In our recent research paper, we argue that venture capital-friendly corporate law should feature flexible fair value protections.
Venture capital is critical to innovation and, thus, economic growth. As policy-makers around the world make strides to support the development of vivid venture capital markets, reforms have been flourishing, particularly in Europe, which seek to instil corporate laws with greater degree of flexibility, so as to facilitate the cooperation between entrepreneurs and venture capitalists in the context of venture capital-backed firms (‘VC-BFs’).
Although often ambitious, these initiatives have seemingly omitted to consider the evolution that VC-BFs typically undergo during their lifecycle, as well as the contents of the explicit and implicit arrangements that allow for their diachronic metamorphosis. The potential contrast between these arrangements and existing corporate laws has accordingly gone unnoticed and, therefore, it has thus far remained completely unaddressed by reforms.
Building on a novel theorization of VC-BFs, our research seeks to take a step in this new direction by focusing on the dynamics unfolding through ‘unavoidable value-destroying trade sales’ to lay bare the frictions between the standard entrepreneur-venture capitalist contract and ‘fair value protections’, a cornerstone component of corporate law. Trade sales— the most-used divestment techniques for venture capitalists on both sides of the Atlantic Ocean—are a variety of M&A transactions (eg, a merger) instrumental to carrying out the sale of the entire VC-BF to a competitor. Unavoidable trade sales are those trade sales the venture capitalist in control executes as the VC-BF enters into its divestment mode to generate the liquidity needed to meet his obligations towards his own investors, particularly towards the end of the lifetime of the venture capital fund. Conceptually, ‘fair value protections’ are, in functional terms, a number of safeguards and remedies entitling shareholders external to decision-making to claim the fair value of their shareholdings, taken to be a function of firm value as an independent entity, vis-à-vis a given list of actually or potentially value-destroying transactions, so as to possibly escape their negative consequences. US appraisal rights are perhaps the best-known example, but they come in a variety of forms that differ along a number of dimensions.
The arguments are, in essence, as follows. The contract governing venture capital funds feature a fixed-term provision that serves a well-known efficiency function, for it enables fund investors to assess the performance of fund managers, who, in turn, are therefore compelled to generate the promised returns in the agreed-upon timespan. To support the achievement of this goal, the contract at the fund level informally penetrates, through so-called ‘braiding’, into the contract governing VC-BFs, shaping its structure, design, and implementation. The entrepreneur-venture capitalist business relationship does accordingly exhibit a peculiar biphasic structure. VC-BFs, in fact, do typically first serve as ’investment incubators’ and then transform into ‘liquidity-generating devices’. Consistent with the idiosyncratic timeline informing the existence of venture capital funds, VC-BFs will generally stay in an ‘investment mode’ for some 5 years and spend an additional 3-5 years in a ‘divestment mode’. Both contract design, with its plethora of private ordering-based solutions, and, more importantly, the rule governing contract implementation reflect contracting parties’ ambition to support VC-BFs’ evolutionary process. To facilitate the venture capitalist’s quest for timely liquidity, the standard contract assigns the venture capitalist with a ‘termination option’ that, albeit only as the VC-BF enters into divestment mode, enables him to implement a timely divestment regardless of any contingency. Intuitively, this contract term makes the room for counterintuitive instances of contractually compliant value destruction.
The ideal experimental laboratory for appreciating this theorization and its implications are unavoidable value-destroying trade sales. In a manner similar to so-called ‘fire sales’, these transactions may well end up sacrificing total shareholder value. First, time-constraints on the sell-side may in fact cause a shift in bargaining power that the buyer may exploit to his own benefit to buy the VC-BF for cheap. Second, inefficiencies in the M&A market may make it temporarily impossible to realize the VC-BF’s full value. Their ostensible ‘opportunistic aftertaste’ notwithstanding, these transactions are, indeed, just the function of ex-ante agreed-upon contractual terms. They are, in fact, the most tangible manifestation of the venture capitalist’s termination option.
To counteract value-destruction, corporate law does resort—inter alia—to so-called fair value protections, which are often available vis-à-vis trade sales—particularly, but not exclusively, if consummated in the form of asset combinations (eg, mergers). Fair value protections, however, tend to interfere with the venture capitalist’s termination option: while the standard entrepreneur-venture capitalist contract grants the venture capitalist the license to generate liquidity even if this comes at the costs of sacrificing firm value, fair value protections enable the entrepreneur to escape the effects of these transaction by claiming the fair value of his shareholding.
The resulting ‘exit penalty’, then, causes a schism between the observable allocation of the value generated by unavoidable value-destroying trade sales and the allocation upon which the entrepreneur and the venture capitalist would typically agree. This outcome may then affect contracting parties’ ex-ante incentives to cooperate, and possibly inhibit their cooperation altogether. To obviate to this unfortunate result, the entrepreneur and the venture capitalist may then choose to resort to a variety of private ordering-based solutions aimed at deactivating or at least re-shaping fair value protections, with a view to ultimately depriving them—one way or the other—of their bite.
Here is where the design of corporate law becomes significant. By preventing the adoption of firm-specific solutions aimed at remoulding fair value protections, a corporate law contemplating rigid fair value protections may inhibit the formation of a given number of business relationships between those entrepreneurs and venture capitalists unable to redistribute value through other contractual components. A corporate law that, by contrast, adopts flexible fair value protections does not present this drawback, and, by allowing for the formation of this additional number of relationships, it does emerge, from a social welfare perspective, as a superior solution.
Hence, a straightforward conclusion: policy-makers interested in supporting social welfare through venture capital should consider injecting a significant dose of flexibility into fair value protections.
Casimiro A Nigro is a Post-Doctoral Researcher at the Foundations of Law and Finance Research Center, Goethe Universität, Frankfurt am Main.
Jörg R Stahl is Assistant Professor at the Católica Lisbon School of Business & Economics, Lisbon.