Debt as venture capital

University of Illinois Law Review

Volumn 2010, Issue 4, 2010, Pages 1169-1210

  Ibrahim, Darian M ^a  

^a UNIVERSITY OF WISCONSIN LAW SCHOOL   (United States)

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EID: 78650832731     PISSN: 02769948     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (261)

1. See infra notes 29-32 and accompanying text for sources espousing the conventional wisdom.
2. See infra notes 51-53 and accompanying text on the size of the venture debt industry.
3. See Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874, 902 (2003) ("Empirical evidence suggests that [VCs] sometimes use convertible debt.");
4. Darian M. Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 VAND. L. REV. 1405, 1430 n.119 (2008) (arguing that angels sometimes use convertible debt to avoid having to price their investments).
5. See infra note 28 and accompanying text on personal guarantees in start-ups versus lifestyle businesses.
6. See Press Release, Nat'l Venture Capital Ass'n, Nat'l Venture Capital Ass'n Releases Recommendations to Restore Liquidity in the U.S. Venture Capital Industry (Apr. 29, 2009), http://www. dcm.com/dnld/news/ NVCARecommendations042909.pdf ("[I]n 2008 public companies that were once venture-backed accounted for more than 12 million U.S. jobs and $2.9 trillion in revenues, which equates to 21 percent of U.S. GDP.").
7. See infra notes 36-37 and accompanying text.
8. See Pui-Wing Tarn, Venture Funding Twist: Start-ups Increasingly Take On Debt to Keep Businesses Chugging Along, WALL ST. J., Feb. 14, 2007, at C1 (explaining that venture debt remains largely "out of the spotlight").
9. See infra notes 61-62 and accompanying text for more on the interviewing portion of this project.
10. See Darian M. Ibrahim & D. Gordon Smith, Entrepreneurs on Horseback: Reflections on the Organization of Law, 50 ARIZ. L. REV. 71, 82 n.65 (2008) (citing examples of academic work that fits within the "law and entrepreneurship" genre).
11. See generally Darian M. Ibrahim, Financing the Next Silicon Valley, 87 WASH. U. L. REV. 717 (2010) (discussing angel investors and state-sponsored venture capital funds as alternatives to private venture capital); Ibrahim, supra note 3 (explaining the basics of angel investing and its differences from venture capital).
12. For excellent examples of data gathering through interviews from "law and entrepreneurship" work alone, see Ronald J. Mann, Secured Credit and Software Financing, 85 CORNELL L. REV. 134 (1999) (exploring software-related lending);
13. Mark C Suchman & Mia L. Cahill, The Hired Gun as Facilitator: Lawyers and the Suppression of Business Disputes in Silicon Valley, 21 LAW & Soc. INQUIRY 679 (1996) (portraying Silicon Valley lawyers as networkers and business transaction facilitators);
14. Brian J. Broughman & Jesse M. Fried, Do VCs Use Inside Financing to Dilute Founders? (Aug. 13, 2009) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm? abstract-id=1442524 (investigating whether VCs use their control rights to dilute entrepreneurs in inside rounds).
15. Mann, supra note 11.
16. Venture debt is longer term than a bridge loan, however. Compare J.V. Rizzi, A Framework to Mitigate the Risks of Bridge Lending, 17 COM. LENDING REV., Mar. 2002, at 5, 8 (explaining that bridge loans still outstanding after twelve months are known as "hung or failed"), with infra note 56 and accompanying text (citing the term of venture loans between twenty-four and thirty-six months, sometimes with the addition of a three to nine month interest-only period preceding the official term).
17. As discussed more fully in Part II.C, this Article will use quotations from those in the venture debt industry. The interviewees were promised anonymity, so quotations cannot be attributed.
18. See infra Part IV.B.
19. Yakov Amihud et al, A New Governance Structure for Corporate Bonds, 51 STAN. L. REV. 447, 453 (1999).
20. OFFICE OF ADVOCACY, U.S. SMALL BUS. ADMIN., FINANCING PATTERNS OF SMALL FIRMS: FINDINGS FROM THE 1998 SURVEY OF SMALL BUSINESS FINANCE 3 (2003). In 2003, small businesses owed $718 billion to commercial banks alone. The Small Business Administration estimated that this was 58% of small business debt, implying that small businesses owed more than $1.2 trillion.
21. OFFICE OF ADVOCACY, U.S. SMALL BUS. ADMIN., SMALL BUSINESS IN FOCUS: FINANCE 11 (2009).
22. See Stephen Levin, Venture Debt: Device Financing Lifeline or Anchor?, IN VIVO: THE Bus. & MED. REP., Mar. 2008, at 50, 56.
23. Other examples of home runs include well-known companies eBay, Yahoo!, and Oracle.
24. See Levin, supra note 18, at 56 ("[VCs'] kind of binary bets can kill a venture debt player because we can't hit home runs; the best we can do are singles and doubles, and they aren't enough to make up for the strikeouts.").
25. See Francis v. United Jersey Bank, 432 A.2d 814, 821 n.1 (N.J. 1981) ("The obligations of directors of banks involve some additional consideration because of their relationship to the public generally and depositors in particular."). The presence of FDIC insurance, however, may cut against a prudent approach.
26. See Jonathan R. Macey & Maureen O'Hara, The Corporate Governance of Banks, 9 ECON. POL'Y REV. 91, 97 (2003) ("Despite the positive effect of FDIC insurance on preventing bank runs, the implementation of deposit insurance poses a regulatory cost of its own-it gives the shareholders and managers of insured banks incentives to engage in excessive risktaking.").
27. See BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK 2-5 (2006), http://www.bis. org/publ/bcbs128.pdf (discussing minimum capital requirements).
28. MARK VAN OSNABRUGGE & ROBERT J. ROBINSON, ANGEL INVESTING: MATCHING STARTUP FUNDS WITH START-UP COMPANIES-THE GUIDE FOR ENTREPRENEURS, INDIVIDUAL INVESTORS, AND VENTURE CAPITALISTS 52-53 (2000).
29. Id. at 29-31,163-64.
30. See Mann, supra note 11, at 155 ("[Current accounting conventions] make it quite hard to capitalize expenditures on developing software.... The result is that a company with a substantial investment in developing a valuable asset still might show almost no assets on its balance sheet.").
31. See 35 U.S.C. § 101 (2006);
32. UNIF. TRADE SECRETS ACT § 2 (amended 1985), 14 U.L.A. 619 (2005).
33. Mann, supra note 11, at 138-53 (detailing practical and legal obstacles to liquidating software collateral);
34. see also Stewart C Myers, Capital Structure, 15 J. ECON. PERSP. 81, 83 (2001) (explaining that firms with intangible assets and valuable growth opportunities are "associated with low debt ratios").
35. See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. FIN. ECON. 243, 259 (1998) ("The failure rate for startup companies is high enough.");
36. Ronald J. Mann, The Role of Secured Credit in Small-Business Lending, 86 GEO. L.J. 1, 23 (1997) (arguing that lenders demand personal guarantees from founders of small, life-style businesses).
37. VAN OSNABRUGGE & ROBINSON, supra note 23, at 53.
38. Paul Gompers & Josh Lerner, The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements, 39 J.L. & ECON. 463, 465 (1996).
39. Mira Ganor, Improving the Legal Environment for Start-up Financing by Rationalizing Rule 144, 33 WM. MITCHELL L. REV. 1447, 1448 (2007);
40. see also John S. Dzienkowski & Robert J. Peroni, The Decline in Lawyer Independence: Lawyer Equity Investments in Clients, 81 TEX. L. REV. 405, 514 (2002) ("[T]here are many instances in which start-up clients cannot easily obtain debt financing of their operations or capital expenditures because they have no income or hard assets.").
41. Mann, supra note 11, at 153. Mann's article is discussed throughout and introduced in relation to this Article infra notes 63-64 and accompanying text.
42. As discussed in Part II.C, my promises of anonymity to my interviewees do not allow me to attribute quotes recited in this Article to particular lenders.
43. See Angela Sormani, Venture Finance: Enhancing Growth, EUR. VENTURE CAP. & PRIVATE EOUITY J., July-Aug. 2004, at 52, 52-53.
44. See Levin, supra note 18, at 50-51.
45. Steven Musil, Facebook Borrows $100 Million, CNET NEWS, May 11, 2008, http://news. cnet.com/8301-10784-3-9941154-7.html (discussing TriplePoint's loan to Facebook).
46. See Alexander Haislip, Venture Debt Industry Makes Comeback, PRIVATE EQUITY WK., June 25, 2007, at 1, 5 (discussing TriplePoint's loan to YouTube).
47. For a brief history and explanation of venture leasing, see PAUL A. GOMPERS & WILLIAM A. SAHLMAN, ENTREPRENEURIAL FINANCE: A CASEBOOK 360-68 (2002). One of my interviewees told me that the former large VL Comdisco Ventures introduced the idea of debt for purely growth capital purposes in 1998.
48. See Levin, supra note 18, at 51 ('"The big step in the growth of venture debt was the initiation of lenders providing growth capital.... You use it in the same way a company would use equity, with no strings attached.'" (quoting an employee of Western Technology Investment)).
49. The major U.S. VLs were identified through independent research and by talking to interviewees.
50. For more on the history and operations of Silicon Valley Bank, see GOMPERS & SAHLMAN, supra note 38, at 432-37. According to one interviewee, Silicon Valley Bank may bank one-half of the start-ups that receive venture capital in the United States.
51. ANNALEE SAXENIAN, THE NEW ARGONAUTS: REGIONAL ADVANTAGE IN A GLOBAL ECONOMY 30-31 (2006).
52. COMERICA BANK, CORPORATE PROFILE (n.d.), http://www.comerica.com/ Comerica- Content/Corporate.Communications/Docs/companyprofile.PDF;
53. Press Release, Bridge Bank of Silicon Valley, Bridge Bank of Silicon Valley Receives Initial Charter Approval (Dec. 1, 2000), http://www.bridgebank. com/news/press-releases/documents/pressreleasel.pdf.
54. Square 1 Financial, https://www.squarelfinancial.com (last visited May 11, 2010).
55. Interestingly, while almost all VCs operate as limited partnerships, non-bank VLs appear to have no standard organizational form. Through my interviews, I discovered non-bank VLs organized as limited partnerships, limited liability companies, and corporations. The differences in organizational form, which might have something to do with the firms' source of funding, are not something I have enough information about to explore in this Article.
56. Information about participants in the industry came primarily from interviewees.
57. See Levin, supra note 18, at 52 ("[Western] is the most active player in the venture debt industry, having done more than 400 deals in the last three years alone.").
58. These smaller shops-which I did not attempt to interview out of concern for skewing the information obtained from the major lenders-include Goldhill Capital, Leader Ventures, ORIX Venture Finance, ATEL Ventures, Eastward Capital Partners, Costella Kirsch, and Escalate Capital Partners, according to interviewees. One article claims there were more than fifty new entrants into the field of venture debt from 2003 to 2005.
59. See Jonathan Fitzgerald, Financing the Growth Economy with Venture Debt, VENTURE CAPITAL J., Dec. 2005, at 41, 41 ("More than 50 of these [venture debt] institutions collectively managing over $2 billion in assets simply didn't exist two years ago."). None of my interviewees, however, suggested that the number was nearly so high.
60. According to one interviewee, the bank VLs are "capped at about $2 million" due to regulation, something I explore further infra notes 73-75 and accompanying text.
61. See Amanda Fung, Techies Take Loans, CRAIN'S N.Y. BUS., July 16-22, 2007, at 3 ("Venture debt loans typically range from $1 million to $10 million-");
62. Levin, supra note 18, at 52 (explaining that average deal size for non-bank Western Technology Investment is "about $3 million");
63. Tarn, supra note 7, at C1 ("[VLs] typically provide loans of $500,000 to $10 million and sometimes more to fund start-up operations or equipment purchases.").
64. See Tam, supra note 7, at C1 (citing VentureOne statistics).
65. See Ibrahim, supra note 3, at 1419 n.57 (citing statistics).
66. According to two interviewees, VL loans were substantially lower than the rule of thumb would predict in 2000. Comdisco Ventures, the largest VL at the time, was said to invest only $1.5 billion during 2000. A Forbes article puts the figure at $1.2 billion.
67. See Joanne Gordon, Greek Tragedy, FORBES, June 11, 2001, at 72, 73. While the 10-20% rule of thumb may not hold in anomalous years, venture debt does still appear to rise and fall with venture capital in those years.
68. See Tarn, supra note 7, at C1 (citing venture debt to have increased after being down to $434 million in 2002 after the dot.com bust).
69. See infra notes 87-95 and accompanying text.
70. One non-bank VL sometimes uses convertible debt, but that was the exception both in VL practice generally and within that particular firm.
71. Levin, supra note 18, at 52 (explaining that Western Technology Investment usually has a 36-month repayment period);
72. Id. ("[S]ome deals nave draw periods of up to one year, while others may require that the money be drawn immediately.").
73. See Tom Taulli, How Venture Debt Financing Works and How to Get It, Bus. WK., Sept. 19, 2008, http://www.businessweek.com/smallbiz/content/sep2008/ sb20080919-927652.htm (" [Warrant coverage is] normally 5% to 15% of the loan amount."). One of my interviewees put the range at 5% to 10% of the loan amount.
74. See George G. Triantis, Financial Contract Design in the World of Venture Capital, 68 U. CHI. L. REV. 305, 306 (2001) (
75. reviewing PAUL GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE (1st ed. 1999)).
76. See, e.g., Jeff Strnad, Taxing Convertible Debt, 56 SMU L. REV. 399, 403 (2003) ("[C]onvertible bonds are, at least approximately, a 'straight' bond with no conversion privilege, plus a warrant.").
77. See Jeremy C Stein, Convertible Bonds as Backdoor Equity Financing, 32 J. FIN. ECON. 3, 3-4 (1992) ("[C]ompanies may use convertible bonds to get equity into their capital structures 'through the backdoor' in situations where ... informational asymmetries make conventional equity issues unattractive.");
78. Alexander J. Triantis & George G. Triantis, Conversion Rights and the Design of Financial Contracts, 72 WASH. U. L.Q. 1231,1237 n.12 (1994) ("[I]n many cases convertibles are issued with the intent to eventually shift debt into equity.").
79. "Principals" include the CEO, President, Vice President, Founder, Regional Director, or President of a major division.
80. As part of the promise of anonymity, I cannot reveal which VLs did and did not participate in my study.
81. Mann, supra note 11, at 166-87.
82. Id. at 156.
83. See infra note 102 and accompanying text.
84. See infra Part III.B.2.
85. A paper by Thomas Hellman, Laura Lindsey, and Manju Puri examines banks making equity investments in start-ups, a different phenomenon than venture debt. Thomas Hellman et al., Building Relationships Early: Banks in Venture Capital (May 2007) (unpublished manuscript), available at http://ssrn.com/ abstract=474500.
86. See Tam, supra note 7, at C1 ("[VLs] generally charge double-digit interest rates on par with the interest payments on high-risk corporate bonds, known as junk bonds.").
87. See Luis Villalobos & Len Ludwig, Understanding Venture Debt 1 (unpublished manuscript, on file with author).
88. See JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST, AND MONEY 165-68 (First Harvest/Harcourt, Inc. 1964) (1937).
89. See Paul Sweeney, Lending on an IDEA, U.S. BANKER, Feb. 1999, at 32, 34 ("Silicon Valley Bank has three to four dollars in deposits for every dollar they lend out. This is really a deposit-driven business.");
90. see also Charles K. Whitehead, The Evolution of Debt: Covenants, the Credit Market, and Corporate Governance, 34 J. CORP. L. 641, 654-56 (2009) (discussing the evolution of the banking business in the 1970s and 1980s, when lending became less profitable in its own right and more of a means of securing other fee-generating business for banks).
91. Levin, supra note 18, at 52 ("Banks ... often use venture lending as a means of attracting new customers for their other banking services and therefore frequently include in their deals a covenant requiring the start-up to keep all of its cash with the lending institution."). One interviewee told me that his bank has a separate division that banks the VCs.
92. See, e.g., SVB Financial Group, Annual Report (Form 10-K), at 10 (Mar. 2, 2009) ("[Silicon Valley Bank], as a California state-chartered bank and a member of the Federal Reserve System, is subject to primary supervision and examination by the Federal Reserve Board, as well as the California Department of Financial Institutions-").
93. GOMPERS & SAHLMAN, supra note 38, at 432 ("Young, entrepreneurial firms were difficult to evaluate by conventional financial metrics, and government regulators often saw them as very risky.").
94. See Levin, supra note 18, at 57 ("[Non-bank Western Technology Investment] has no preference in terms of what stage of development a company has reached in order to be an appropriate venture debt candidate. Rather, it is simply a matter of assessing the risk/reward factor, which varies both by individual company and by stage of development.").
95. See infra notes 128-33 and accompanying text on VL contracting practices.
96. See Haislip, supra note 37, at 5 (estimating that the lender TriplePoint's warrants in YouTube were worth $6.5M when YouTube was acquired by Google);
97. see also SVB Financial Group, supra note 73, at 54 ("At December 31, 2008, [Silicon Valley Bank] held warrants in 1,307 companies, compared to 1,179 companies at December 31, 2007 and 1,287 companies at December 31, 2006.").
98. One VL claims to have made two to three dollars in warrant gain for each dollar of default loss.
99. Venture debt is typically provided between venture capital rounds, but can sometimes be woven into them and constitute up to 20-30% of the total capital provided. See Taulli, supra note 57 ("Venture debt usually comes as a part of a Series A or Series B investment and will be 20% to 30% of the total"). When provided between VC rounds, especially in difficult economic climates such as the current one, VLs prefer that VCs have invested within the past six months to ensure more present equity is available to repay loans since follow-on investments are more uncertain.
100. See generally D. Gordon Smith, The Exit Structure of Venture Capital, 53 UCLA L. REV. 315 (2005) (describing implications of VC pre-planned exit strategies, especially regarding control of portfolio companies).
101. Levin, supra note 18, at 51 (emphasis omitted).
102. Mann, supra note 11, at 137 ("The lender relies primarily on a symbiotic relation with the venture capitalist-").
103. Id. at 158 ("Interestingly, the venture capitalist apparently does not offer any formal legal commitment that it will repay the bank's loan or otherwise advance funds to the portfolio company; as a legal matter, future funding obligations fall almost entirely within the venture capitalist's discretion.").
104. Id.
105. Black & Gilson, supra note 28, at 261-64.
106. Id. at 262.
107. Id. at 263-64.
108. Mann, supra note 11, at 158 (emphasis added).
109. Note that this may be one of the main reasons why venture debt does not appear after angel rounds. Contrary to VCs, angels do not commonly follow-on to their original investments, and when they do follow-on, it is associated with lower returns, suggesting that no other funding was available.
110. See Ibrahim, supra note 3, at 1422. Therefore, the angel-backed start-up must be able to attract venture capital to be able to repay venture debt. I have argued elsewhere that high quality angel groups can attract VCs for follow-on rounds,
111. see Ibrahim, supra note 10, at 752-53, yet VCs following on their own investments is much more of a sure thing.
112. See Robert P. Bartlett, III, Venture Capital, Agency Costs, and the False Dichotomy of the Corporation, 54 UCLA L. REV. 37, 68 (2006).
113. Manju Puri & Rebecca Zarutskie, On the Lifecycle Dynamics of Venture-Capital- and NonVenture-Capital-Financed Firms 21 (U.S. Census Bureau Ctr. for Econ. Studies, Working Paper No. CES-WP-08-13, 2009), available at http://papers.ssrn.com/so13/papers.cfm?abstract-id=967841 ("VC, helps keep firms alive in the early part of firms' lifecycles. In the first four years after receiving VC, VC-financed firms are given a chance to grow while venture capitalists rapidly grow the firms in terms of employment and sales relative to non-VC-financed firms. However, after this initial growth period, VC-financed firms have a higher shut down rate, as well as a higher exit rate via acquisition and IPO, relative to non-VC-financed firms.").
114. Levin, supra note 18, at 57 (quoting the CEO of a device start-up).
115. Id.
116. See Bartlett, supra note 89, at 68 n.114 ("Later-stage funds have historically allocated even less amounts to follow-on financing.").
117. On the other hand, depending on the profit spread on non-defaulting loan repayments coupled with warrant returns, a 5% default rate may be high. The internal economics of venture lending are a more complicated question than what I address in this Article. The point made here is simply that there are far more start-up failures than loan defaults, which is not an immediately obvious proposition before considering the timing of venture loans.
118. Mann, supra note 11, at 159 ("In practice, banks' low rate of losses suggests that only a very small number of portfolio companies to which they loan money fail to reach a point at which one of [the possible] exit strategies is available."). According to one of my interviewees, the default rate for loans that bore the brunt of the dot.com bust reached only 12%. Yet the bust did largely contribute to the end of some of the biggest VLs in operation at the time, including Comdisco Ventures.
119. See infra note 201 and accompanying text.
120. Mann reports, [I]t is important to note that my interview subjects agreed that their lending relies on that [venture capital] revenue stream for repayment, not on the value of any underlying collateral. In particular, my interview subjects expressed surprisingly little concern about the safety of their lending programs, while at the same time agreeing that prospects for liquidating the assets of their working-capital borrowers were bleak. Mann, supra note 11, at 157 (citations omitted).
121. See Id. at 142.
122. According to one interviewee, the buyers sometimes include patent trolls.
123. Mann, supra note 11, at 139.
124. Id. at 138-53 (observing numerous practical and legal barriers to extracting value from software collateral, including difficulties in perfecting a security interest and software's rapid product obsolescence);
125. see also Ronald J. Mann, Explaining the Pattern of Secured Credit, 110 HARV. L. REV. 625, 638-68 (1997) (discussing both the benefits and the costs of secured credit).
126. See Ronald J. Mann, An Empirical Investigation of Liquidation Choices of Failed High Tech Firms, 82 WASH. U. L.Q. 1375,1390-91 (2004) (discussing the benefits of ABCs over liquidations).
127. See Posting of Darian M. Ibrahim to Concurring Opinions, http://www.concurringopinions. com/archives/2008/07/the-greening-of-1.html (July 2, 2008, 11:05 EST).
128. See Sweeney, supra note 71, at 34 ("Besides warrants, another big upside of venture lending is the prospect of riding a breakout success, opening the door to a panoply of services."). The prospect of not just present, but future business is also a reason why some law firms take on cash-poor, earlystage start-ups.
129. See Dzienkowski & Peroni, supra note 31, at 438.
130. See Ronald J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience, 55 STAN. L. REV. 1067, 1076 (2003).
131. See generally Ibrahim, supra note 3 (arguing that angels sometimes use convertible debt to avoid having to price their investments).
132. Antonio Davila et al., Venture Capital Financing and the Growth of Startup Firms, 18 J. Bus. VENTURING 689, 692-93 (2003).
133. Mann, supra note 11, at 137.
134. Davila et al., supra note 106, at 706 ("The support of VC-through the funding eventprovides a relevant signal to separate startups with different quality.").
135. See supra Part III.B.2.
136. Clarisa Long, Patent Signals, 69 U. CHI. L. REV. 625, 662 (2002);
137. Ronald J. Mann, Do Patents Facilitate Financing in the Software Industry?, 83 TEX. L. REV. 961, 989-91 (2005).
138. See Long, supra note 110, at 654 ("Nobody associates obtaining patents with sloth and shiftlessness.").
139. Mann, supra note 110, at 992.
140. Id. at 994 ("Notice, of course, that this use of patents [to signal discipline] says nothing about the uniqueness of the technology or the firm's ability to exelude [sic] competitors. Rather, it reflects something positive about the ability of the management team to focus and execute.").
141. Id. at 993-94 (citation omitted).
142. Another signal used by VCs might have purchase in the venture debt context. The venture capital literature observes that an entrepreneur's willingness to issue preferred stock to VCs while taking common for herself signals the entrepreneur's belief that the start-up will be worth more than the VCs preference.
143. See Michael Klausner & Kate Litvak, What Economists Have Taught Us About Venture Capital Contracting, in BRIDGING THE ENTREPRENEURIAL FINANCING GAP 54, 56 (Michael J. Whincop ed., 2001). The same idea could be carried forward to venture debt, which has first priority over all stock under default rules. Here, both the entrepreneur and VC are signaling that the start-up will be worth more than the loan amount. Even if the entrepreneur's signal is questionable due to her cash-strapped position, see Ibrahim, supra note 10, at 752, the VCs stronger bargaining position makes its signal appear credible.
144. See Mann, supra note 110, at 995-96 (noting that companies can obtain patents that have little value in order to impress VCs);
145. cf. Long, supra note 110, at 644-45 (explaining that firms have an incentive to reduce information asymmetries to ensure that investors value them correctly).
146. See Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 N.Y.U. L. REV. 967, 989-90 (2006).
147. See MARK J. ROE, POLITICAL DETERMINANTS OF CORPORATE GOVERNANCE: POLITICAL CONTEXT, CORPORATE IMPACT 171 (2003) (distinguishing agency costs due to mismanagement from those due to disloyalty); Fried & Ganor, supra note 117, at 989-90 (describing entrepreneur agency costs).
148. There is a growing academic literature on whether and when VCs actually control the board. The issue is complicated by the appointment of so-called "independent" directors to the start-up board. Newer entries in this literature debate to what extent these directors are truly independent and to what extent they are assumed to side with VCs. Compare Fried & Ganor, supra note 117, at 988 (stating that independent directors are "not truly independent of the VCs"), and Smith, supra note 79, at 330-37 (noting that independent directors will either be appointed by the entrepreneurs or the VCs, depending on who holds more equity at the time),
149. with William W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, 100 MICH. L. REV. 891 (2002) (setting forth a contingent control model where the independent director either votes with the VC or the entrepreneur depending on the state of the firm), and Brian J. Broughman, The Role of Independent Directors in VC-Backed Firms (Oct. 13, 2008) (unpublished manuscript), available at http://ssrn.com/abstract= 1162372 (modeling independent directors in VC-backed start-ups as arbitrators).
150. See Smith, supra note 79, at 346 (explaining that negative covenants prevent entrepreneurs from single-handedly engaging in business combinations, amending the charter in ways adverse to the VC, redeeming or paying dividends to the common stock, and issuing more preferred stock).
151. Fried & Ganor, supra note 117, at 987.
152. See Orban v. Field, No. 12820,1997 WL 153831, at *8-9 (Del. Ch. Apr. 1, 1997) (holding that the VC-controlled board did not breach its fiduciary duties in selling a start-up at a price below its liquidation preference because the sale was the start-up's best option, even though the common stockholders received nothing in the transaction).
153. See Randall S. Kroszner & Philip E. Strahan, Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability, 62 J. FlN. ECON. 415, 416 (2001). This is also a reason that lenders may take warrants instead of stock.
154. Equitable subordination began as a common law doctrine and has been specifically incorporated in bankruptcy codes. See David Gray Carlson, The Logical Structure of Fraudulent Transfers and Equitable Subordination, 45 WM. & MARY L. REV. 157, 198 (2003) ("Invented by the Supreme Court in Pepper v. Litton, equitable subordination was eventually codified in Bankruptcy Code § 510(c)...." (citation omitted)).
155. See Daniel R. Fischel, The Economics of Lender Liability, 99 YALE L.J. 131, 133 (1989) (stating that lender liability doctrine lacks a "coherent theoretical framework," which increases lender un-certainty, and can lead to large compensatory and punitive damages);
156. Rafael Ignacio Pardo, Note, Beyond the Limits of Equity Jurisprudence: No-Fault Equitable Subordination, 75 N.Y.U. L. REV. 1489, 1490-91 (2000) ("Although § 510(c) [of the Bankruptcy Code] codifies the doctrine of equitable subordination, it does not enumerate the factors that would mandate subordination of a claim.").
157. Kroszner & Strahan, supra note 123, at 416. The same study found, however, that "bankers tend to be on the boards of large and stable firms with high tangible asset ratios and low reliance on short-term debt financing."
158. Id. at 445.
159. Levin, supra note 18, at 52 (noting that Western Technology Investment, as "the most active player in the venture debt industry," made more than 400 venture loans from roughly 2004 to 2007).
160. These covenants include discretion-limiting covenants that, for example, limit the ability of the company to take on new debt or pay dividends, and financial covenants such as minimum networth requirements.
161. See Amihud et al., supra note 16, at 454-56, 463-65.
162. Banks might have greater incentives to monitor through covenants or otherwise because their business model for venture debt is more dependent on a start-up's continued success, which allows banks to keep the start-up's deposit accounts.
163. See supra note 103 and accompanying text. For a general treatment of covenant considerations specific to venture debt deals,
164. see THOMAS G. ANNINO, VENTURE DEBT ALTERNATIVES & EVALUATION GUIDELINES: A DETAILED LOOK AT SENIOR DEBT PRODUCTS AVAILABLE TO EMERGING GROWTH COMPANIES 92-94 (2005).
165. See Levin, supra note 18, at 52 ("[P]unitive ... covenants run contrary to venture lending's goal of furthering a start-up's financial runway under both good circmstances [sic] and bad....").
166. See Mann, supra note 11, at 160-61 ("[B]anks typically rely, at least in part, on the expertise and control of the venture capitalist in helping the borrower through the development stage."). On the benefits of lender monitoring in public corporations,
167. see generally Joanna M. Shepherd et al, What Else Matters for Corporate Governance?: The Case of Bank Monitoring, 88 B.U. L. REV. 991 (2008);
168. George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CAL. L. REV. 1073 (1995);
169. Frederick Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. REV. 115 (2009);
170. Whitehead, supra note 71, at 661-65 (observing that increased liquidity in the credit markets has led to less monitoring by creditors).
171. Absent insolvency, the corporation's directors and officers owe fiduciary duties to shareholders but not creditors. On the other hand, fiduciary law is often a weak impetus for managers to act in a given way,
172. see Edward B. Rock, Saints and Sinners: How Does Delaware Corporate Law Work?, 44 UCLA L. REV. 1009, 1099-1105 (1997), and studies have suggested that reputational concerns will actually cause managers to favor safer projects, and thus creditors over shareholders,
173. see Milton Harris & Artur Raviv, The Theory of Capital Structure, 46 J. FIN. 297, 304-05 (1991) (discussing studies of reputational concerns).
174. The VCs preferred stock has a debt-like liquidation preference, which aligns VC-VL preferences for non-risky outcomes. Indeed, in litigation between VCs and entrepreneurs, VCs can be found favoring the safer, debt-like course of action while entrepreneurs favor the riskier path dictated by their residual, common-stock claims.
175. See Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1041-42 (Del. Ch. 1997);
176. Orban v. Field, No. 12820,1997 WL 153831, at *1 (Del. Ch. Apr. 1, 1997). In addition, when VCs do favor riskier actions, VLs share in the equity upside through their warrants. In short, debt-plus-warrants is a security that closely resembles preferred stock from a risk-reward perspective, and therefore VLs can rationally defer to VCs as monitors of VL interests.
177. See infra notes 183-86 and accompanying text.
178. See Levin, supra note 18, at 50 (noting that venture debt works well in fields marked by clear milestones, such as the device subfield within the life sciences where milestones are "technological, clinical and regulatory").
179. Id. at 57 (quoting a VC specializing in healthcare);
180. accord Taulli, supra note 57 ("[Venture debt] could mean five or six months of extra 'runway' for your company, allowing you more time to reach your goals or get another round of funding.").
181. See D. Gordon Smith, Team Production in Venture Capital Investing, 24 J. CORP. L. 949, 967-69 (1999) (illustrating the anti-dilutive benefits to Jerry Kaplan, the founder of pen-computing start-up GO Corporation, from staged VC investments).
182. While calculating IRRs on complex cash flow streams can be complicated, "[s]imply put, the IRR is the discount rate at which net present value turns out to be zero." WILLIAM J. CARNEY, CORPORATE FINANCE: PRINCIPLES AND PRACTICE 94 (2005);
183. see also ANDREW METRICK, VENTURE CAPITAL AND THE FINANCE OF INNOVATION 52-55 (2007) (offering a brief explanation and critiques of IRR in venture capital).
184. Bartlett, supra note 89, at 72 ("Among early-stage venture capitalists, for instance, it is generally assumed that an investment portfolio should yield an IRR of approximately 30 to 50 percent. Moreover, because many of these investments will ultimately be written off, VC investors commonly make individual company investments with the expectation that each will produce a 40 to 50 percent projected IRR after accounting for the venture capitalist's fees and compensation." (citations omitted));
185. see also Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-ups, 57 TAX L. REV. 137, 151 n.47 (2003) ("Although venture funds lost 27% on average in 2001, the 3-year average IRR is 49.3%, the 5-year average IRR is 36%, the 10-year average IRR is 26.5%, and the 20year average IRR is 17.7%.").
186. Kate Litvak, Governance Through Exit: Default Penalties and Walkaway Options in Venture Capital Partnership Agreements, 40 WILLAMETTE L. REV. 771, 790 (2004).
187. See Levin, supra note 18, at 51 ("[VCs get] higher returns because they've put less capital to work and can see further company development before making the next funding decision."). Whether a VC will lead the next round
188. See Broughman & Fried, supra note 11, at 16.
189. For the basics of Texas hold 'em, see An Introduction to Texas Holdem Poker, http://www.texasholdem-poker.com/beginnersintro (last visited May 11, 2010).
190. Adverse changes in the start-up that can be observed during the additional time bought by venture debt might come from mismanagement or factors "out of a company's control, such as clinical trial problems or regulatory issues." Levin, supra note 18, at 54.
191. See infra Part IV.B.1.
192. Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM. ECON. REV. 261 (1958). Modigliani was awarded the Nobel Prize in Economics in 1985 for his "pioneering analyses of savings and of financial markets," including his work on capital structure, and Miller shared the 1990 Nobel Prize in Economics for his "pioneering work in the theory of financial economics," including his work on capital structure. Nobel Foundation, All Laureates in Economic Sciences, http://nobelprize.org/nobel-prizes/economics/ laureates/ (last visited May 11, 2010).
193. See Robert P. Bartlett III, Taking Finance Seriously: How Debt Financing Distorts Bidding Outcomes in Corporate Takeovers, 76 FORDHAM L. REV. 1975, 1983 (2008) (explaining that a levered firm appears to be more valuable because it has an "overall lower cost of capital" and greater expected earnings per share "in normal economic conditions").
194. For numerical examples illustrating the MM model, see, for example, CARNEY, supra note 138, at 210-17;
195. Bartlett, supra note 146, at 1982-85.
196. See Bartlett, supra note 146, at 2002 n.85 ("[E]xcess cash generated by the acquired business [must] be used to repay outstanding indebtedness....").
197. See CARNEY, supra note 138, at 213;
198. Bartlett, supra note 146, at 1984 n.21.
199. See Alan Schwartz, The Continuing Puzzle of Secured Debt, 37 VAND. L. REV. 1051, 1053 (1984) ("The MM proof assumed perfect capital markets, which meant that individual investors can borrow and lend on the same terms as firms could. . . . [This] assumption, many believe, is not far wrong . . . .").
200. But see Judy Shelton, Equal Access and Miller's Equilibrium, 16 J. FIN. & QUANTITATIVE ANALYSIS 603, 619 (1981) ("Investors are prejudiced in favor of corporate debt-as evidenced by the required certification premium on personal debt.").
201. See generally Harris & Raviv, supra note 132 (collecting literature invoking MM).
202. See Modigliani & Miller, supra note 145, at 263-67.
203. See infra Parts IV.B.2-4.
204. See Katherine Pratt, The Debt-Equity Distinction in a Second-Best World, 53 VAND. L. REV. 1055, 1065-67 (2000).
205. CARNEY, supra note 138, at 219 ("This tax shield explained part of the attraction of the leveraged buyouts ('LBOs') of the 1980s.").
206. Cf. Bartlett, supra note 146, at 1992-98 (questioning whether an LBO's use of cheaper leverage means that the winning bidder might not be the one who will put the target's resources to their most efficient use).
207. Franco Modigliani & Merton H. Miller, Corporate Income Taxes and the Cost of Capital: A Correction, 53 AM. ECON. REV. 433, 433-34 (1963).
208. See Merton H. Miller, The Modigliani-Miller Propositions After Thirty Years, 2 J. ECON. PERSP. 99, 112 (1988);
209. see also Ronald J. Gilson & Charles K. Whitehead, Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets, 108 COLUM. L. REV. 231 (2008) (suggesting that slicing up risk among discrete parties may replace residual equity as the most effective way to increase firm value in public companies).
210. See Bartlett, supra note 146, at 1989 ("[S]uppliers may worry that they will not be paid, customers may fear the firm will not honor its contractual commitments, and key employees may have concerns about layoffs and begin to look for alternative employment.").
211. See Myers, supra note 27, at 88-91. Firms do not always get the "tradeoff" right. For example, although leverage helps drive takeover activity, too much leverage has led some firms to default on their loan obligations.
212. See CARNEY, supra note 138, at 219 ("The LBO phenomenon was not without some missteps, however. Some LBOs of the 1980s were too highly leveraged, and the debtors defaulted.").
213. In fact, many start-ups are technically insolvent at various points in their development. See Cathy Markowitz & Scott Blakeley, 7s Your Venture Capitalist-Financed Customer Able to Pay for the Credit Sale? Show Me the Money: The Cash-Burn Rate Is More Important than Ever, Bus. CREDIT, Mar. 2002, at 61, 62 ("Creditors are contending that cash-burn rates of many companies are outstripping revenues and such companies should be liquidated to satisfy creditors' claims rather than continue to operate.").
214. See Schwartz, supra note 150, at 1066 ("The ability of firms to benefit from the interest deduction ... varies. Firms incurring or expecting losses have little use for it.").
215. See Fleischer, supra note 139, at 147.
216. Joseph Bankman & Ronald J. Gilson, Why Start-ups?, 51 STAN. L. REV. 289, 293 (1999).
217. See PAUL A. GOMPERS & JOSH LERNER, THE MONEY OF INVENTION: HOW VENTURE CAPITAL CREATES NEW WEALTH 28 (2001) ("For newly launched enterprises without venture capital backing, failure is almost assured: nearly 90 percent fail within three years.").
218. Fleischer, supra note 139, at 147. Both Fleischer and Joseph Bankman have observed that most start-ups are organized as C corporations. See Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L. REV. 1737, 1738 (1994);
219. Fleischer, supra note 139, at 147. Fleischer tells me that the interest deduction may even be more valuable to those start-ups organized as partnerships for tax purposes (which would include LLCs) because there may be some immediate use of the interest deduction.
220. See Bankman & Gilson, supra note 164, at 294 ("[A] change of ownership under I.R.C § 382 ... sharply restricts the value of the net operating loss.");
221. Fleischer, supra note 139, at 147.
222. See generally Stewart C. Myers & Nicholas S. Majluf, Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not Have, 13 J. FIN. ECON. 187 (1984).
223. Id. at 188.
224. See Myers, supra note 27, at 91-92.
225. See Bartlett, supra note 146, at 1988-89.
226. An entrepreneur's use of internal funds is known as "bootstrapping, " which includes drawing on personal savings and credit cards to finance the start-up's initial growth.
227. See VAN OSNABRUGGE & ROBINSON, supra note 23, at 23-35.
228. Harris & Raviv, supra note 132, at 306 n.11.
229. See Myers, supra note 27, at 92 ("Equity issues will occur only when debt is costly-for example, because the firm is already at a dangerously high debt ratio where managers and investors foresee costs of financial distress.").
230. For the seminal treatment of bonding, see Oliver E. Williamson, Credible Commitments: Using Hostages to Support Exchange, 73 AM. ECON. REV. 519 (1983).
231. The seminal works are ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932)
232. and Michael C Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976).
233. Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 324 (1986).
234. Id.
235. Id. ("By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases.").
236. Id.
237. Id.
238. See Gompers & Lerner, supra note 30, at 484-85.
239. Paul Gompers & Josh Lerner, The Venture Capital Revolution, 15 J. ECON. PERSP. 145, 155 (2001) (referring to staged financing as the "most potent control mechanism" that a venture capitalist employs).
240. See Smith, supra note 137, at 966.
241. See Pui-Wing Tam & Rebecca Buckman, Tech Start-ups Have Money to Burn, but Choose Thrift, WALL ST. J., Jan. 18, 2007, at B1 (illustrating the shift from start-ups quickly spending all of their venture capital money on employees, advertising, etc., during the dot.com era to a more prudent, savings-based approach in recent years).
242. As Larry Ribstein has noted, however, using an uncorporate form, where owners have greater liquidation and distribution rights, could be a more direct way of mitigating the agency costs of free cash. See Larry E. Ribstein, Uncorporating the Large Firm 8 (Univ. of Ill. Law & Econ., Research Paper No. LE08-016, 2008), available at http://papers.ssrn.com/sol3/papers.cfm? abstract-id=1003790 ("[D]ebt is arguably only a second-best mechanism for ensuring distributions because it exposes the firm to the risk of high transaction costs of liquidation or reorganization in bankruptcy.").
243. See Sweeney, supra note 71, at 34 (observing that banks "enhance their relationships [with VCs] by investing directly in venture capital firms");
244. see also David Rosenberg, The Two "Cycles" of Venture Capital, 28 J. CORP. L. 419, 420 (2003) ("With returns reaching a reported average of 163% in 1999, the top venture capital firms were in the enviable position of having a huge surplus of investors vying to act as the limited partners ...." (citation omitted)).
245. Mann, supra note 11, at 161.
246. Id. at 162.
247. See SAXENIAN, supra note 42, at 82.
248. See George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q. 1029, 1035 (1992) ("[V]enture capitalists demand higher returns than the yield typically paid on debt or even on other types of equity investments.").
249. See Mann, supra note 11, at 162 ("[B]ecause the venture capitalist presumably would have to borrow the money itself to lend to the portfolio company, it is likely that such an arrangement would have significantly higher transaction costs than a direct loan to the borrower.").
250. Another interviewee told me that venture debt was simply "too messy for VCs, and not their expertise or business model."
251. See also id. ("[T]he two investors have different skills. For example, the bank's involvement with later-stage portfolio companies centers on the revolving funding of shortterm receivables. To do that funding safely requires considerable expertise, which banks are much more likely to possess than venture capitalists.").
252. See supra note 124 and accompanying text.
253. See Joseph W. Bartlett & Kevin R. Garlitz, Fiduciary Duties in Burnout/Cramdown Financings, 20 J. CORP. L. 593, 601-02 (1995) (explaining that VCs exercise control as directors or controlling shareholders); id. at 601 ("[VC control is exacerbated] if the VCs are also creditors having, for example, advanced bridge loans to keep the issuer in business until the next equity financing.").
254. DEL. CODE ANN. tit. 8, § 144 (2001 & Supp. 2008).
255. See Black & Gilson, supra note 28, at 254-55 (arguing that reputational constraints keep venture capitalists in check and explain the relative lack of litigation among entrepreneurs and VCs);
256. see also Vladimir A. Atanasov et al., The Effect of Litigation on Venture Capitalist Reputation (Dec. 15, 2008) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id= 1343981 (presenting an empirical study that reveals a notable number of cases in this area).
257. See Atanasov et al., supra note 197, at 28 ("VCs involved in litigation as defendants ... tend to raise smaller funds than their corresponding matching firms after litigation ....").
258. Mann, supra note 11, at 159.
259. See generally Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 YALE L.J. 49 (1982) (discussing the need for creditors to monitor their debtors to contain the threat of freeriding).
260. See Gordon, supra note 53, at 72-73 (attributing Comdisco's failure to mismanagement by the founder's son);
261. Britt Erica Tunick, The Return of Venture Lending: New Entrants Scramble to Get into a Once-Shunned Link, INVESTMENT DEALERS' DIG., Nov. 1, 2004, at 1.