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Abstract: Venture capital contracts contain extensive provisions regulating exit by the venture capitalists. In this Article, Professor Smith employs financial contracting theory in conjunction with original data collected from 367 venture-backed companies to analyze these exit provisions. He concludes that the combination of exit provisions in a typical venture capital relationship serves to lock venture capitalists into the investment during the initial stage. In later stages of the relationship, the venture capitalists acquire increasing control over exit by securing additional seats on the board of directors and by obtaining contractual exit rights. The result is a sophisticated transfer of control from the entrepreneur to the venture capitalists as financial investments increase.
Abstract: This paper is the first attempt to study the process and criteria used by entrepreneurs in evaluating venture capitalists. Selection process involves issues such as the time invested in gathering information, the sources of information, and the number of venture capitalists considered. Selection criteria are split into four groups: (1) Valuation; (2) Value-Added Services; (3) Reputational Factors; and (4) Venture Capitalist Attributes. The paper presents results for all respondents and compares results when the respondents are sorted by geographic region, industry, experience, and age. The paper also examines satisfaction, sorting respondents by geographic region, industry, experience, age, time devoted to the search, and criteria ranking.
Abstract: This Article proposes a new theory to unify the law of fiduciary duty. The prevailing view holds that fiduciary law is atomistic, arising for varied reasons in established categories of cases (such as trustee-beneficiary and director-shareholder) and ad hoc in relationships where one person trusts another and becomes vulnerable to harm as a result. By contrast, the critical resource theory of fiduciary duty holds that every relationship properly designated as "fiduciary" conforms to the following pattern: one party (the "fiduciary") acts on behalf of another party (the "beneficiary") while exercising discretion with respect to a critical resource belonging to the beneficiary. Relying on insights from the property rights theory of the firm, this critical resource theory holds that the primary purpose of the law of fiduciary duty is to combat opportunism within relationships that fit this pattern. The beneficiary initially protects against opportunism through self-help denying or threatening to deny the fiduciary access to the critical resource that is an essential platform for opportunistic behavior in these settings. Fiduciary law supplements self-help by depriving the fiduciary of the benefits from opportunism. By requiring the existence of a critical resource at the core of all fiduciary relationships, the critical resource theory assists courts in differentiating fiduciary relationships from relationships in which harm is caused merely by misplaced trust. The critical resource theory also justifies the varying intensity of fiduciary duties across fiduciary relationships: Where self-help is effective, fiduciary constraints are relatively weak, and where self-help is weak, fiduciary constraints are relatively intense. Three additional implications of the critical resource theory of fiduciary duty are also developed: (1) The critical resource theory implies that fiduciary duty and the contractual obligation of good faith and fair dealing are close cousins, both imposing loyalty obligations of varying intensity to combat opportunism; (2) the critical resource theory affirms the capacity of parties in a fiduciary relationship to contract out of fiduciary duties; and (3) the critical resource theory explains why restitution is the usual remedy for a breach of fiduciary duty.
Abstract: Corporate directors have a fiduciary duty to make decisions in the best interests of the shareholders. This aspect of fiduciary duty is often called the shareholder primacy norm. Legal scholars generally assume that the shareholder primacy norm is a major factor considered by boards of directors of publicly traded corporations in making ordinary business decisions and that changing the shareholder primacy norm would have an effect on the substance of those decisions. This Article challenges this view and argues that the shareholder primacy norm was never equipped to mediate conflicts between shareholders and nonshareholder constituencies of a corporation. The origins and development of the shareholder primacy norm suggest that it was introduced into corporate law to perform a much different and somewhat surprising function: the shareholder primacy norm was first used by courts to resolve disputes among majority and minority shareholders, and over time this use of the shareholder primacy norm evolved into the modern doctrine of minority oppression. This application of the shareholder primacy norm seems incongruous today because minority oppression cases involve conflicts among shareholders, not conflicts between shareholders and nonshareholders. Nevertheless, when early courts employed rules requiring directors to act in the interests of all shareholders (not just the majority shareholders), they were creating the shareholder primacy norm. Once used to resolve minority oppression cases, the shareholder primacy norm easily found its way into cases involving publicly traded corporations because courts did not routinely distinguish closely held corporations from publicly traded corporations until the middle of this century. But the application of the shareholder primacy norm to the ordinary business decisions of publicly traded corporations is muted by the business judgment rule. As a result, even though the shareholder primacy norm is closely associated with debates about the social responsibility of publicly traded corporations, it's impact on the ordinary business decisions of such corporations is extremely limited.
Abstract: Corporate law expresses a profound ambiguity toward the role of shareholders. Courts announce that shareholders are "critical to the theory that legitimates the exercise of power - by directors and officers over vast aggregations of property that they do not own." At the same time shareholders have a very difficult time actually making any corporate decisions. In this Article, we strive to define a new role for shareholders by drawing on economic theories of the firm and the structure of corporate law. More particularly we examine the role of shareholders in hostile corporate takeovers, the area where the interests of shareholders and directors collide most dramatically, and highlight a necessary "sacred space" for shareholder self-help, free of director or judicial intrusion.
Abstract: Empirical studies of contracts have become more common over the past decade, but the range of questions addressed by these studies is narrow, inspired primarily by economic theories that focus on the role of contracts in mitigating ex post opportunism. We contend that these economic theories do not adequately explain many commonly observed features of contracts, and we offer four organizational theories to supplement-and in some instances, perhaps, challenge-the dominant economic accounts. The purpose of this Article is threefold: first, to describe how theoretical perspectives on contracting have motivated empirical work on contracts; second, to highlight the dominant role of economic theories in framing empirical work on contracts; and third, to enrich the empirical study of contracts through application of four organizational theories: resource theory, learning theory, identity theory, and institutional theory. Outside economics literature, empirical studies of contracts are rare. Even management scholars and sociologists who generate organizational theories largely ignore contracts. Nevertheless, we assert that these organizational theories provide new lenses through which to view contracts and help us understand their multiple purposes.
contracts, organizations, empirical, law
Abstract: The community of corporate law scholars in the United States is fragmented. One group, heavily influenced by economic analysis of corporations, is exploring the merits of increasing shareholder power vis-a-vis directors. Another group, animated by concern for social justice, is challenging the traditional, shareholder-centric view of corporate law, arguing instead for a model of stakeholder governance. The current disagreement within corporate law is as fundamental as in any area of law, and the debate is more heated than at any time since the New Deal. This paper is part of a debate on the audacious question, Can Corporate Law Save the World? In the first part of the debate, Professor Kent Greenfield builds on his book, THE FAILURE OF CORPORATE LAW: FUNDAMENTAL FLAWS AND PROGRESSIVE POSSIBILITIES, offering a provocative critique of the status quo and arguing that corporate law matters to issues like the environment, human rights, and the labor question. In response, Professor Smith contends that corporate law does not matter in the way Professor Greenfield claims. Corporate law is the set of rules that defines the decision making structure of corporations, and reformers like Professor Greenfield have only two options for changing corporate decision making: changing the decision maker or changing the decision rule. More specifically, he focuses on board composition and shareholder primacy. Professor Smith argues that changes in corporate law cannot eradicate poverty or materially change existing distributions of wealth, except by impairing the creation of wealth. Changes in corporate law will not clean the environment. And changes in corporate law will not solve the labor question. Indeed, the only changes in corporate law that will have a substantial effect on such issues are changes that make the world worse, not better.
corporate law, corporate social responsibility
Abstract: Venture capital contracts are inherently incomplete. When interpreting such contracts, courts could deal with the expectations of parties formally by inquiring only about the plain meaning of the contract or qualitatively by enforcing the presumed expectations of the parties, regardless of whether those expectations are expressed in the contract. The Delaware courts have opted for a formal approach. In doing so, they appear to be engaged in an effort to force contracting parties toward completeness. While the duty of good faith appears to respond to the inevitable incompleteness of contracts, the courts largely ignore this duty in preferred stock cases. This omission, coupled with the doctrine of independent legal significance - which treats charter amendments via merger separately from charter amendments via board and stockholder approval - virtually ensures that preferred stockholders will be subject to opportunistic behavior by common stockholders. Whether courts should respond to claims of injustice in this context depends on comparative institutional analysis. Just because market contracting produces incomplete contracts does not mean that courts should be obligated to fill such contracts. On the other hand, this Article suggests that the application of the duty of good faith in this context might provide valuable incentives to renegotiate when unexpected circumstances arise.
Independent legal significance, good faith, venture capital, Delaware corporate law
Abstract: Modern corporate governance scholars often extol an activist role by institutional investors in directing corporate activity. Widely viewed as a solution to the "collective action" problems that inhibit such activism by individual investors, institutional investors are praised for adding value to corporations through their participation in the decision making process. The ouster of Joseph Antonini as Chief Executive Officer of Kmart Corporation in 1995 might be taken as a vindication of this view, because substantial evidence indicates that institutional investors played a crucial role in influencing Kmart's board of directors to remove him. In this Article, Professor Smith challenges this potential reading of the events at Kmart and poses the fundamental question of whether institutional investor activism designed to address perceived incompetence among corporate managers consistently adds value to corporations in which such activism is present. Professor Smith analyzes the effect of internal and external forces on managers, particularly on Antonini and Kmart's directors, and derives two fundamental lessons: (1) External constraints are ineffective in solving managerial incompetence; and (2) Investor activism will often be counterproductive because it destroys the value of centralized decision making.
Abstract: Most venture capitalists provide services to their portfolio companies beyond capital investment. Although these services form an important part of the bargain between the venture capitalists and the entrepreneur, they are rarely specified or even capable of specification in venture capital contracts. This article examines the moral hazard and adverse selection problems facing entrepreneurs who "hire" venture capitalists to provide value-added services and describes the role of the market for venture capitalist reputation in addressing those problems. Further, the Article speculates about whether advances in information technology - specifically, the World Wide Web - are likely to improve the efficiency of the market for venture capitalist reputation.
Abstract: Today, many biotechnology firms use strategic alliances to contract with other companies. This article contends that the governance structure of these alliances - specifically, the "contractual board" - provides an integrated restraint on opportunism. While an alliance agreement's exit structure could provide a check on opportunism by allowing the parties to exit at will, such exit provisions also can be used opportunistically. Most alliance agreements, therefore, provide for contractual "lock in" of the alliance partners, with only limited means of exit. Lock in, of course, raises its own concerns, and the contractual board - which typically is composed of representatives from each alliance partner, each wielding equal power - addresses these concerns about opportunism via the potential for deadlock.
Strategic alliances, opportunism, lock in, deadlock, exit
Abstract: This brief essay, prepared for a symposium on Bloggership: How Blogs Are Transforming Legal Scholarship, held at Harvard Law School on April 27-28, 2006, uses blogging about The Walt Disney Company Derivative Litigation at the Conglomerate blog to illustrate the potential of blogging as a scholarly medium. Blogging encourages individual research and reflection, and its public nature provides an opportunity for scholarly activity that is similar in many ways to presenting at an academic conference or publishing an editorial article. Bloggership is a useful neologism that distinguishes this sort of scholarship from traditional, long-form scholarship and it distinguishes blogging that has scholarly aspirations from other forms of blogging. If scholarship is about making a contribution to knowledge, and the receptacle for that contribution is a scholarly community, then blogs seem well positioned to serve as delivery mechanisms.
Abstract: In this essay, we sketch the outlines of a research agenda exploring links between courts and entrepreneurship. Our conception of "law and entrepreneurship" encompasses the study of positive law (including constitutions, statutes, and regulations), common law doctrines, and private ordering that relate to "the discovery and exploitation of profitable opportunities by new firms." We briefly survey the economics literatures that relate to law and entrepreneurship, including the "law and finance" literature launched by the work of Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny ("LLSV"). Relying on the suggestive work of LLSV and other economists who have labored over the connections between entrepreneurship and law, we suspect that courts may play an important role in facilitating or hindering entrepreneurial activity. We are particularly interested in the possibility that courts may facilitate the evolution of legal rules to address novel issues raised by entrepreneurial firms. This "adaptability hypothesis" may be subject to empirical testing, thus shedding light on the otherwise perplexing divide between common law and civil law countries identified by LLSV. The motivation for such a test lies in the conjecture that common law countries update their laws more frequently than civil law countries through judicial intervention. Adaptability in this sense is said to encourage entrepreneurship because outmoded laws allow for opportunism, thus discouraging capital formation. The adaptability hypothesis implies that judges in common law systems have more room to maneuver than judges in civil law systems, and we describe the method by which we intend to approach our future study of adaptability.
law and entrepreneurship, legal origins, common law, civil law, judicial adaptability
Abstract: Entrepreneurs and venture capitalists engage in "team production." Inherent in team production is an incentive problem: team members have an incentive to shirk. The incentive to shirk derives from the inability to monitor team members perfectly and compensate them based on productivity. Economic models of team production teach that solutions to shirking must involve (1) a principal (2) with authority to "break the budget" by realigning the claims of team members through use of a penalty or a bonding arrangement (3) based only on observations of team output, not on monitoring of individual inputs. This paper analyzes the team production problem in venture capital investing using the rich set of facts provided by the book Startup: A Silicon Valley Adventure, which recounts how entrepreneur Jerry Kaplan and his venture capitalists at Kleiner Perkins Caufield & Byers, the most prominent venture capital firm in Silicon Valley, formed and operated GO Corporation. The paper argues that entrepreneurs and venture capitalists address the team production problem through staged financing, the practice of investing only enough money to allow the entrepreneur to progress to the next milestone in its business plan. Under the traditional view, the possibility of abandonment by the venture capitalist is the key virtue of staged financing. This insight is important but incomplete because it fails to accord full credit to the power of staged financing to provide incentives to both the entrepreneur and the venture capitalist. From the entrepreneur's perspective, the prospect of abandonment is not the only danger in staged financing, and it may not even be the most important. Another danger is that successive rounds of financing may substantially dilute the entrepreneur's interest in the company. This threat of dilution provides the entrepreneur with incentives to be diligent, thus effectively addressing the team production problem. Unlike the entrepreneur, the venture capitalist is not susceptible to dilution because the venture capitalist has a fixed claim, enforced by the right of first refusal in all additional financings. Nevertheless, the venture capitalist has incentives to maximize valuation at each stage of the financing process. Those incentives derive primarily from the reputational effects of high valuations.
Abstract: Law and entrepreneurship is an emerging field of study. Skeptics might wonder whether law and entrepreneurship is a variant of that old canard, The Law of the Horse. In this essay, we defend law and entrepreneurship against that charge and urge legal scholars to become more engaged in the wide-ranging scholarly discourse regarding entrepreneurship. In making our case, we argue that research at the intersection of entrepreneurship and law is distinctive. In some instances, legal rules and practices are tailored to the entrepreneurial context, and in other instances, general rules of law find novel expression in the entrepreneurial context. As a result, the study of law and entrepreneurship yields unique insights about both law and entrepreneurship.
Entrepreneurship, Law and Entrepreneurship, Law of the Horse
Abstract: The Committee on Corporate Laws of the Business Section of the American Bar Association recently adopted amendments to the section of the Model Business Corporation Act (MBCA) enunciating standards of director performance. In place of the current section 8.30, which has been adopted by 42 states, the Committee has adopted two sections - one defining a "standard of conduct" and one defining a "standard of liability" for corporate directors. This paper argues that these new standards do not achieve the goals of bifurcation. Moreover, if adopted and used, the new standards will engender confusion and possibly inequitable results. This paper proposes the removal of standards governing the duty of care from the MBCA, returning authority over this area of law to the common law courts.
Abstract: In his case study of the MasterCard IPO and its predecessor piece on the Google IPO, Victor Fleischer claims to find evidence of a branding effect of legal infrastructure. The branding effect is not aimed at reducing the potential for opportunism by a counterparty to a contract, but rather at increasing the attractiveness of a product to present and future users or improving the image of a company in the eyes of regulators, judges, and juries. In this essay commenting on Fleischer's work, I endorse the notion that deal structures have branding effects and position Fleischer's work within a larger stream of scholarship that focuses on the substantive terms of contracts rather than on contract doctrine or dispute resolution in various contractual settings. In addition, I offer a few refinements to Fleischer's notion of branding effect.
branding, contracts, opportunism
Abstract: During his tenure on the bench, Chancellor William Allen was widely regarded as the leading judicial expert on matters of corporate law. In this Article, I attempt to explain Chancellor Allen's expansive reputation by examining his ability to speak to what philosopher John Danley calls "the fundamental question": "What is the appropriate role of the modern corporation in a free society?" Nowhere in corporate law is the fundamental question more conspicuous or more relevant than in takeover cases implicating the shareholder primacy norm. When a board of directors has elected to sell control of a corporation, Delaware courts evaluate the behavior of the directors pursuant to standards announced in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., which requires directors to obtain "the highest price for the benefit of the stockholders." Chancellor Allen began his judicial tenure shortly before the Delaware Supreme Court decided Revlon, and Allen's first opinion citing Revlon appeared less than one month after the Supreme Court's opinion was issued. Allen's final Revlon opinion was written shortly before he left the bench. In the 11 years between his first and last opinions dealing with Revlon, Chancellor Allen successfully defended the traditional allocation of power over corporate decision making among directors, shareholders, and courts by artfully and insistently rebuffing attempts of the Delaware Supreme Court to expand the role of the courts into areas where they have no useful role. In so doing, Chancellor Allen helped to ensure that the appropriate role of the modern corporation in a free society would be decided by individual actors in that society rather than by judicial fiat.
Abstract: In this essay, I trace the legal precursors of transaction cost economics by focusing on three prominent faculty of the University of Wisconsin: John R. Commons, J. Willard Hurst, and Stewart Macaulay.
contracts, transaction cost economics
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