Venture capital on the downside: preferred stock and corporate control.

• Author: Bratton, William W.

INTRODUCTION

When stock indices drop precipitously, when the startup companies fizzle out, and when it stops raining money on places like Wall Street and Silicon Valley, attention turns to downside contracting. Law and business lawyers, sitting in the back seat as mere facilitators on the upside, move up to the front and sometimes even take the wheel. The job is the same on both the upside and downside: to maximize the value of going concern assets. But what comes easily on the upside can be dirty work on the down, where assets need to be separated from dysfunctional teams of business people to stem the flow of red ink to disappointed investors. The team members rarely go quietly, no matter how unsuccessful. The outcome can turn on provisions in contracts entered into on the upside--cookie-cutter paragraphs in boilerplate forms, barely noticed when the cash flows easily.

This Article takes the occasion of the simultaneous collapse of the high technology stock market and the failure of the dot-com startups, (1) along with the subsequent retrenchment of the venture capital business, (2) to examine the law and economics of downside arrangements in venture capital contracts. The subject matter implicates core concerns of legal and economic theory of the firm. Debates about the separation of ownership and control, (3) relational investing, (4) takeover policy, the law and economics of debt capitalization, (5) and bankruptcy reform, (6) all grapple with the downside problem of controlling and terminating unsuccessful managers for the benefit of outside debt and equity investors (and the related upside problem of incentivizing effective but fallible managers). The factors motivating these debates also bear on venture capital contracting. But venture capital presents a special puzzle for solution. Convertible preferred stock is the dominant financial contract in the venture capital market, (7) at least in the United States. (8) This contrasts with other contexts in corporate finance, where preferred stock is thought to be a financing vehicle long in decline. The only mature firms that finance with preferred, which once was ubiquitous in American capital structures, tend to be firms in regulated industries having little choice in the matter. Tax rules favoring debt finance provide the primary explanation for preferred's decline. But many corporate law observers would suggest dysfunctional downside contracting as a concomitant cause. Simply, preferred performs badly on the downside, where senior security contracts supposedly are at their most effective. Preferred stockholders routinely have been victimized in distress situations by opportunistic issuers who strip them of their contract rights, transferring value to the junior equityholders who control the firm's management. The cumulation of bad experiences adds impetus to a wider trend in favor of debt as the mode of senior participation.

Venture capital finance is the exception to the trend. With preferred stock as the investing vehicle of choice, the number of venture capital funds increased from thirty-four with capital of $1.69 billion in 1991 to 228 funds with committed capital of $67.7 billion in the peak year of 2000. (9) Given preferred stock's history of contract failure, two questions arise. First, why do American venture capitalists employ preferred instead of debt or common stock, and second, how, if at all, do venture capital preferred contracts solve or avoid downside failure? This Article draws on the economics of incomplete contracts to offer answers to these questions.

The first line of downside defense for any outside source of capital is not closing in the first place. Venture capital contracts employ this defense to the utmost, staging the drawdowns of funds over time and conditioning the funding commitment on performance targets. If the stock issuer misses its target, the venture capitalist has the option of refusing further funds. The venture capitalist's final line of downside defense lies in its preferred stock redemption rights and liquidation preference. Venture capital investments tend to have an intermediate duration. If after five years or so the stock issuer has not produced a payoff in the form of an initial public offering, the venture capitalist has the backstop right to have its stock redeemed at the purchase price. That right implies a power to terminate an issuer unable to fund the redemption, along with priority rights respecting remaining assets.

Between these two lines of defense there lies a middle ground where downside protection may also be needed. This is the ground taken up in this Article. Here downside protection for a venture capitalist means two things--first, power to replace the firm's managers (or, alternatively, to force premature sale or liquidation of the firm), and second, power to protect the venture contract itself from opportunistic amendment. Venture capital investments possess this protection in varying degrees, depending on the mode of their participation and the governing contracts' terms. At the best-protected end of the range of possibilities lie transactions where the venture capitalist holds a majority of the voting shares, whether common or preferred. This imports control of the board and all necessary power to effect results in the firm. Thus situated, a holder of venture capital preferred can block any opportunistic stripping of its priorities and need not overly concern itself with the completeness of the protections specified in its contracts. At the opposite, least-protected end of the range of possibilities lie transactions where the venture capitalist holds preferred in the absence of either a voting stock majority or control of the board of directors. With no control whatsoever, the venture capitalist has the burden of extracting protection in the form of express terms of the type conventional in contracts governing senior securities--promises to pay, negative covenants, liquidation provisions, conditions on commitments to make additional investments, and so forth. In many cases these provide a cumbersome, unreliable means to achieve the fundamental downside objective of removing managers or forcing a sale. To see why, consider the archetypical case of a payment default on a bond contract. This is a governance event because as a practical matter it forces a bankruptcy reorganization. But Chapter 11 is designed in the first instance to prevent the removal of managers and to avert a sale of the business. The proceeding will be controlled initially by the incumbent management, which will be biased toward the status quo and will lack a strong commitment toward protecting the contract rights of senior securityholders. (10)

Until recently, academic observers assumed that venture capitalists always insist on full protection, taking voting control of their portfolio companies' shares and dominating their boardrooms. (11) New empirical work shows that venture capitalists emerge with such full control at both the shareholder and board level in only a significant minority of cases. (12) In another significant minority of cases, the venture capitalist emerges at the vulnerable end of the range of protection, lacking voting and boardroom control and relying entirely on terms articulated ex ante in the preferred stock contract. In these cases, a risk of exposure to issuer opportunism arises.

This Article evaluates this risk, reviewing contract terms employed in venture capital transactions and the case law 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 they offer incomplete protection from issuer opportunism. Meanwhile, the case law is as hostile as ever. Delaware has taken the lead, sustaining a classic case of preferred stock victimization in a venture capital context. This Article 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. The discussion also suggests that Delaware's adherence to the traditional patterns of treatment of preferred is short sighted. Venture capital contracts present a unique alignment of financial and governance interests. A responsive legal regime seeking venture capital incorporations will tailor its contract and fiduciary principles accordingly, developing an even-handed framework in which to arbitrate disputes.

VENTURE CAPITAL CONTRACTS--THE CONTROL RANGE Traditional Shared Control Full Voting Contracts Control Power to Weak Incomplete Full Control Assets Contracting Exposure to Yes No (stock majority) No Contract Yes (stock minority) Opportunism The most likely venture capital transaction structure entails neither full protection nor classic preferred stock vulnerability. In the majority of transactions, the venture capitalist emerges at a midpoint on the protection range, sharing control with the entrepreneur. Here the defining characteristic is an open-ended balance of power in the boardroom. The venture capitalist accordingly gets no unilateral power to control the assets and terminate the entrepreneur on the downside. Instead these matters are left open to contest. In a majority of this subset of transactions, the venture capitalist takes a majority of the voting stock even though it does not take a majority of board seats. The stock majority imports determinative protection against the stripping of contract rights. In a significant minority of these shared-control transactions, however, the entrepreneur holds a minority of the shares with control in the boardroom being shared. This arrangement opens up a possibility of exposure to opportunism respecting the preferred stock contract.

In sum, in a majority of venture...