Venture capital on the downside: Preferred stock and corporate control

Michigan Law Review

Volumn 100, Issue 5, 2002, Pages 891-945

  Bratton, William W ^a  

^a NONE

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EID: 0345757422     PISSN: 00262234     EISSN: None     Source Type: Journal    
DOI: 10.2307/1290501     Document Type: Article

References (178)

1. In the first seven months of 2001, 367 internet companies went out of business, and nearly 83,000 dot-com employees were laid off. One result was a marked uptick in applications to business school. Big Ex-Techies On Campus, BUS. WK., Aug. 13, 2001, at 8.
2. See Mark Heinzl, Starting Gate, WALL ST. J., July 16, 2001, at B5 (reporting that U.S. venture capital investments in the first quarter of 2001 were $11.7 billion compared to $26.7 billion in the first quarter of 2000).
3. See, e.g., Michael C. Jensen, The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, 48 J. FIN. 831 (1993) (arguing that internal governance systems are failing at the task of achieving the downsizing and disinvestment needed by the wider economy).
4. See, e.g., Michael E. Porter, Capital Choices: Changing the Way America Invests in Industry, in STUDIES IN INTERNATIONAL CORPORATE FINANCE AND GOVERNANCE SYSTEMS: A COMPARISON OF THE U.S., JAPAN, AND EUROPE 5-17 (Donald H. Chew ed., 1997) (arguing for business and law reform toward the end of encouraging relational investing).
5. See, e.g., Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance and Takeovers, 76 AM. ECON. REV. PAPERS & PROC. 323 (1986) (arguing that managers put excess cash into suboptimal projects and need to be disciplined by high leverage and takeovers).
6. See, e.g., THOMAS H. JACKSON, THE LOGIC AND LIMITS OF BANKRUPTCY 209-24 (1986) (arguing that bankrupt firms should be put up for sale as going concerns rather than recapitalized).
7. See, e.g., William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J. FIN. ECON. 473 (1990); Jeffrey J. Trester, Venture Capital Contracting Under Asymmetric Information, 22 J. BANKING & FIN. 675 (1998).
8. See, e.g., William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J. FIN. ECON. 473 (1990); Jeffrey J. Trester, Venture Capital Contracting Under Asymmetric Information, 22 J. BANKING & FIN. 675 (1998).
9. Douglas J. Cumming, The Convertible Preferred Equity Puzzle in Canadian Venture Capital Finance (SSRN Elec. Paper Coll. No. 218352, 2001), at http://papers.ssrn.com/abstract=218352, reports that preferred is not extensively utilized in Canadian venture capital financing. This is even true with respect to U.S. venture capital firms' investments in Canada. Douglas Cumming. United States Venture Capital Financial Contracting: Evidence from Investments in Foreign Securities (SSRN Elec. Paper Coll. No. 288111, 2002), at http://papers.ssrn.com/abstract=288111. D. Gordon Smith & Annaleena Parhankagas, Conflict Management in the Entrepreneur-Venture Capitalist Relationship: An International Comparative Study (working paper on file with author, June 2000) makes the same report for Finland.
10. Douglas J. Cumming, The Convertible Preferred Equity Puzzle in Canadian Venture Capital Finance (SSRN Elec. Paper Coll. No. 218352, 2001), at http://papers.ssrn.com/abstract=218352, reports that preferred is not extensively utilized in Canadian venture capital financing. This is even true with respect to U.S. venture capital firms' investments in Canada. Douglas Cumming. United States Venture Capital Financial Contracting: Evidence from Investments in Foreign Securities (SSRN Elec. Paper Coll. No. 288111, 2002), at http://papers.ssrn.com/abstract=288111. D. Gordon Smith & Annaleena Parhankagas, Conflict Management in the Entrepreneur-Venture Capitalist Relationship: An International Comparative Study (working paper on file with author, June 2000) makes the same report for Finland.
11. Douglas J. Cumming, The Convertible Preferred Equity Puzzle in Canadian Venture Capital Finance (SSRN Elec. Paper Coll. No. 218352, 2001), at http://papers.ssrn.com/abstract=218352, reports that preferred is not extensively utilized in Canadian venture capital financing. This is even true with respect to U.S. venture capital firms' investments in Canada. Douglas Cumming. United States Venture Capital Financial Contracting: Evidence from Investments in Foreign Securities (SSRN Elec. Paper Coll. No. 288111, 2002), at http://papers.ssrn.com/abstract=288111. D. Gordon Smith & Annaleena Parhankagas, Conflict Management in the Entrepreneur-Venture Capitalist Relationship: An International Comparative Study (working paper on file with author, June 2000) makes the same report for Finland.
12. Paul Gompers & Josh Lerner, The Venture Capital Revolution, 15 J. ECON. PERSP. 145, 151, tbl.1 & n.a. (2001). For a concise overview of all aspects of venture capital contracting, see Michael Klausner & Kate Litvak, What Economists Have Taught Us About Venture Capital Contracting (SSRN Elec. Paper Coll. No. 280024, 2001), at http://papers.ssrn.com/abs tract=280024.
13. Paul Gompers & Josh Lerner, The Venture Capital Revolution, 15 J. ECON. PERSP. 145, 151, tbl.1 & n.a. (2001). For a concise overview of all aspects of venture capital contracting, see Michael Klausner & Kate Litvak, What Economists Have Taught Us About Venture Capital Contracting (SSRN Elec. Paper Coll. No. 280024, 2001), at http://papers.ssrn.com/abs tract=280024.
14. Under section 1121(c) of the Bankruptcy Code, the debtor in possession has the exclusive right to propose a plan during the first 120 days of a proceeding. Section 1129(a), (b) contemplates that seniors can be asked to give up value to juniors subject to the limit that seniors must at least receive liquidation value. 11 U.S.C. §§ 1121(c), 1129(a), (b) (1994).
15. See infra text accompanying notes 17-20.
16. Steven Kaplan & Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts, (SSRN Elec. Paper Coll. No. 218175, 2000), at http://papers.ssrn.com/abstract=218175.
17. Philippe Aghion & Patrick Bolton, An Incomplete Contracts Approach to Financial Contracting, 59 REV. ECON. STUD. 473 (1992). In so doing, it follows the suggestion of Kaplan & Strömberg, supra note 12, that the Aghion-Bolton model is the most cogent of the theoretical explications of venture capital relationships. Thomas Hellmann, The Allocation of Control Rights in Venture Capital Contracts, 29 RAND J. ECON. 57 (1998), makes the same commendation.
18. Philippe Aghion & Patrick Bolton, An Incomplete Contracts Approach to Financial Contracting, 59 REV. ECON. STUD. 473 (1992). In so doing, it follows the suggestion of Kaplan & Strömberg, supra note 12, that the Aghion-Bolton model is the most cogent of the theoretical explications of venture capital relationships. Thomas Hellmann, The Allocation of Control Rights in Venture Capital Contracts, 29 RAND J. ECON. 57 (1998), makes the same commendation.
19. The fit between the Aghion-Bolton construct and the real world contracting pattern is not precise. In order to explain the ambiguous, shared control arrangements that dominate venture capital contracting, the model's menu of modes of control transfer and decisionmaking contingencies has to be expanded. This Article fills in the additional menu items.
20. For another discussion of the Aghion-Bolton model and the Kaplan and Strömberg results, see Oliver Hart, Financial Contracting, 39 J. ECON. LIT. 1079, 1084-90 (2001).
21. 705 A.2d 1040 (Del. Ch. 1997).
22. Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. FIN. ECON. 243, 253, 255-56, 260-61 (1998).
23. Id. at 257-64.
24. Id. at 261.
25. It also should be noted that the IPO is not the only means of VC exit on the upside. Four additional routes are available: (1) the VC can retain all or part of its shares and sell them into the trading market subsequent to the IPO; (2) the firm can be sold to a third-party acquirer, with the VC taking a share of merger consideration upon exit; (3) the VC can sell its shares to a third-party acquirer: and (4) the VC can sell its shares back to the issuer or to E. Any of these exits can be partial or full. For discussion of possibilities and practices, including empirical results in the U.S. and Canada, see Douglas J. Cumming & Jeffrey G. MacIntosh, The Extent of Venture Capital Exits: Evidence from Canada and the United States (SSRN Elec. Paper Coll. No. 250519, 2000), at http://papers.ssrn.com/abstract=250519. Cumming and MacIntosh suggest that the likelihood of exit increases over time; the value added by the VC declines as the firm matures, management becomes more seasoned, the firm's business contacts are put in place, and product development and marketing issues are resolved. D. Gordon Smith, Control Over Exit in Venture Capital Relationships (SSRN Elec. Paper Coll. No. 272231, 2001), at http://papers.ssrn.com/abstract=272231), studies the regulation of exit in venture capital contracts, showing that the VC comes to acquire control over exit over time.
26. It also should be noted that the IPO is not the only means of VC exit on the upside. Four additional routes are available: (1) the VC can retain all or part of its shares and sell them into the trading market subsequent to the IPO; (2) the firm can be sold to a third-party acquirer, with the VC taking a share of merger consideration upon exit; (3) the VC can sell its shares to a third-party acquirer: and (4) the VC can sell its shares back to the issuer or to E. Any of these exits can be partial or full. For discussion of possibilities and practices, including empirical results in the U.S. and Canada, see Douglas J. Cumming & Jeffrey G. MacIntosh, The Extent of Venture Capital Exits: Evidence from Canada and the United States (SSRN Elec. Paper Coll. No. 250519, 2000), at http://papers.ssrn.com/abstract=250519. Cumming and MacIntosh suggest that the likelihood of exit increases over time; the value added by the VC declines as the firm matures, management becomes more seasoned, the firm's business contacts are put in place, and product development and marketing issues are resolved. D. Gordon Smith, Control Over Exit in Venture Capital Relationships (SSRN Elec. Paper Coll. No. 272231, 2001), at http://papers.ssrn.com/abstract=272231), studies the regulation of exit in venture capital contracts, showing that the VC comes to acquire control over exit over time.
27. Significantly, the touchstone discussion of venture capital contracting, Sahlman, supra note 7, at 506, makes no assertion respecting the frequency of VC control. It does note the incidence of shared control in the boardroom.
28. Kaplan & Strömberg, supra note 12 (working paper at 17).
29. See, e.g., DEL. CODE ANN. tit. 8, § 141(a) (2001).
30. Or, in the case of the VC, a vote equal to the number of shares of common stock into which its shares are convertible.
31. Kaplan & Strömberg, supra note 12 (working paper at 59 tbl. 6, 60 tbl. 7).
32. OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE 146-48 (1995); see also Anat R. Admati & Paul Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. FIN. 371 (1994) (setting forth the fixed fraction model of venture capitalist participation).
33. OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE 146-48 (1995); see also Anat R. Admati & Paul Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. FIN. 371 (1994) (setting forth the fixed fraction model of venture capitalist participation).
34. See HART, supra note 27, at 146-48. The treatment of Hellmann, supra note 13, should be contrasted at this point. In that set up, E's private benefits from control may be outweighed by the upside prospects of a payoff on E's common stock in the firm, which payoff will be realized only if E gives up control.
35. For contributions to the literature making this point, see Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691 (1986); Oliver Hart & John Moore, Incomplete Contracts and Renegotiation, 56 ECONOMETRICA 755 (1988) [hereinafter Hart & Moore, Incomplete Contracts]; Bengt Holmstrom & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 J.L. ECON. & ORG. 24 (1991) (special issue) (showing that contracts that tie an agent's compensation to verifiable measures can divert effort and attention from other more important but less easily measured aspects of performance).
36. For contributions to the literature making this point, see Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691 (1986); Oliver Hart & John Moore, Incomplete Contracts and Renegotiation, 56 ECONOMETRICA 755 (1988) [hereinafter Hart & Moore, Incomplete Contracts]; Bengt Holmstrom & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 J.L. ECON. & ORG. 24 (1991) (special issue) (showing that contracts that tie an agent's compensation to verifiable measures can divert effort and attention from other more important but less easily measured aspects of performance).
37. For contributions to the literature making this point, see Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691 (1986); Oliver Hart & John Moore, Incomplete Contracts and Renegotiation, 56 ECONOMETRICA 755 (1988) [hereinafter Hart & Moore, Incomplete Contracts]; Bengt Holmstrom & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 J.L. ECON. & ORG. 24 (1991) (special issue) (showing that contracts that tie an agent's compensation to verifiable measures can divert effort and attention from other more important but less easily measured aspects of performance).
38. Unlike most law and economics, which tends to include any voluntary economic relation within its notion of the ex ante contract, incomplete contracts theory restricts the reach of the ex ante contract to cases where actors make explicit specifications about the future. That is, to have "contract" terms that govern future states, those contingent states must be specified and the future outcomes must be computable. Since many future states of nature clearly are not computable, transacting parties as a result lack the technology necessary to enable the negotiation and composition of a contract term ex ante. See Luca Anderlini & Leonardo Felli, Incomplete Written Contracts: Undescribable States of Nature, 109 Q.J. ECON. 1085 (1994).
39. See Aghion & Bolton, supra note 13, at 479.
40. Notably, "owner" is here specially defined as the party who has the right to control all aspects of the asset that have not been given over to contractual specification ex ante. Grossman & Hart, supra note 29, at 695. Under this definition, ownership and control cannot be separated, although they can be shared. Since asset control is ownership, residual claimants who do not manage are not owners, whatever the law's contemplation.
41. It should be noted that the basic assertions of the incomplete contracts school are a subject of debate in economic theory. See Eric Maskin & Jean Tirole, Unforeseen Contingencies and Incomplete Contracts, 66 REV. ECON. STUD. 83 (1999), for an argument that parties can indeed design contracts that overcome the problems the school describes as "noncontractible," and that irrelevance obtains as between an incomplete contract left open to ex post renegotiation and a contract with described trades. The response appears in Oliver Hart & John Moore, Foundations of Incomplete Contracts, 66 REV. ECON. STUD. 115 (1999) [hereinafter Hart & Moore, Foundations].
42. It should be noted that the basic assertions of the incomplete contracts school are a subject of debate in economic theory. See Eric Maskin & Jean Tirole, Unforeseen Contingencies and Incomplete Contracts, 66 REV. ECON. STUD. 83 (1999), for an argument that parties can indeed design contracts that overcome the problems the school describes as "noncontractible," and that irrelevance obtains as between an incomplete contract left open to ex post renegotiation and a contract with described trades. The response appears in Oliver Hart & John Moore, Foundations of Incomplete Contracts, 66 REV. ECON. STUD. 115 (1999) [hereinafter Hart & Moore, Foundations].
43. See Frank H. Easterbrook & Daniel R. Fischel, Contract and Fiduciary Duty, 36 J.L. & ECON. 425, 445 (1993) (asserting a presumption in favor of forcing parties to get their own contracts). At the same time, gaps can be filled in when the decisionmaker knows what the actors would have agreed on in a costless contracting environment. See, e.g., Jeffrey N. Gordon, The Mandatory Structure of Corporate Law, 89 COLUM. L. REV. 1549, 1550-52 (1989). To the author's knowledge, the latter principle has never been brought to bear to protect a senior securityholder.
44. See Frank H. Easterbrook & Daniel R. Fischel, Contract and Fiduciary Duty, 36 J.L. & ECON. 425, 445 (1993) (asserting a presumption in favor of forcing parties to get their own contracts). At the same time, gaps can be filled in when the decisionmaker knows what the actors would have agreed on in a costless contracting environment. See, e.g., Jeffrey N. Gordon, The Mandatory Structure of Corporate Law, 89 COLUM. L. REV. 1549, 1550-52 (1989). To the author's knowledge, the latter principle has never been brought to bear to protect a senior securityholder.
45. The dispute between Maskin & Tirole and Hart & Moore, see supra note 33, in part turns on whether the parties credibly can commit not to renegotiate. If they can, then the case for investing resources in advance specification strengthens. See Hart & Moore, Foundations, supra note 33, at 128.
46. See Aghion & Bolton, supra note 13, at 479. The model is applied in the context of a discussion of dividend policy in William W. Bratton, Dividends, Noncontractibility, and Corporate Law, 19 CARDOZO L. REV. 409, 429-34 (1997). For contrasting theoretical pictures of control transfer in senior-junior security holder contexts, see G. Mitu Gulati et al., Connected Contracts, 47 UCLA L. REV. 887, 908-18 (1999); D. Gordon Smith, Team Production in Venture Capital Investing, 24 J. CORP. L. 949 (1999).
47. See Aghion & Bolton, supra note 13, at 479. The model is applied in the context of a discussion of dividend policy in William W. Bratton, Dividends, Noncontractibility, and Corporate Law, 19 CARDOZO L. REV. 409, 429-34 (1997). For contrasting theoretical pictures of control transfer in senior-junior security holder contexts, see G. Mitu Gulati et al., Connected Contracts, 47 UCLA L. REV. 887, 908-18 (1999); D. Gordon Smith, Team Production in Venture Capital Investing, 24 J. CORP. L. 949 (1999).
48. See Aghion & Bolton, supra note 13, at 479. The model is applied in the context of a discussion of dividend policy in William W. Bratton, Dividends, Noncontractibility, and Corporate Law, 19 CARDOZO L. REV. 409, 429-34 (1997). For contrasting theoretical pictures of control transfer in senior-junior security holder contexts, see G. Mitu Gulati et al., Connected Contracts, 47 UCLA L. REV. 887, 908-18 (1999); D. Gordon Smith, Team Production in Venture Capital Investing, 24 J. CORP. L. 949 (1999).
49. See Kaplan & Strömberg, supra note 12.
50. b > K. In addition, there are only two possible returns r at t = 2, either 0 or 1, and the initial contract between E and VC may be renegotiated after the realization of θ, with all the bargaining power lying with E. Id. at 477-79.
51. The model assumes that both E and VC are risk neutral as to income. Id. at 476.
52. g
53. b entail a selection between a limited set of choices identifiable in advance - for example, either merger, liquidation, or sale of assets. But even given the feasibility of that sort of specification, ex post judicial enforcement of the contractual directive could still fall short of feasibility if information asymmetries led to problems of third-party verification. Aghion & Bolton, supra note 13, at 477-78.
54. Id. at 476-77.
55. Id. at 480-81.
56. The model assumes that the world is full of venture capitalists but contains only a few entrepreneurs with good projects. E as a result has all the bargaining power: E can make a take-it-or-leave-it offer which VC will accept so long as the deal holds out an expected return of at least K. Id. at 480-82.
57. See HART, supra note 27, at 98 (discussing the Aghion-Bolton model).
58. g).
59. g) + t.
60. g) ≥ K.
61. b).
62. b) + t.
63. See Aghion & Bolton, supra note 13, at 480-83. The CTM runs the VC control scenario with similarly equivocal results. Here first-best choices of action will follow only where the choice of a that maximizes y happens to be a*, meaning that VC's incentives are perfectly aligned with the general maximizing result. Where the choice of a that maximizes y is not first-best there can be room for Pareto-improving renegotiation in the form of a bribe paid to the actor in control by the actor disadvantaged by the suboptimal choice of a. But once again, it turns out that the optimal choice a* does not result in every case. The model's reasonable assumption of a wealth constraint on E's part (VC provides all of K) substantially limits the possibility of renegotiation where VC controls. Simply put, since b and t constitute E's entire wealth, E lacks the resources to make the bribe. For VC control to assure first-best results, then, the amount of t has to be set high enough to give E sufficient cash for the bribe. But this adjustment, in turn, returns us to the same place as the search for the first-best under E control. As t increases, projected investment returns to VC fall short of K at some point and VC refuses to invest. Id. at 483-84.
64. See, e.g., John C. Coffee, Jr., The Mandatory Enabling Balance in Corporate Law: An Essay on the Judicial Role, 89 COLUM. L. REV. 1618, 1664-65 (1989).
65. g. 54. Aghion & Bolton, supra note 13, at 484-86.
66. The precedent model is in Jaime F. Zender, Optimal Financial Instruments, 46 J. FIN. 1645 (1991).
67. Aghion & Bolton, supra note 13, at 487.
68. Provided there is not a significant amount of debt, which by definition is senior to VC's preferred stock, in the capital structure.
69. Mathias Dewatripont & Jean Tirole, A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence, 109 Q.J. ECON. 1027-28 (1994).
70. See, e.g., Edward I. Altman, A Further Empirical Investigation of the Bankruptcy Cost Question, 39 J. FIN. 1067 (1984) (estimating total bankruptcy costs to be 20% of the value of the firm).
71. See Dewatripont & Tirole, supra note 58. Although still a model denominated as a debt-equity model, it nonetheless captures the dynamic of a boardroom control transfer. This is another two-period contingent control model. Unlike the Aghion-Bolton model, this one includes outside debt and outside equity interests. Here, at t = 0, outside financing and incentive compensation arrangements are worked out and management chooses an effort level e. The level of e will be either high or low, with high e producing higher returns in later periods but resulting in the incurrence of a utility cost U to the managers. At t = 1 the firm reports its first period profit, np1, a verifiable amount that is determined by e, but which is not a sufficient statistic for e. In addition, a signal s is realized at this point. The distribution of signal s also is determined by e, and s is a sufficient statistic for the profit to be realized at t = 2, np2. But s is noncontractible and management compensation accordingly cannot be made directly contingent on it. This model's distinguishing assumption is that the firm's capital structure accords decisionmaking power to either the outside debtholder or the outside equityholder at a critical moment. More specifically, immediately after t = 1, the outside holder accorded this control power takes action a, which can either be acquiescence and continuance C in present management operations or stoppage S of management's continued pursuit of its business plan. Stoppage S can entail any number of subsequent actions, including liquidation, sale of a division or other downsizing, or redirection of investment policy. Whatever the action taken, for any given signal s, S entails less risky subsequent management than C, the probability distribution of which has fatter upper and lower tails. At t = 2, np2 is realized and income is shared in accordance with the contracts in the capital structure. Id. at 1031-34. Investment, Realization of np1 Contract and signal s Realization of np2 t = 0 Choice t = 1 Action a taken t = 2 of e The model examines two possible compensation incentive schemes for E: one constituted of private benefits only and the other including a salary. The purpose of any such scheme is of course to induce E to choose a high level e. But given the model, and in particular the noncontractibility of s, the optimal arrangement must include a possibility of punishment in the form of a control transfer to outsiders who have the power to choose action S. Since management always prefers C to S (whether or not C is efficient), a structure that increases the possibility of such intervention as np1 and s decline lends management an incentive to choose a high level of e, maximizing the possibility of a choice of C despite the cost of U thereby incurred. Given this, any bonus payments should be based on earnings results of both np1 and np2, with the np2 target level rising as the np1 amount declines. Id. at 1035-39.
72. For a model amplifying the efficiency properties of creditors' liquidation rights, see Oliver Hart & John Moore, Default and Renegotiation: A Dynamic Model of Debt, 113 Q.J. ECON. 1 (1998).
73. See supra text accompanying note 59.
74. If the going concern retains more value still, E can refinance and pay off VC. If VC is the party positioned to choose a* the result is suboptimal.
75. Kaplan & Strömberg, supra note 12 (working paper at 18), report that preferred dividends are cumulative in only 46% of the cases. This suggests that periodic income is not a primary concern here.
76. Klausner & Litvak, supra note 9 (working paper at 10).
77. For the tax deduction, a firm promise to pay would be necessary. The income contingency would not strengthen the case. See Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968).
78. Klausner & Litwak, supra note 9 (working paper at 4-5).
79. The classic case, Martin v. Peyton, 158 N.E. 77 (N.Y. 1927), concerns a loan to a partnership. The liability of bank lenders to small businesses is the subject of leading cases in recent years. See, e.g., K.M.C. Co., Inc. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985); State Nat'l Bank of El Paso v. Farah Mfg. Co., 678 S.W.2d 661 (Tex. App. 1984). See generally Margaret Hambrecht Douglas-Hamilton, Creditor Liabilities Resulting from Improper Interference with the Management of a Financially Troubled Debtor, 31 BUS. LAW. 343 (1975). There is of course a way to deflect this risk for a debt holding VC with control power. If the VC is a human being, one forms a wholly owned shell corporation or limited liability company to hold the debt; if the VC is a corporation, it forms a shell wholly owned subsidiary. Both steps are costly, and there remains a residual risk of veil piercing.
80. F. HODGE O'NEAL & ROBERT E. THOMPSON, O'NEAL'S CLOSE CORPORATIONS: LAW AND PRACTICE § 2.21 (3d ed. 1998). Sahlman, supra note 21, at 510, suggests an additional tax reason. The overhang of preferred rights lowers the value of the common for tax purposes, permitting E to buy the common stock at low prices without reporting taxable income on the differential between the amount paid and the greater amount paid by VC. See also Klausner & Litvak, supra note 9 (working paper at 9).
81. One could presumably replicate the preferred stock outcome by placing in VC a combination of common stock and debt. This would, however, mean a process burden on VC in the event of exercise of control to make it clear that it acted in the capacity of a common stockholder. A residual litigation risk would endure even so.
82. Incidence of insurance company participation in venture capital firms varies from year to year. PAUL A. GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE 8-9 tbl.1.1 (1999), shows that insurance company and bank participation levels in venture capital partnerships amounted to 16% in 1978, 15% in 1987, and 18% in 1995, but 4% in 1979, 6% in 1991 and 1% in 1997. Public and private pension funds consistently are the largest investors, putting in 40% of the capital in 1997.
83. g. 73. For a formal model of joint control in venture capital contexts in which control is a continuous variable to be adjusted through different contract provisions, see Andrei A. Kirilenko, Valuation and Control in Venture Finance, 56 J. FIN. 565 (2001). This model, by opening up control to a range, moves the formal theory of the firm closer to Kaplan and Strömberg's real-world picture. It does not, however, specify any direct connections between its formal terms and real world institutions.
84. Aghion & Bolton, supra note 13, at 486.
85. Venture capital transactions include a separate "Investor Rights Agreement" entered into between the issuer and individual purchasers of preferred. These contracts customarily include a right to attend board meetings in a nonvoting capacity. See Craig E. Dauchy, Venture Capital Financings, in DOING DEALS 2000: UNDERSTANDING THE NUTS AND BOLTS OF TRANSACTIONAL PRACTICE 233, 301 (PLI Corp. L. & Prac., Course Handbook Series No. 1167, 2000).
86. O'NEAL & THOMPSON, supra note 69, at §§ 9.0-.38.
87. For a contrasting discussion of shared control arrangements see Armando Gomes & Walter Novaes, Sharing of Control as a Corporate Governance Mechanism (SSRN Elec. Paper Coll. No. 277111, 2001), at http://papers.ssrn.com/abstract=277111. Gomes and Novaes model shared control as a governance mechanism for a firm with a dispersed minority shareholder interest. They hypothesize two blockholders who together control management decisions but cannot act unilaterally, and they show that in some circumstances such an arrangement could be superior to either of control by a single blockholder or widely dispersed shareholding.
88. The practitioner literature shows that this is effected by a shareholder voting agreement pursuant to which, in the event that performance targets are not met, E promises to vote for additional directors nominated by VC. Dauchy, supra note 75, at 243.
89. For a comparison venture capital form, which provides for VC control on a three out of five basis, see 1 MICHAEL J. HALLORAN ET AL., VENTURE CAPITAL AND PUBLIC OFFERING NEGOTIATION § 8-23 (3d ed. 2000).
90. Black & Gilson, supra note 17, at 262-63; Sahlman, supra note 7, at 513; see also Kirilenko, supra note 73, at 570 (noting that "venture capital firms are greatly differentiated by reputation").
91. GOMPERS & LERNER, supra note 71, at 176-78, reports turnover in 40 out of 220 venture capital rounds in their data set. M.T. Hannan et al., Inertia and Change in the Early Years: Employment Relations in Young, High Technology Firms, 5 INDUS. & CORP. CHANGE 503 (1996), finds that in the first twenty months following a firm's initial round of venture capital finance, 20% of firms replace E with a nonfounder CEO; the percentage goes up to 40% after forty months and 80% after eighty months. See also Klausner & Litvak, supra note 9 (working paper at 6).
92. John A. Byrne, How a VC Does It, BUS. WK., July 24, 2000, at 97. More generally, "high-reputation VCs tend to replace CEOs more often than low-reputation VCs do." Klausner & Litvak, supra note 9 (working paper at 6). For a discussion of the problems an E faces in choosing a VC and a description of a reputational market for VC services, see D. Gordon Smith, Venture Capital Contracting in the Information Age, 2 J. SMALL & EMERGING BUS. L. 133 (1998).
93. John A. Byrne, How a VC Does It, BUS. WK., July 24, 2000, at 97. More generally, "high-reputation VCs tend to replace CEOs more often than low-reputation VCs do." Klausner & Litvak, supra note 9 (working paper at 6). For a discussion of the problems an E faces in choosing a VC and a description of a reputational market for VC services, see D. Gordon Smith, Venture Capital Contracting in the Information Age, 2 J. SMALL & EMERGING BUS. L. 133 (1998).
94. One also needs to control the size of the board. The practitioner literature contains an exemplar of a VC-E voting agreement containing a provision requiring unanimous consent to increase the size of the board. Lawrence B. Low, Venture Capital Agreements, in NUTS AND BOLTS OF FINANCIAL PRODUCTS: UNDERSTANDING THE EVOLVING WORLD OF CAPITAL MARKET AND INVESTMENT MANAGEMENT PRODUCTS 313, 413 (PLI Corp. L. & Prac., Course Handbook Series No. 1035, 1998).
95. See Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling, 53 A.2d 441 (Del. 1947); O'NEAL & THOMPSON, supra note 69, at §§ 9.0-.38.
96. Dauchy, supra note 75, at 316.
97. Malcom P. Baker & Paul A. Gompers, Executive Ownership and Control in Newly Public Firms: The Role of Venture Capitalists (SSRN Elec. Paper Coll. No. 165173, 1999), at http://papers.ssrn.com/abstract=165173.
98. Hellman, supra note 13, at 58.
99. Id. at 60.
100. Kirilenko, supra note 73, at 579-80.
101. BENJAMIN GRAHAM ET AL., SECURITY ANALYSIS: PRINCIPALS AND TECHNIQUE 379 (4th ed. 1962).
102. Id. at 382; see also SIDNEY COTTLE ET AL., GRAHAM AND DODD'S SECURITY ANALYSIS 470-74 (5th ed. 1988).
103. GRAHAM ET AL, supra note 90, at 375.
104. Id. at 381.
105. RICHARD A. BREALEY & STEWART C. MYERS, PRINCIPLES OF CORPORATE . FINANCE 392-93 (6th ed. 2000).
106. Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AMER. ECON. REV. PAPERS & PROC. 323 (1986).
107. Cf. Robert Heinkel & Josef Zechner, The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives, 25 J. FIN. & QUANT. ANAL. 1 (1990) (showing that preferred creates incentives for the firm's common holders to invest, and thus ameliorates the underinvestment problem that follows from the issuance of debt; a new issue of preferred counters the agency costs of debt, and thereby not only enhances the firm's debt capacity but increases the overall value of the firm).
108. VICTOR BRUDNEY & WILLIAM W. BRATTON, BRUDNEY & CHIRELSTEIN'S CASES AND MATERIALS ON CORPORATE FINANCE 337-38 (4th ed. 1993). Some of this relative disadvantage is made up by the intercorporate dividend exclusion, under which corporate holders of preferred can exclude a substantial percentage of dividends received from their corporate tax bases. I.R.C. §§ 243, 244 (1990). The result is that preferred, particularly if issued by a high-grade public utility, can offer an attractive opportunity to insurance companies and other corporate institutional investors. The tax benefit means a lower yield and cost of capital to the issuer. Donald E. Fischer & Glenn A. Wilt, Non-Convertible Preferred Stock as a Financing Instrument 1950-1965, 23 J. FIN. 611 (1968). Short-term floating rate preferred with dividend rates tied to short-term interest rates also makes use of the intercorporate dividend exclusion. This paper is often issued by banks and sold to corporations with excess cash available for short-term investment, for which it makes an attractive alternative to short-term debt instruments. Another tax dodge also must be noted. In the mid-1990s, investment bankers put the corporate trust device to use in inventing tax deductible preferred. Here the corporation raising the capital issues bonds to a special purpose trust. The trust in turn raises the capital to pay for the bonds by issuing preferred stock to corporate taxpayers. The ultimate credit on the deal takes an interest deduction while the ultimate sources of capital get the intercorporate dividend exclusion. By the end of 1997, more than 285 of these issues were outstanding; they had raised $27 billion. Arun Khanna & John J. McConnell, MIPs, QUIPs AND TOPrs: Old Wine in New Bottles, 11 J. APPLIED CORP. FIN. 39 (1998).
109. VICTOR BRUDNEY & WILLIAM W. BRATTON, BRUDNEY & CHIRELSTEIN'S CASES AND MATERIALS ON CORPORATE FINANCE 337-38 (4th ed. 1993). Some of this relative disadvantage is made up by the intercorporate dividend exclusion, under which corporate holders of preferred can exclude a substantial percentage of dividends received from their corporate tax bases. I.R.C. §§ 243, 244 (1990). The result is that preferred, particularly if issued by a high-grade public utility, can offer an attractive opportunity to insurance companies and other corporate institutional investors. The tax benefit means a lower yield and cost of capital to the issuer. Donald E. Fischer & Glenn A. Wilt, Non-Convertible Preferred Stock as a Financing Instrument 1950-1965, 23 J. FIN. 611 (1968). Short-term floating rate preferred with dividend rates tied to short-term interest rates also makes use of the intercorporate dividend exclusion. This paper is often issued by banks and sold to corporations with excess cash available for short-term investment, for which it makes an attractive alternative to short-term debt instruments. Another tax dodge also must be noted. In the mid-1990s, investment bankers put the corporate trust device to use in inventing tax deductible preferred. Here the corporation raising the capital issues bonds to a special purpose trust. The trust in turn raises the capital to pay for the bonds by issuing preferred stock to corporate taxpayers. The ultimate credit on the deal takes an interest deduction while the ultimate sources of capital get the intercorporate dividend exclusion. By the end of 1997, more than 285 of these issues were outstanding; they had raised $27 billion. Arun Khanna & John J. McConnell, MIPs, QUIPs AND TOPrs: Old Wine in New Bottles, 11 J. APPLIED CORP. FIN. 39 (1998).
110. VICTOR BRUDNEY & WILLIAM W. BRATTON, BRUDNEY & CHIRELSTEIN'S CASES AND MATERIALS ON CORPORATE FINANCE 337-38 (4th ed. 1993). Some of this relative disadvantage is made up by the intercorporate dividend exclusion, under which corporate holders of preferred can exclude a substantial percentage of dividends received from their corporate tax bases. I.R.C. §§ 243, 244 (1990). The result is that preferred, particularly if issued by a high-grade public utility, can offer an attractive opportunity to insurance companies and other corporate institutional investors. The tax benefit means a lower yield and cost of capital to the issuer. Donald E. Fischer & Glenn A. Wilt, Non-Convertible Preferred Stock as a Financing Instrument 1950-1965, 23 J. FIN. 611 (1968). Short-term floating rate preferred with dividend rates tied to short-term interest rates also makes use of the intercorporate dividend exclusion. This paper is often issued by banks and sold to corporations with excess cash available for short-term investment, for which it makes an attractive alternative to short-term debt instruments. Another tax dodge also must be noted. In the mid-1990s, investment bankers put the corporate trust device to use in inventing tax deductible preferred. Here the corporation raising the capital issues bonds to a special purpose trust. The trust in turn raises the capital to pay for the bonds by issuing preferred stock to corporate taxpayers. The ultimate credit on the deal takes an interest deduction while the ultimate sources of capital get the intercorporate dividend exclusion. By the end of 1997, more than 285 of these issues were outstanding; they had raised $27 billion. Arun Khanna & John J. McConnell, MIPs, QUIPs AND TOPrs: Old Wine in New Bottles, 11 J. APPLIED CORP. FIN. 39 (1998).
111. See Robert M. Blair-Smith & Leonard Helfenstein, A Death Sentence or a New Lease on Life? A Survey of Corporate Adjustments under the Public Utility Holding Company Act, 94 U. PA. L. REV. 148, 150-51, 162-69 (1946).
112. It should be noted that a surrender of rights by a class of preferred in connection with a distressed issuer's recapitalization is not per se unfair. Sometimes the common stock has rights too, as where both the preferred and the common have to vote as a class to approve a charter amendment or merger that will make the firm as a whole more valuable. In such a case, the common will not support the transaction unless it is allocated a part of the proceeds. Responsible managers do their best to give the common enough to garner its support but otherwise respect the rights of the preferred. The classic case is Goldman v. Postal Telegraph, Inc., 52 F. Supp. 763 (D. Del. 1943).
113. See Davison v. Parke, Austin & Lipscomb, 35 N.E.2d 618, 622 (N.Y. 1941); NORMAN D. LATTIN, THE LAW OF CORPORATIONS 573-82 (2d ed. 1971). The legal landscape surrounding bonds also changed drastically during the course of the twentieth century. Fiduciary duties to bondholders today are hypothesized by law review commentators. No significant case supports them. In the 1920s, fiduciary duties to bondholders were everyday subject matter in litigated cases. See, e.g., Charles H. Haines, Jr., Comment, Corporations - Modification Provisions of Corporate Mortgages and Trust Incentives. 38 MICH. L. REV. 63 (1939).
114. See Davison v. Parke, Austin & Lipscomb, 35 N.E.2d 618, 622 (N.Y. 1941); NORMAN D. LATTIN, THE LAW OF CORPORATIONS 573-82 (2d ed. 1971). The legal landscape surrounding bonds also changed drastically during the course of the twentieth century. Fiduciary duties to bondholders today are hypothesized by law review commentators. No significant case supports them. In the 1920s, fiduciary duties to bondholders were everyday subject matter in litigated cases. See, e.g., Charles H. Haines, Jr., Comment, Corporations - Modification Provisions of Corporate Mortgages and Trust Incentives. 38 MICH. L. REV. 63 (1939).
115. The leading Delaware case is Federal United Corp. v. Havender, 11 A.2d 331 (Del. 1940).
116. ALFRED F. CONARD, CORPORATIONS IN PERSPECTIVE 266 (1976);
117. Victor Brudney, Standards of Fairness and the Limits of Preferred Stock Modifications, 26 RUTGERS L. REV. 445 (1973):
118. Lawrence E. Mitchell, The Puzzling Problem of Preferred Stock (And Why We Should Care About It), 51 BUS. LAW. 443 (1996).
119. For expositions of this view, see Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate Contracting (or "The Economics of Boilerplate"), 83 VA. L. REV. 713 (1997), and Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 VA. L. REV. 757 (1995).
120. For expositions of this view, see Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate Contracting (or "The Economics of Boilerplate"), 83 VA. L. REV. 713 (1997), and Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 VA. L. REV. 757 (1995).
121. A promise to pay can be inserted into the preferred stock contract in addition to dividend priority. The promise is not of the same order, however, as the promise to pay debt. Since dividends cannot be paid where debt is outstanding in distress situations, the promise is inherently conditional.
122. 705 A.2d 1040 (Del. Ch. 1997).
123. Id. at 1043-44.
124. Id. at 1045-52.
125. Id. at 1044 n.6.
126. Id. at 1050-52.
127. See Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986); Dalton v. Am. Inv. Co., 490 A.2d 574 (Del. Ch. 1985).
128. Kaiser Aluminum Corp. v. Matheson, 681 A.2d 392 (Del. 1996) (refusing to resort to extrinsic evidence in interpreting preferred stock contract and instead employing the maxim of interpretation contra proferentum); Warner Communications Inc. v. Cris-Craft Indus., Inc., 83 A.2d 962 (Del. Ch. 1989) (interpreting language literally protecting preferred stockholders against them).
129. 506 A.2d 173 (Del. 1986).
130. Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1057 (Del. Ch. 1997).
131. Id. at 1058-59.
132. See, e.g., ALI PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOMMENDATIONS § 2.01 (1994).
133. The reference is to corporate law's constituency statutes. CONN. GEN. STAT. ANN. § 33-756(d) (West 1997); IND. CODE ANN. § 23-1-35-1(f) (West Supp. 2001); N.Y. BUS. CORP. LAW § 717(b) (McKinney Supp. 2001-02).
134. Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 STETSON L. REV. 23 (1991). Distress situations are the exception. There the equity has a number of perverse incentives that can lead to reduction in the value of the firm's producing assets. See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Co., 1991 WL 277613, at *33 & n.55 (Del. Ch. Dec. 30, 1991).
135. For a contrasting economic approach to the same endpoint, see Thomas A. Smith, The Efficient Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty, 98 MICH. L. REV. 214 (1999).
136. Morey W. McDaniel, Bondholders and Stockholders, 13 J. CORP. L. 205 (1998); Morey W. McDaniel, Bondholders and Corporate Governance, 41 BUS. LAW 413 (1986).
137. Morey W. McDaniel, Bondholders and Stockholders, 13 J. CORP. L. 205 (1998); Morey W. McDaniel, Bondholders and Corporate Governance, 41 BUS. LAW 413 (1986).
138. See Paramount Communications, Inc. v. QVC Network Inc., 637 A.2d 34 (Del. 1993), where the Delaware Supreme Court moves Revlon review away from business substance in the direction of process review. Under QVC the question is less whether the board maximizes value than whether the board informed itself of available alternative courses of action respecting value maximization.
139. Compare Orban v. Field, 1997 WL 153831 (Del. Ch. Apr. 1, 1997), a venture capital case in which the court sustains the board's action to wipe out a common stockholder in favor of preferred classes holding a majority of the votes.
140. Had the Genta board taken no steps to delay, delisting would have occurred in early December 1996. 705 A.2d 1040, 1047 (1997). Delaying tactics caused delisting to be delayed until February 4, 1997; the Genta board approved the Aries deal on January 28, 1997. Id. at 1051-52 & n.34.
141. Simons v. Cogan, 542 A.2d 785 (Del. Ch. 1987); Katz v. Oak Indus. Inc., 508 A.2d 873 (Del. Ch. 1986).
142. RESTATEMENT (SECOND) OF CONTRACTS § 205 cmt. a (1981).
143. Id. § 204 cmt. d.
144. 642 F.2d 929, 957 (5th Cir. 1981) (en banc), cert. denied, 454 U.S. 965 (1981); see also Metro. Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989).
145. For a second example, see HB Korenvaes Investments, L.P. v. Marriott Corp., 1993 WL 257422 (Del. Ch. Jul. 1, 1993) (showing that antidilution provisions governing an issue of convertible preferred can fail on some fact patterns, requiring intervention under the good faith rule).
146. See supra text accompanying notes 34-35.
147. DEL. CODE ANN. tit. 8, § 141(a) (2001).
148. DEL. CODE ANN. tit. 8, §§ 242, 251, 271, 275 (2001).
149. 249 A.2d 89 (R.I. 1969). In the actual case, direct amendment of the preferred stock contract required a 100% approval by the preferred and the merger required a class vote of the preferred. The retelling in the text substitutes the scenario that would have followed under today's Delaware statute. For a more recent example, see Elliott Assocs., L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998).
150. See supra text accompanying note 100.
151. DEL. CODE ANN. tit. 8. § 242(b)(2) (2001). Even with a class vote, publicly traded preferred has been known to approve right-stripping amendments. See, e.g., Bowman v. Armour & Co., 160 N.E.2d 753 (Ill. 1959).
152. Some states, such as New York, N.Y. BUS. CORP. LAW § 903(a)(2)(B) (McKinney Supp. 2002), provide for a class vote. Delaware does not. DEL. CODE ANN. tit. 8, § 251 (2001).
153. Note, Arrearage Elimination and the Preferred Stock Contract: A Survey and a Proposal for Reform, 9 CARDOZO L. REV. 1335 (1988).
154. Rothschild Int'l Corp. v. Liggett Group, 474 A.2d 133 (Del. 1984).
155. Dalton v. Am. Inv. Co., 490 A.2d 574 (Del. Ch. 1985).
156. 583 A.2d 962 (Del. Ch. 1989).
157. It should be noted that Delaware has since ruled that a provision for a class vote respecting "amendment . . . by merger" did apply to a merger. But it did so only after the case was litigated to the state's supreme court. Elliott Assocs., L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998).
158. ROBERTA ROMANO, THE GENIUS OF AMERICAN CORPORATE LAW 37-44 (1993).
159. The most famous case is the Delaware Supreme Court's sudden expansion of the duty of care to cover board approval of an arm's length merger in Smith v. Van Gorkom, 488 A.2d 858. 873-81 (Del. 1985). Insurance premiums rose substantially as a result and the legislature amended the Code to permit firms to opt out of the duty of care by charter amendment. See DEL. CODE ANN. tit. 8, § 102(b)(7) (2001).
160. See William W. Bratton & Joseph A. McCahery. Regulatory Competition, Regulatory Capture and Corporate Self-Regulation, 73 N.C. L. REV. 1861, 1894-95 (1995).
161. See Telcom-SNI Investors, L.L.C. v. Sorrento Networks, Inc., No. Civ. A. 19038-NC, 2001 WL 1117505 (Del. Ch. Sept. 7, 2001) (enjoining an E from violating a debt covenant and a provision requiring a preferred class vote to
162. See Black & Gilson, supra note 17, at 260-61, 264; Edward B. Rock, Greenhorns, Yankees and Cosmopolitans: Venture Capital, IPOs, Foreign Firms & U.S. Markets, 2 THEORETICAL INQUIRES IN LAW 711 (2001). For a theoretical model showing how the conversion feature aligns the incentives of the entrepreneur with those of the venture capitalist, see Francesca Cornelli & Oved Yasha, Stage Financing and the Role of Convertible Debt (SSRN Elec. Paper Coll. No. 48581, 1997), at http://papers.ssrn.com/abstract=48581.
163. See Black & Gilson, supra note 17, at 260-61, 264; Edward B. Rock, Greenhorns, Yankees and Cosmopolitans: Venture Capital, IPOs, Foreign Firms & U.S. Markets, 2 THEORETICAL INQUIRES IN LAW 711 (2001). For a theoretical model showing how the conversion feature aligns the incentives of the entrepreneur with those of the venture capitalist, see Francesca Cornelli & Oved Yasha, Stage Financing and the Role of Convertible Debt (SSRN Elec. Paper Coll. No. 48581, 1997), at http://papers.ssrn.com/abstract=48581.
164. See Kaplan & Strömberg, supra note 12 (working paper at 30 & n.10); see also Oliver Hart & John Moore, A Theory of Debt Based on the Inalienability of Human Capital, 109 Q.J. ECON. 841 (1994).
165. The IPO must pass quality tests keyed to the stock price, the amount of proceeds or the resulting market capitalization. Kaplan & Strömberg, supra note 12 (working paper at 21).
166. Black & Gilson, supra note 17, at 261.
167. Sahlman, supra note 7, at 507.
168. GOMPERS & LERNER, supra note 71, at 139-202.
169. Some venture capital firms have members who specialize in this downside cleanup function. I owe this point to Professor Marcus Cole.
170. Morey McDaniel, Sinking Fund Preferred Stock, 13 FIN. MGT. 45-52 (Spring 1984).
171. Kaplan & Strömberg, supra note 12.
172. See Dauchy, supra note 75, at 315; see also Hank Barry, Negotiating Preliminary Financing, in 20TH ANNUAL INSTITUTE ON COMPUTER LAW 849, 860 (PLI Patents, Copyright, Trademarks, and Literary Property, Course Handbook Series No. 590, 2000).
173. Ellen B. Corenswet et al., Venture Capital Considerations in Mergers and Acquisitions, in HANDLING MERGERS & ACQUISITIONS IN HIGH-TECH AND EMERGING GROWTH ENVIRONMENTS 1999, at 655, 661-62 (PLI Corp. L. & Prac., Course Handbook Series No. 1122, 1999); Dauchy, supra note 75, at 317;
174. Richard R. Plumridge, Typical Venture Capital Transaction Documents, in PRIVATE PLACEMENTS 2001, at 817, 856-57 (PLI Corp. L. & Prac., Course Handbook Series No. 1239, 2001).
175. See supra text accompanying note 136.
176. Plumridge, supra note 154, at 647; Kathryn K. Lindauer, Critical Issues in Negotiating Venture Capital for the Software Development Company, in 19TH ANNUAL INSUTUTE ON COMPUTER LAW 799, 321-22 (PLI Patents, Copyright, Trademarks, and Literary Property, Course Handbook Series No. 547, 1999).
177. Kaplan & Strömberg, supra note 12 (working paper at 19 & tbl.6). It is entirely possible that Kaplan and Strömberg were not looking to see if the investor rights agreements in their transactions contained business covenants. It also is possible to draft negative covenants that do not turn on future financial performance figures. One can, for example, completely forbid short term borrowing and funded debt without regulating it by reference to a balance sheet test.
178. Sahlman, supra note 7, at 508. For a formal of the interactive relationship of venture capitalists and entrepreneurs at the draw down stage, see Rafael Repullo & Javier Suarez, Venture Capital Finance: A Security Design Approach (SSRN Elec. Paper Coll. No. 145134, 1999), at http://papers.ssrn.com/abstract=145134.