Venture Capital and Preferred Stock

The following post comes to us from Charles Korsmo, Assistant Professor of Law, Case Western University School of Law and is based on his recent article, “Venture Capital and Preferred Stock,” 78 Brook. L. Rev. 1163 (2013).  The full paper is available here.

Scholarly attention to the governance issues surrounding preferred stock has been sporadic at best, perhaps due to a general impression that preferred stock is a relic of an earlier era of corporate finance.  In fact, however, preferred stock—which combines some of the features of debt with some of the features of equity—has become the investment vehicle of choice for venture capitalists investing in high-risk, cutting-edge startup companies.  As a result, cases involving preferred stock have begun appearing in the Delaware courts with increasing frequency, most recently in Vice Chancellor Laster’s opinion in In re Trados, discussed on this blog two weeks ago.

In my article, “Venture Capital and Preferred Stock,” which was recently published in the Brooklyn Law Review, I consider the proper legal treatment of preferred stock in the venture capital context.  In particular, I address two fundamental governance questions.  First, to what extent, if any, should venture capitalists holding preferred stock be entitled to fiduciary protection from exploitation by holders of common stock?  Second, conversely, to what extent should holders of common stock be entitled to fiduciary protection against exploitation by preferred stockholders?

The major conclusion of my article is that venture capitalists holding preferred stock should never be afforded fiduciary protections, and should always be required to rely on contractual protections included in the charter.  The traditional rationales for the imposition of fiduciary duties do not apply in the context of preferred stock used for venture capital financing.  The sophisticated nature of venture capitalists and their counsel, their status as repeat players, their concentrated financial interest, the heavily bargained nature of venture capital financing, advances in contracting technique, and the lack of any uncontroversial majoritarian defaults or norms of fairness all combine to make traditional corporate fiduciary duties an unnecessary—and potentially destructive—supplement to contractual bargaining.  In the venture capital context, fiduciary duties provide preferred stockholders little protection they could not provide themselves by contract, while generating uncertainty that could interfere with the ability to accurately price contractual terms.

The fact that venture capitalists holding preferred stock should not be provided with fiduciary protection, however, does not imply that they should not owe fiduciary duties to the common stockholders.  I argue that when preferred stockholders control the board, fiduciary protections for common stockholders will generally be appropriate even in the venture capital context—perhaps especially in the venture capital context.  The common stockholders in a VC-backed startup are typically the entrepreneurs and early employees of the company.  While the computer programmers and biologists who populate Silicon Valley are undoubtedly of high intelligence, they are rarely repeat players and there is little reason to believe they possess the financial and legal sophistication necessary to evaluate and price potentially exploitative charter terms.  Without fiduciary protection, a very real possibility exists that venture capitalists could exploit their information advantage to undercompensate entrepreneurs and other startup employees by paying them with common stock that is worth less than it may appear.

Nonetheless, I argue that fiduciary duties imposed on preferred stockholders should be carefully limited to the “gap filler” fiduciary duties envisioned by contractarian scholars, rather than expanded to encompass broader normative notions of contract-trumping “fairness.”  Venture capital deals tend to be highly customized, and deciding what is “fair” in a given context is unlikely to be a straightforward proposition.  Evaluating fairness is likely to be particularly difficult in hindsight.  The ability to take actions that appear unfair ex post—such as forcing liquidation of a promising firm—will often create value-maximizing incentives ex ante.  Care must be taken not to allow fiduciary duties to displace voluntary bargains and destabilize contractual relationships.

Vice Chancellor Laster’s recent In re Trados opinion offers an excellent example.  The case involved a VC-backed startup, where the venture capitalist holders of preferred stock ended up controlling the board.  The venture capitalists sought to exit their investment via a sale of the company that left the common stockholders with nothing.  In his opinion, Vice Chancellor Laster held—correctly, I believe—that the preferred stockholders’ control of the board did not equate to an absolute right to force sale of the company whenever doing so was in the preferred stockholders’ interest.  Instead, the preferred stockholders could only sell the company subject to their fiduciary obligations to the common stockholders, which the court interpreted in terms of the standard norm of common stockholder wealth-maximization.

While the court did not need to reach the issue, my framework would suggest that if the preferred stockholders had provided themselves with an explicit right to force sale of the company, they should have been entitled to do so even if, viewed ex post, doing so would harm the common stockholders.  Likewise, if it had been the common stockholders in control of the board, my framework would suggest that protections for the preferred stockholders should be limited to those provided in the share contract.