} =
{X = x|Agreement, CT, L, &}{L|CT, Agreement, &}
L
(5.2)
Z
{X = x|Agreement, CT, L, &}
=
L
{Agreement|CT, L, &} ∗ {L|CT, &}
(5.3)
{Agreement|CT, &}
Figure 5.8 shows the discretized probability distribution of the the negotiated
pre-valuation given that an agreement has taken place and given the proposed
partial contract. It is more likely to reach an agreement by proposing the
second partial contract to the negotiation, yet the agreement on the pre-money
valuation will likely be less favorable to the venture capitalist.
(a) Given CT=1
(b) Given CT=2
Figure 5.8: {X = x|Agreement, CT, &}: Probability distribution on the pre-money
valuation given agreement and given the proposed contract
5.4
53
Evaluating the Decision
At this point, the decision analyst evaluates the decision diagram. Figure 5.9 shows
the cumulative probability distributions of the venture capitalist’s alternatives; for
each point x on the X axis, a CDF curve returns the probability that the value of
the deal will be less than or equal to x. The shape of the CDFs is typical in venture
capital investments; there is a high probability of failure and a small probability of
very high return. Because there is not a dominating alternative, the analyst needs to
calculate the certain equivalent or the expected value of the alternatives. The venture
capitalist likes to behave as a risk neutral decision maker in the range of prospects.
So, the expected value is calculated for each alternative as shown in Figure 5.10.
The recommendation is that the venture capitalist should enter the negotiation and
propose the second partial contract (Table 5.3), which requires the startup to give
the venture capitalist the power to veto any proposed acquisition of the company.
Figure 5.9: Cumulative Distribution Function (CDF): {X ≤ x|&} the probability
that the net value to the venture capitalist is less than or equal to x. The X axis is
truncated at $350M.
54
Figure 5.10: Expected Value of the Venture Capitalist’s Alternatives
5.5
Appraising the Analysis
In order to produce a sound recommendation, the decision analyst performs sensitivity
analysis to check if the best alternative found in the evaluation phase might change
when the value of a variable changes. Sensitivity analysis also communicates general
interesting insights about the design of venture capital contracts.
First, the board’s acceptance of an acquisition offer is a major uncertainty in the
contract design problem. Currently, the venture capitalist believes the probability of
this event is 40%. Figure 5.11 shows the sensitivity analysis to this variable. The
best alternative changes to the first partial contract if the probability is below 30%.
Given that, the venture capitalist may want to examine this uncertainty further or
seek more information about it.
Moreover, some investors in the venture capital community are more influential
than others, in the sense that they can exert non-contractual influence in situations
like this one. For instance, members of the board of directors of the startup may
reject the acquisition offer because they value their future relationship with the investor. Therefore, an influential investor will assign a low probability on the board’s
acceptance of an acquisition offer and thus choose the first contract as shown in the
sensitivity analysis plot. This analysis illustrates that an investor’s choice of contract
55
Figure 5.11: Sensitivity analysis to the probability that the board will accept the
acquisition offer
can be a function of the investor’s social status or other personal characteristics.
Another important factor in contract design is the status of the investment market.
An expansion in the supply of funds to the industry will result in more competition
between venture capitalists, which will probably drive up startups’ valuation. It
might also affect investors’ choice of contracts. As discussed in this investment case,
the value of investment is a function of the negotiated pre-valuation of the startup
and is also a function of the closing conditions in the contract. When the venture
capitalist decides to enter the negotiation and propose the second partial contract
(Table 5.3), he is making a tradeoff between the value of the more stringent condition
and the possibility of investing at higher valuation reflected in the {L | CT, & }, the
valuation point at which the founder would be indifferent at between walking away
and accepting the deal.
In a different investment market condition, the venture capitalist’s belief about {L
| CT, & } may change and so his choice of the contract. Initially, the venture capitalist
assigned the following: {L|CT = 1, &} ∼ N (20, 5) and {L|CT = 2, &} ∼ N (25, 5).
Keeping {L|CT = 1, &} the same, Figure 5.12 shows a sensitivity analysis to the
mean of the distribution {L | CT=2, & }. When the investor proposes stringent
56
conditions, the founders might demand higher valuation in return. In an oversupplied
investment market, the founder can have the power to demand higher valuation. The
founder loses this power in an undersupplied investment market. This dynamic has an
influence the venture capitalist’s choice of contract. If the venture capitalist believes
that the mean of the {L | CT=2, & } is about $28M or higher, his decision will change
to proposing the first partial contract (CT=1).
Figure 5.12: Sensitivity analysis to the probability that the board will accept the
acquisition offer
At this point of the decision analysis cycle, the venture capitalist may decide
to proceed with the current recommendation or continue working with the decision
analyst to refine the analysis. Refining the analysis might include the introduction
of new alternatives, adding new uncertainties or updating information about existing
uncertainties.
5.6
57
General Discussion about Contract Design
The venture capital investment case provides a framework for the valuation and design
of contracts. While most researchers take symmetrically descriptive or prescriptive
approach and use game-theoretic models to study contract design, I take an asymmetrically prescriptive/descriptive research orientation and apply decision analysis
to this problem. I study the problem from the point of view of a single contracting
party given a descriptive understanding of the counterparty. The tools of decision
analysis enrich the study beyond the calculation of a single value measure. The goal
in decision analysis is to give the decision maker clarity about why a certain course
of action is best at this point of time. In the venture capital investment case, the
formulation stage and the issue raising dialog specifically may have been the most
important parts of the study for the purpose of achieving that goal. Finally, I believe
that having a systematic process for contract evaluation and design can prove to be an
important competitive advantage for companies that routinely engage in contractual
relationships like venture capital firms.
Chapter 6
Conclusion
“Knowledge exists potentially in the human soul like the seed in the soil; by learning
the potential becomes actual.”
Abu Hamid al-Ghazali (b. 1058)
6.1
Summary
Division of labor and exchange of goods and services lead to productivity and wealth.
Contracts are the medium facilitating future-oriented exchange transactions. Reducing the cost of contracting should promote more specialization of production and trade
activities. The main contribution of this research is the development of a marketbased contractual system that allows contracts to be managed by private entities in
a competitive market.
Chapter 1 motivated the research and reviewed relevant literature. In chapter 2, I
presented the self-governing contractual system. A contract in this system is defined
as a transfer of the titles to properties depending on different future possibilities.
This system requires intermediaries between the contracting parties: the Resolver to
decide the outcome of events included in the contract and an escrow agent to secure
the evidence of titles to the properties and transfer them in the future according to
58
CHAPTER 6. CONCLUSION
59
the contract and the Resolver’s decision. A private entity, a contract management
firm, can provide the services of a Resolver and of an escrow agent. Many such entities
can compete in the marketplace. In chapter 3, I briefly discussed economic aspects
of the contract management market.
In chapter 4, I developed the contract flowchart as a visualization tool for contracts. The contract flowchart represents a contract as a sequence of instructions to
resolve events and make property transfer between the contracting parties over time.
Visual contracts should enhance the process of designing, negotiating and managing contracts. In Chapter 5, I applied decision analysis to the problem of designing
venture capital investment contracts.
6.2
Areas for Future Research
Future work on the subject should be focused on the practical implementation of the
self-governing contractual system.
• In chapter 2, I briefly discussed the legal status of a contract management firm
and showed that it can operate as an arbitration agency. This area requires
deeper investigation. For example, are there potential legal obstacles and corner
cases? How should international transactions be handled?.
• An interesting area of study is the competitive environment and the strategic
decisions facing a contract management firm. For example, should the firm
specialize in one type of contract or offer a wide range of contracts? What standards should the firm use when developing contracts? How can the firm control
the cost of managing contracts? What pricing strategy should be used? How
to educate customers about the value of using the self-governing contractual
system?
• As part of this study, I studied venture capital investment contracts. I presented a visual representation of a couple of venture investment contracts. I
also illustrated a process for designing venture investment contracts. While I
CHAPTER 6. CONCLUSION
60
think venture investment contracts deserve further research, future work can
be focused on other types of contracts such as supply chain contracts, employment contracts, . . . etc. The objective is to communicate to people that
contracts, in the legal system or in the self-governing contractual system, have
the same structure, a transfer of property in different future possibilities. The
way contracts are written today does not show this structure. Effectively communicating this idea is an important step toward moving to the self-governing
contractual system.
Chapter 7
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a decision analytic proposal for a self

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