What is the role of legal systems in financial intermediation? Theory and evidence

https://doi.org/10.1016/j.jfi.2008.04.003Get rights and content

Abstract

We develop a theory’ and empirical test of how the legal system affects the relationship between venture capitalists and entrepreneurs. The theory uses a double moral hazard framework to show how optimal contracts and investor actions depend on the quality of the legal system. The empirical evidence is based on a sample of European venture capital deals. The main results are that with better legal protection, investors give more non-contractible support and demand more downside protection. These predictions are supported by the empirical analysis. Using a new empirical approach of comparing two sets of fixed-effect regressions, we also find that the investor’s legal system is more important than that of the company in determining investor behavior.

Introduction

The work of LaPorta et al., 1997, LaPorta et al., 1998, LaPorta et al., 2000 demonstrates the importance of the legal system for economic activity. Their work, and a large ensuing literature shows that countries with different legal origins also systematically differ in terms of their financial systems. In this paper we ask how financial intermediation is affected by the nature of the legal system, focusing specifically on venture capital. We look at how the entire relationship—contractual and non-contractual—between an investor and an entrepreneur depends on the legal system.

Since it is not immediately obvious how the legal system should affect this relationship, we let our analysis be guided by theory. We examine how optimal contracts, and the resulting investor behavior, depend on the legal system. We propose a simple theory that makes three predictions. First, the better the legal system the more investors provide value-adding support. The underlying intuition is that investing in support activities is only worthwhile if the legal system provides investors with sufficient guarantees that these efforts will not be wasted. Second, the better the legal system the more they demand contractual downside protection, using securities such as debt, convertible debt, or preferred equity. The main intuition is that in a better legal system it is optimal to give the entrepreneur stronger upside incentives. In order to satisfy their participation constraint, investors thus require additional cash flow rights on the downside. Third, we consider the influence of the legal system on intermediaries’ incentives to develop the competencies necessary to provide value added services, predicting that intermediaries from countries with a better legal system will provide more value added services, even when investing abroad.

To test the predictions of the theory, we use a hand-collected dataset on European venture capital investments for the period 1998–2001. We focus on venture capital as a specialized form of financial intermediation because prior research has already established the richness of relationships between venture capital firms and their companies.1 Venture capital investors can play a value-adding role in the companies they finance, both through contracting and by providing largely non-contractible inputs such as advice and support. Europe is an excellent testing ground for our purposes, since it consists of a set of comparable countries with reasonably mature venture capital markets, yet it features a rich variety of legal systems.

Our sample consists of 1431 venture deals from 124 venture capital firms in 17 European countries. Our primary data source is a comprehensive survey of all venture capital firms in these countries. We augmented the data with numerous secondary sources, including commercial databases and websites. This data collection effort required considerable time and effort but allowed us to gather a dataset that has several unique advantages. The dataset is considerably larger than other hand-collected datasets on venture capital, and is much richer than the commercially available databases; it also contains a significant number of investments that cross different legal systems. Moreover, it allows us to introduce to the literature a novel measure of the intensity of interactions between venture capitalists and entrepreneurs, a measure that cannot be obtained from standard sources of venture capital data (such as VenturExpert), nor from venture capital contracts.

We find clear empirical support for our theoretical predictions. Better legal systems are associated with more investor involvement and more downside protection for the investors. The results hold for legal origin, using the standard interpretation that the Anglo-Saxon common law system is better for investors than systems based on civil law. They also hold for two widely used index measures of the quality of the legal system: the rule of law and the degree of legal procedural complexity.

Our data allows us to examine whether the effects of legal systems come through the company or the investor, an issue that has not yet been fully answered in the prior literature. We introduce a novel empirical approach of determining the relative importance of company and investor legal system effects comparing two sets of regressions: one with company legal system variables and investor country fixed effect controls, the other with investor legal system variables and company country fixed effect controls. We find that company legal system effects are not robust to the introduction of investor country fixed effects, but that investor legal system effects are robust to the introduction of company country fixed effects. These results are consistent with the theoretical model prediction that investors from countries with stronger legal protection provide more support and demand more downside protection. They suggest that the legal system affects financial transactions not only directly, but also indirectly by affecting the practices adopted by financial intermediaries.

Our results provide new insights into how legal systems affect financial intermediation. In particular, they point to the importance of considering the relationship between investor and entrepreneur in its entirety, accounting both for contractual and non-contractual aspects. Moreover, the analysis shows how the legal system affects not only contracts, but also investors’ actions and their investment styles. These findings also have implications for our understanding of cross country differences in financial intermediation. We discuss these implications, and their relevance for policy, in the main body of the paper.

The paper is organized as follows. Section 2 addresses the relationship with the literature. Section 3 develops the theoretical model. Section 4 describes the data. Section 5 discusses the empirical results. It is followed by a brief conclusion.

Section snippets

Related literature

A few theoretical papers have begun to explore the relationship between legal systems and corporate finance choices. Shleifer and Wolfenzon (2002) examine a model where an entrepreneur wants to divert funds for private use. They show how the strength of the legal system affects the willingness to go public, and thus the equilibrium size of the capital market. Burkhart et al. (2003) consider how the legal system affects a manager’s ability to divert funds. They show that the willingness of an

Theory

The main objective of the theory is to motivate the empirical analysis and provide a conceptual framework for understanding the main empirical results. The model is based on the double moral hazard problem which has become the workhorse of the theoretical venture capital literature (Casamatta, 2003, Cestone, 2004, Hellmann, 2000, Hellmann, 2002, Inderst and Müller, 2004, Repullo and Suarez, 2004, Schmidt, 2003). Our main theoretical contribution is to introduce legal systems issue into such a

The data

In this section we discuss the sources and nature of our data. We want to point out that the European venture capital markets is a useful setting for testing our model. European countries are broadly comparable in terms of their stages of economic development. The European venture capital market has matured considerably throughout the 1990s, growing in size and in its ability to invest in innovative companies with a potential for high-growth (Bottazzi and Da Rin, 2002, Bottazzi and Da Rin, 2004

Main legal system effects

We are now in a position to empirically test our theoretical propositions. Our empirical base regression is as follows:

Yic=Legal*β1+Xiβi+Xcβc+εic, where i indexes investors and c indexes companies. The dependent variables Yic measures for investor i in company c the level of INTERACTION or DOWNSIDE. We use an ordered Probit model for INTERACTION, and a simple Probit model for DOWNSIDE. Xi is a vector of investor characteristics (INDEPENDENT-VC, VC-SIZE and VC-AGE), and Xc is a vector of

Conclusion

In this paper we develop a theory of how the legal system affects investor involvement and downside protection. Testing the theory on a hand-collected dataset of European venture capital deals, we confirm the model predictions. The evidence shows how the legal system affects not only the contractual, but also the non-contractual aspects of the financing relationship. These results show that the law and finance literature can gain new insights by adopting a wider perspective. Most of the

Acknowledgments

We are grateful to all the venture capital firms which provided us with data. We received valuable comments from the editor (Per Strömberg), anonymous referees, Reneé Adams, Giacinta Cestone, Vicente Cuñat, Steve Kaplan, Michele Pellizzari, Alessandro Sembenelli, Oren Sussman, and from seminar participants at the 2005 AFA Meetings in Philadelphia, CSEF (Salerno), IDEI (Toulouse), Lugano, Pompeu Fabra, Tilburg, UBC (Vancouver), at the ECGI Corporate Governance Conference (Oxford, 2005), at the

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