Venture capital funds, organizational law, and passive investors.

• Author: Gulinello, Christopher

1. INTRODUCTION

   The current orthodox view is that investors in U.S. venture capital funds are passive. (1) They delegate decision-making authority and other management responsibilities to the fund manager. (2) Legal scholarship on the U.S. venture capital market, however, has offered surprisingly little analysis on why venture capital fund investors are passive. (3) Furthermore, scholars have almost completely ignored the possibility that investors could be active in their fund's business. (4)

   The emphasis that scholarship has placed on passive investors in venture capital funds might cause one to assume it was a global phenomenon. In fact, it is not. The Taiwanese venture capital market, for example, is dominated by funds whose investors are active in decision-making and other aspects of the fund's business. (5)

   This Article does not directly challenge the view that investors in most U.S. venture capital funds are passive, (6) but it does question why a venture capital market in any jurisdiction would exhibit a preference for either active- or passive-investor funds. More specifically, this Article questions whether organizational law influences a venture capital market to develop a preference for either strategy. Indeed, when scholars have addressed the question of investor passivity in U.S. venture capital funds, they have tended to focus on how the preferred organizational form for U.S. venture capital funds, the limited partnership, contributes to investor passivity. (7)

   Against the backdrop of the U.S. experience, an initial glance at the Taiwanese venture capital market raises even more questions regarding the role of organizational law in creating a market preference for a specific management strategy. In Taiwan, where active-investor funds are prevalent, funds organize as corporations, not limited partnerships. The contrast between the Taiwanese and U.S. venture capital markets causes us to ask why passive-investor funds do not dominate in Taiwan as they do in the United States and whether organizational law has an influence on this difference. (8)

   Admittedly, there are strong arguments that organizational law should not influence a market preference for either management strategy. In most cases, a fund's choice of management strategy--active- or passive-investors--will determine the organizational form it chooses, not vice versa. That is to say, the limited partnership form will not influence a preference for passive-investor funds in a venture capital market. Instead, market conditions cause the participants in the market to prefer a passive-investor strategy and they then select the limited partnership because it suits their management strategy. Similarly, the corporate form does not influence a preference for active-investor funds in a venture capital market. Instead, participants in the market choose to pursue an active-investor strategy and then organize as corporations because the corporate form best meets the needs of their preferred management strategy.

   These arguments have obvious merit, but they assume that organizational law in every jurisdiction creates sufficient choice and flexibility for the parties. (9) When organizational law does not provide choice and flexibility, however, then it will influence the decisions of the parties in the market to pursue either active- or passive-investor strategies and contribute to a market preference for a particular strategy. Thus, although there may be many factors that contribute to the predominance of passive-investor funds in the United States and active-investor funds in Taiwan, we should not unquestioningly accept the status quo as efficient. Rather, we should consider whether organizational law hinders more efficient contract design.

   This Article analyzes whether organizational law has an influence on the development of a market preference for either active- or passive-investor venture capital funds. Indeed, organizational law will have such an influence, but only at the margin. Outside the margin, organizational law will not influence the creation of a preference, but it will often create additional transaction costs for the market. The practical implications are obvious for nations that may adjust their organizational laws to accommodate and promote burgeoning venture capital markets. Without an understanding of organizational law's influence on the venture capital market, legislative decisions to amend or retain current organizational laws may lead to suboptimal private ordering.

   This Article also explores private ordering within active-investor venture capital funds. If passive investment in venture capital funds is not inevitable, as the Taiwanese experience indicates, then we are confronted with the question of how the parties in active-investor funds reduce their transaction costs. Because existing scholarship has focused almost exclusively on passive-investor venture capital funds, there has been no discussion of the transaction costs of active-investor funds. Do the transaction costs of active-investor funds differ from those of passive-investor funds? If they do differ, what strategies do the parties employ to reduce them? What benefits do the parties receive from an active-investor strategy that may offset these costs? This Article attempts to provide a foundation for analyzing the transaction-cost strategies of active-investor venture capital funds.

   Part II of this Article discusses generally why parties choose either active- or passive-investor strategies. This Part explains the transaction costs of each strategy.

   Part III examines how organizational law influences the parties' choice between active- and passive-investor strategies, thereby contributing to a market preference for a particular strategy. It explores whether particular organizational forms, i.e., the limited partnership form and the corporate form, make it more difficult for parties to reduce the transaction costs or exploit the benefits of their preferred management strategy. Part III also discusses how the venture capital fund manager can reduce transaction costs specific to each of the active- and passive-investor strategies.

   Part IV further analyzes passive-investor venture capital funds. It asks whether the limited partnership control rule contributes to the efficiency of the U.S. venture capital market by reducing the transaction costs of passive-investor funds.

   Part V further analyzes active-investor venture capital funds by examining the Taiwanese venture capital market. This Part briefly discusses the factors, including organizational law, that may contribute to the popularity of the active-investor strategy in Taiwan. This Part, then, explores the strategies Taiwanese active-investor funds employ to reduce the transaction costs and maximize the net benefit of the active-investor fund.

2. THE COSTS AND BENEFITS OF THE ACTIVE- AND PASSIVE-INVESTOR STRATEGIES

   When parties plan to pool their resources to establish a firm--whether it is a venture capital fund or some other type of firm--they will naturally need to decide whether the investors will be active or passive in the management of the firm's business. (10) When the benefits of a particular management strategy, i.e., an active- or passive-investor strategy, outweigh its costs, then the parties will reap a net benefit under that strategy. Obviously, if one strategy provides a net benefit and another does not, then the parties will choose the strategy with the net benefit. When the parties are able to realize a net benefit with either an active- or passive-investor strategy, they will choose the strategy that provides the greater net benefit.

   When three friends decide to start a company, for example, their decision to act as the directors and the key management employees of the company may seem like an obvious choice, but there were other strategies available to them. Instead of running the firm themselves, they could have hired a management team and remained passive in the firm's business. They decided to be active-investors because their net benefit under an active-investor strategy outweighed their net benefit under a passive-investor strategy. (11)

   Parties who form a venture capital fund will engage in the same deliberation regarding whether the investors will be active or passive. We might make assumptions, based on our preconceived notions of venture capital funds, that the investors will decide to delegate all responsibility to the fund manager and remain passive in the fund's business decisions. This strategy may be very common in the U.S. venture capital market, but only because the participants in the market have determined that, under most circumstances, their net benefit under a passive-investor strategy will be greater than their net benefit under an active-investor strategy.

   There are various market factors that will influence a preference for active- or passive-investor funds in a particular venture capital market. For example, the market may have many institutional investors whose large, diversified investment portfolios make it impractical for them to participate in their funds. In contrast, a market may be dominated by corporate investors with expertise and industry connections that make them better candidates for active-investor funds than institutional investors would be.

   In addition, the number of qualified fund managers in the market may influence the number of active- or passive-investor funds. If there are fewer qualified managers, then there may be more funds with active investors whose expertise and industry connections supplement the performance of less qualified fund managers. Conversely, a greater number of qualified fund managers in the market may result in more passive-investor funds. (12)

   One could also imagine that the presence of entrepreneurs who want to protect their information and technology would negatively affect the creation of active-investor venture...