Venture Capital on the Downside: Preferred Stock and Corporate Control

TLDR: In this article, the authors examine the law and economics of downside arrangements in venture capital contracts and evaluate the risk of exposure to issuer opportunism in downside situations, reviewing contract terms employed in VC transactions and the caselaw on preferred stock.

Abstract: This paper examines the law and economics of downside arrangements in venture capital contracts. Downside protection for a venture capitalist means two things-first, power to replace the firm's managers (or alternatively, to force sale or liquidation of the firm), and, second, power to protect the venture contract itself from opportunistic amendment. Recent empirical work by Kaplan and Stromberg shows that venture capital investments possess this protection in varying degrees, depending on the mode of their participation and the governing contracts' terms. The venture capitalist remains vulnerable in a significant number of cases, lacking voting and boardroom control and relying entirely on terms articulated ex ante in the preferred stock contract. In these cases, there arises a risk of exposure to issuer opportunism in downside situations. The paper evaluates this risk, reviewing contract terms employed in venture capital transactions and the caselaw on preferred stock. A mixed picture emerges. The terms of venture capital contracts improve in significant respects on those of traditional preferred stock contracts. But they are not perfect and offer incomplete protection from issuer opportunism. Meanwhile, the caselaw is as hostile as ever. Delaware has taken the lead, sustaining a classic case of preferred stock victimization in a venture capital context. The paper criticizes this approach as a matter of both contract law and contract economics. Contract law's good faith duty can be used to protect venture capital preferred without a cognizable risk of unproductive judicial interference in corporate affairs. Furthermore, under the economics of incomplete contracts, where subject matter is noncontractible a blanket presumption against ex post intervention on the ground of forced contract is incoherent. Drawing on the control transfer model of Aghion and Bolton, the paper shows that efficient results and the interests of senior securityholders are aligned in a larger set of cases than previously supposed. Accordingly, when disputes between venture capitalists and entrepreneurs come to court, a rote presumption favoring the common stockholder is not defensible on efficiency grounds.