Ebook Private Ordering and Corporate Governance: The Case of Venture Capital
Since the turn of the century and the Enron-class corporate scandals the debate on corporate governance has been shaped by a massive complex of realized or contemplated legal reforms. The introduction of the Sarbanes-Oxley Act in 2002, the proposed amendments to the proxy rules regarding shareholder access and lately the proposed regulations pertaining to executive compensation have all led to a unidirectional view of corporate governance emanating from state actors and imposed upon corporations. This top-down perspective has shifted the focus away from the plethora of corporate governance institutions that do not stem from state or federal law, but are privately designed by the corporate constituencies and are legitimized through their inclusion in the firm’s charter or bylaws. To put it differently, now that the Congress and the SEC have started interfering more with internal corporate affairs the study of the contribution of private ordering to the US corporate governance system is to a certain extent put aside in the corporate law literature.
This paper seeks to rejuvenate the interest in private corporate governance institutions by attempting to reconcile corporate governance with contract theory. The underlying theme of the paper is that the comprehension of the factors that shape corporate governance in a private company setting presupposes the comprehension of the factors that impact contract design. In reality, many of the governance mechanisms that are designed by the parties to the corporate contract are essentially devices used to mitigate the various contractual impasses that contract theory identifies. The features of the contractual problems of adverse selection, moral hazard and incompleteness actually act as determinants of corporate governance planning. In other words, corporate governance institutions are a response to contractual design exigencies. Without corporate governance the members of the firm would have no way to fend off the cognitive chaos that derives from the problems of hidden knowledge, hidden action and unanticipated contingencies, to which the corporate contract gives rise.
factors that impact contract design. In reality, many of the governance mechanisms that are designed by the parties to the corporate contract are essentially devices used to mitigate the various contractual impasses that contract theory identifies. The features of the contractual problems of adverse selection, moral hazard and incompleteness actually act as determinants of corporate governance planning. In other words, corporate governance institutions are a response to contractual design exigencies. Without corporate governance the members of the firm would have no way to fend off the cognitive chaos that derives from the problems of hidden knowledge, hidden action and unanticipated contingencies, to which the corporate contract gives rise.
To illustrate this argument I use the example of venture capital, where start-up firms and venture capitalists, acting within the scope of the enabling regime of state corporate law and free of the burdens of federal securities regulation or listing standards, draft their financial contract in a way that allows an optimal corporate governance structure to be established in the venture-backed firm. In Parts II and III of the paper I show step-by-step how the venture capital financial contract is designed in order to put in place governance tools that will help the parties surmount the three basic problems of contracting.
In Part I of the paper I explain the contractarian foundations of the firm by using concepts of agency theory and transaction-cost economics. I introduce the term “lato sensu incompleteness of contracts”, which includes not only the traditional (stricto sensu) incompleteness of contracts, namely the fact that the parties to a contract cannot foresee all future contingencies, but also the two other major contractual problems of moral hazard and adverse election. I, then, present my main argument that corporate governance mechanisms in a private company setting are actually devices, with which corporate constituencies try to tackle this three-dimensional lato sensu incompleteness of contracts, so that a private firm’s governance structure will reflect the severity and peculiarities of this contractual challenge.
Contents
Introduction
I. The Contractarian Theory of the Firm and Corporate Governance
A. The departure from the neoclassical theory of the firm and the “nexus of contracts” approach
B. Transaction-Cost Economics, Incomplete Contracting and the Need for Corporate
Governance
C. The Dimensions of the Lato Sensu Incompleteness of Contracts as Determinants of Corporate Governance
1. Moral Hazard Costs and Post-Contractual Opportunism
2. Adverse Selection
3. Stricto Sensu Incompleteness of Contracts
II. Screening Private Information: How VCs Deal With Adverse Selection
A. The Theory of Financial Intermediation and Venture Capital
B. The Staged Investment of Venture Capital
1. Integrating Governance Design into the Screening Game
2. Real Options Theory and Staged Investment
3. Staged Investment as a Screening Strategy
i. The traditional view of staged financing as a monitoring device
ii. A behavioral approach to staged investment: Looking for entrepreneurial intrinsic motivation
iii. The problem of "soft-budget constraints"
iv. The VC partnership agreement as a hard budget constraint
III. Infusing Governance through Security Design: Why Convertible Preferred Stock?
A. Venture Capital’s Investing Vehicle of Choice: Convertible Preferred Stock
1. Dividend and Liquidation Preference
2. Redemption Rights
3. Convertibility
4. Control Rights
B. The Theories of Capital Structure and their Application in VC Financing: Governance Features of Convertible Preferred Stock I
1. Solving the Enigma of Convertible Preferred; Standardization, Mimetic Isomorphism and Corporate Governance
2. The Modigliani-Miller Capital Structure Irrelevance Theorem and the Rise of the Capital Structure Debate
3. Taxation and Capital Structure Choice; The Tax Effects of Convertible Preferred Stock in VC-backed firms
4. Capital Structure as an Agency Cost-Mitigating Mechanism
i. The disciplining effects of debt
ii. Replicating the incentive-compatible cash flow structure of debt with convertible preferred stock; Placing convertible preferred on the debt-equity continuum
5. Capital Structure as a Signaling Mechanism
i. Leverage signaling models
ii. Reversing the signaling game; Sorting out entrepreneurs by using convertible preferred stock
C. Financial Contracting Theory and its Application in VC Financings: Governance Features of Convertible Preferred Stock II
1. Advanced Security Design: Separating Cash Flow and Control Rights
2. Financial Contracting Theory and the State-Contingent Optimal Allocation of Control Rights
3. Optimal Programming of the Control Rights Pendulum in VC Contracts
IV. The Mandatory Model of Corporate Law in Europe and its Implications for Venture Capital
A. Comparing the US and the European VC Industry
B. The Enabling Character of US Corporate Law versus the Mandatory Nature of
European Corporate Law
C. Does the Mandatory Nature of European Corporate Laws Directly Impede VC Contracting?
D. Contractual Path Dependence and Mandatory Corporate Law
V. Conclusion
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