Design and Application in China of Trading Mechanism for Venture Capital

Due to the factors of asymmetric information and inconsistent interests, venture capitalists and venture entrepreneurs have the problem of principal-agent relationship. This paper mainly explores the design arrangements of four transaction structures, namely, phased financing, choice of financial instruments, corporate governance structure and gambling agreement, and their local practices in China. The analysis results show that due to the imperfectness of our legal system, the immaturity of the capital market environment and other objective conditions, some good system designs, such as convertible equity and gambling agreements, are facing many difficulties in their implementation. Therefore, even though China’s current venture capital is developing rapidly, the interests of China’s venture investors have not been properly protected and venture entrepreneurs have not received sufficient incentives and supervision. If the current situation is not changed, it will be unfavorable to the development of China’s venture capital industry in the long term.


Introduction
In recent years, China's venture capital has developed rapidly and has become the second largest venture capital center after the United States. The number of venture capital institutions such as venture capital funds, venture capital management institutions and the total amount of management capital are increasing. Although venture capitalists participate in the investment by means of equity, their main interest goal is to sell or list the invested projects and realize the realization of owner's equity, and they do not require to obtain the control right of the enterprise. However, venture entrepreneurs demand control and long-term development of enterprises. Then, how to reduce the efficiency loss of both venture capital parties caused by the principal-agent problem? According to the previous study, the solution to this problem is to solve it through transaction structure design such as betting agreement and participation in post-investment management. This article will further discuss the specific scheme of designing the transaction structure of both parties in venture capital and its practice in China.
According to the existing literature, there is a considerable gap in the application of the solutions to the principal-agent problem of venture capitalists and venture entrepreneurs in China. From the content point of view, previous studies have generally put forward a specific transaction mechanism as a solution, and have not systematically examined the relationship between the transaction mechanism and the legal environment in China's overall market. Methodologically speaking, the existing research focuses on the construction of mathematical models, and its research conclusion is not based on real cases, so it is impossible to construct a systematic theoretical system. Through literature review, this paper systematically sorts out the current relevant literature on the domestic ap- The structure of this paper is as follows. The second part will introduce four commonly used transaction structure design mechanisms in venture capital, including phased financing in the investment phase, the use of convertible financial instruments in the equity structure of venture enterprises, the distribution of shareholders' power and board seats in the corporate governance structure of venture enterprises, and a gambling agreement to coordinate the interests between management and investors. The third part is a summary of the whole article. The main conclusion is that good transaction structure design and post-investment management can effectively motivate the management. However, due to the imperfect domestic legal environment and immature capital market in China, the application of these transaction structure designs in China is restricted.

Investment Mode Design: Financing in Stages
Phased financing refers to that when venture capitalists invest in enterprise projects, they generally do not invest all the funds required by the enterprise or needed to complete its business plan at one time, but will adopt a gradual and multi-round investment process according to the actual situation of the enterprise. Venture capitalists will regularly evaluate factors such as the market prospect of the enterprise, the performance of the management and the realization of the stage objectives, and then decide whether to continue to invest, the amount of investment, the transaction price, the investment agreement, etc. [3].

Conversion of Control Rights: Choice of Financial Instruments
In the equity structure of start-up enterprises, the core team holds most of the equity. Enterprise management holds common shares, while venture capitalists usually hold preferred shares or convertible financial instruments. Generally, venture capitalists do not require holding shares, but the ultimate shareholding In the income structure of the management of the enterprise that accepts venture capital, equity income is the most important. The higher the profit of the enterprise, the lower the proportion of preferred shares converted into common shares by venture capitalists. However, the price per share increases due to the increase in profit, which can maintain a higher stock market value and realize a win-win situation. However, if the enterprise is not managed properly, not only will the share conversion ratio increase, but also the value of common shares will be greatly reduced after the dividend of preferred shares. From a system point of view, convertible financial instruments are a special interest adjustment mechanism between venture capitalists and the management of venture enterprises, which plays many roles such as controlling risks, protecting investors and encouraging the management of enterprises [8]. It has become the most commonly used investment tool for venture capitalists to invest in start-up enterprises.
Most companies listed in the United States use convertible preferred shares for financing, while most companies listed in Hong Kong use convertible bonds and common shares for financing, as for companies listed in the mainland, they basically use common shares for financing due to restrictions on the issuance of preferred shares and convertible bonds. Preferred stock, a common type of shares in western countries, has not been fully utilized in China, and the issuance of convertible corporate bonds and share option bonds is also subject to various restrictions. With regard to convertible preferred shares, China's current "Company Law" and "Securities Law" have not made corresponding legal provisions on the issue of convertible preferred shares (issue subject, issue conditions, issue scale and issue method, etc.). With regard to convertible bonds, although the relevant laws specify the operating procedures of convertible bonds and there are laws to be followed in implementing and promoting convertible bonds, strict restrictions have been imposed on the issuers of convertible bonds. Venture enterprises (mainly high-tech small enterprises) in the initial and growth stages are generally unable to meet the stringent conditions for issuing convertible bonds.
In addition to legal reasons, there are administrative reasons that hinder the widespread use of convertible preferred shares in China. Even if it is possible to use convertible bonds, the payment of interest is ignored only for future conversion. China is very sensitive to the change of ownership structure of unlisted companies and companies to be listed. The latest requirement of the CSRC is that there should be no major equity change within one year before the listing application is filed, and the responsible equity will be locked for three years after listing. However, the ownership change itself also requires a long approval period, which takes 4 -6 months in the departments of industry and commerce, taxation, commerce, etc. Long waiting may miss a good market environment, so the price of time paid for the conversion of common shares cannot be accepted by venture investors [9].

Corporate Governance Structure: Shareholder Power and Board Seats
Venture capital, as a resource-embedded capital, can exercise shareholders' power through equity or directors' power through the board of directors [10].
The exercise of shareholder power through equity is related to the shareholding ratio of venture entrepreneurs. Bottazzi    level and corporate performance is not significant. This shows that the venture capital industry in China still needs to be greatly improved [13].

Gambling Agreement
Gambling agreement originated from Anglo-American legal system and has been widely used in the field of venture capital in our country. It is also called valuation adjustment agreement. It refers to a series of financial terms and arrangements made by investors and financiers to ensure their respective interests.
Usually, the two parties take the performance index of the target company as the standard and make an agreement on the future uncertainty. If the agreed conditions appear, the investors shall exercise the valuation adjustment right to make up for the loss of overestimated enterprise value. On the other hand, the financier exercises a right to compensate for the loss of undervalued enterprises [14].
Specifically, the clauses in the gambling agreement can be broadly divided in- As a valuation adjustment mechanism, the gambling agreement coordinates the different interests of investors and management (or original major shareholders). First, financiers protect their own interests through the design of corresponding clauses, such as redemption clauses and restrictive clauses. Secondly, the enthusiasm of the management has been greatly improved by dynamically determining the ownership of the enterprise's income right or control right. The management must make every effort to reach the judgment standard, otherwise it will probably lose the control right or profit right of the enterprise. Finally, the common interests of both sides of this mechanism compromise the creation of enterprise value, which is conducive to the promotion of enterprise value [15]. whether the financier meets the agreed performance standard, the investor will get the corresponding return. This is obviously different from the content of the company investor sharing profits and risks according to the proportion of investment stipulated in China's "Company Law". Therefore, some people question the legal effect of the gambling clause [16]. Although the gambling agreement is an effective mechanism to balance the interests of investors and financiers, the legal soil for its application in China is not mature enough and the local legal environment needs further optimization.

Summary
The principal-agent problem between venture capitalists and venture entrepreneurs has always been a hot topic in the field of venture capital research. Chinese and foreign scholars have determined a series of institutional arrangements, and these transaction design structures have also been widely used in practice. Good transaction structure design and post-investment management can effectively motivate the management and unify the interests of management and shareholders, thus ensuring the financial value-added objectives of venture capitalists.
Establish and clarify the rules of procedure in advance between venture capitalists and team founders, and set up a supervision and restriction mechanism to prevent management from seeking maximum benefits at the expense of investors. In addition, it can also prevent market operation risks and legal risks, and transfer part of the market operation risks to the actual controllers of the enterprise to protect investors to a certain extent. Although there are many venture capital institutions in our country and the enthusiasm of venture investors and entrepreneurs is high, due to the imperfect domestic legal environment, immature capital market and other factors, which restrict the application of these transaction structure designs in our country, the interests of our country's venture investors have not been properly protected, and venture entrepreneurs have not received sufficient incentives and supervision. If the current situation is not changed, it will be unfavorable to the development of our country's venture capital industry in the long run.