The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements

Abstract

This article examines covenants in 140 partnership agreements establishing venture capital funds. Despite the similar objectives and structures of these funds and the relatively limited number of contracting parties, the agreements are quite heterogenous in their inclusion of covenants. We examine two complementary hypotheses that suggest when covenants will be used. Covenant use may be determined by the extent of potential agency problems: because covenants are costly to negotiate and monitor, they will be employed only when these problems are severe. Alternatively, covenant use may reflect the supply and demand conditions in the venture capital industry. The price of venture capital services may shift if the demand for venture funds changes while the supply of fund managers remains fixed in the short run. The evidence suggests that both factors are important. This is in contrast to previous studies which have either focused exclusively on costly contracting or provided only weak support for the effects of supply and demand on contracts.