Venture Capital Legal Resource Materials
Entrepreneurship Law Editorial Team
Vladimir Atanasov, Vladimir Ivanov & Kate Litvak, The Impact of Litigation on Venture Capitalist Reputation (2007).
Abstract (from authors):
Venture capital contracts give VCs enormous power over entrepreneurs and early equity investors of portfolio companies. A large literature examines how these contractual terms protect VCs against misbehavior by entrepreneurs. But what constrains misbehavior by VCs? We provide the first systematic analysis of legal and non-legal mechanisms that penalize VC misbehavior, even when such misbehavior is formally permitted by contract. We hand-collect a sample of over 177 lawsuits involving venture capitalists. The three most common types of VC-related litigation are: 1) lawsuits filed by entrepreneurs, which most often allege freezeout and transfer of control away from founders; 2) lawsuits filed by early equity investors in startup companies; and 3) lawsuits filed by VCs. Our empirical analysis of the lawsuit data proceeds in two steps. We first estimate an empirical model of the propensity of VCs to get involved in litigation as a function of VC characteristics. We match each venture firm that was involved in litigation to otherwise similar venture firm that was not involved in litigation and find that less reputable VCs are more likely to participate in litigation, as are VCs focusing on early-stage investments, and VCs with larger deal flow. Second, we analyze the relationship between different types of lawsuits and VC fundraising and deal flow. Although plaintiffs lose most VC-related lawsuits, litigation does not go unnoticed: in subsequent years, the involved VCs raise significantly less capital than their peers and invest in fewer deals. The biggest losers are VCs who were defendants in a lawsuit, and especially VCs who were alleged to have expropriated founders.
Paul A. Gompers & Josh Lerner, THE MONEY OF INNOVATION: HOW VENTURE CAPITAL CREATES WEALTH (2001).
Paul A. Gompers & Josh Lerner, THE VENTURE CAPITAL CYCLE (1999).
Jane Greyf et al, PRIVATE EQUITY AND VENTURE CAPITAL TRENDS IN A TURBULENT ECONOMY: LEADING LAWYERS ON DEVELOPING STRATEGIC ALLIANCES, EVALUATING NEW GROWTH OPPORTUNITIES, AND ANALYZING MARKET CHANGES (2009).
Abstract (from product description at Amazon.com):
Provides a perspective on the impact of the financial crisis on market conditions and the key strategies to surviving the crisis. Featuring partners and chairs from law firms, these experts offer their insight into the current and potentially lasting economic trends that will impact private equity and venture capital deals today and tomorrow. Emphasizing the need for legal counsel to help clients spot the warning signs of an economic slowdown and think outside of the box in deal structuring, negotiations, and risk assessment, the authors offer new techniques that enable clients to remain successful despite the financial market s downward path and share predictions for potential market reforms that will further affect clients businesses. Additionally, these leaders discuss the increasing significance of global commerce on the U.S. private equity market and how to keep clients abreast of new opportunities abroad. The different niches represented and the breadth of perspectives presented enable readers to get inside some of the great legal minds of today, as these experienced lawyers offer up their thoughts around the keys to success within this constantly changing area of law.
Michael Klausner & Kate Litvak, What Economists Have Taught Us About Venture Capital Contracting, in Bridging the Entrepreneurial Financing Gap: Linking Governance with Regulatory Policy (Michael J. Whincop ed., 2001.)
Jochen Bigus, Staging of Venture Financing, Investor Opportunism, and Patent Law, 33 J. Bus. Fin. & Acct. 939 (2006).
Abstract (from author): Stage financing provides a real option that is valuable when facing external uncertainty. However, it may also induce investor hold-up, if the property rights on an invention are not sufficiently protected. As a consequence, the entrepreneur may not work hard. Investor opportunism is less likely to occur, if investors' residual cash-flow-rights are contingent on verifiable ‘milestones’ in the previous stage. Equity-linked financing also provides high-powered incentives to the investor not to ‘steal the idea’ because his payoff becomes sensitive to the project value. The paper provides a new explanation for both types of contractual provisions.
Abraham J.B. Cable, Fending for Themselves: Why Securities Regulations Should Encourage Angel Groups, 13 U. Pa. J. Bus. L. 107 (2010).
This article argues that securities law has not kept up with the needs of today’s entrepreneurs and their investors, artificially lowering the potential for new companies to find financing, especially from angel groups.
Douglas Cumming et al., Entrepreneurial Litigation and Venture Capital Finance (2011), available at http://ssrn.com/abstract=1786479.
Abstract (from author):
This paper empirically examines the impact of entrepreneurial firm plaintiff litigation on the ability of entrepreneurial firms to obtain venture capital (VC), and the subsequent effect on VC exit outcomes. This empirical context is important, as both the costs of litigation and potential benefits are arguably more pronounced for start-ups relative to established firms. We consider cases of litigation being initiated both before and during VC financing. The data indicate (1) plaintiff firms are more likely to obtain financing by less reputable VCs, (2) VCs provide more oversight of plaintiff firms relative to non-plaintiff firms in their portfolio, (3) plaintiff firms are more likely to exit by an IPO (versus acquisition), and less likely to be defunct at the end of the investment period; these exit outcomes are more pronounced for successful plaintiff firms, and (4) underpricing is reduced when PCs win or lose cases but is increases when cases are settled. For all results, implications are less severe for litigants who begin their suit after VC suggesting these entrepreneurial litigants have the backing of the VC.Raquel Fonseca, Pierre-Carl Michaud & Thepthida Sopraseuth, Entrepreneurship, Wealth, Liquidity Constraints, and Start-up Costs, 28 Comp. Lab. L. & Pol'y J. 637 (2006).
Douglas J. Cumming & April M. Knill, Disclosure, Venture Capital and Entrepreneurial Spawning, 43 J. Int’l Bus. Stud. 563 (2012), available at http://ssrn.com/abstract=2127055.
Abstract (by author): Venture capital (VC) funds have been facing increasing regulatory scrutiny since the 2007 financial crisis, particularly with respect to calls for increased disclosure requirements. In this paper, the authors examine the effect of more stringent securities regulation on the supply and performance of VC, as well as on new business creation (i.e., entrepreneurial spawning). Using country-level and investment-level data from 34 countries over the years 2000–2008, the authors find that more stringent securities regulation is positively associated with the supply and performance of VC around the world. More stringent securities regulation is also positively associated with entrepreneurial spawning induced by VC. Among different forms of securities regulation, disclosure stands out as having the most economically meaningful impact, which casts doubt on the oft-repeated objections to disclosure in VC – that it would stifle the VC industry, because secrets would have to be revealed to competitors and the public. These findings are robust to numerous robustness checks for endogeneity. The policy implications are clear, however, regardless of endogeneity concerns: VC and entrepreneurship markets are enabled, not curtailed, in countries with better disclosure standards, when one compares the existing differences in disclosure around the world and changes thereto over the 2000–2008 period.
Ronald J. Gilson & David Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 Harv. L. Rev. 874 (2003).
Abstract (from authors): In this Article, we examine the influence of a more mundane factor on venture capital structure: tax law. Portfolio companies issue convertible preferred stock to achieve more favorable tax treatment for the entrepreneur and other portfolio company employees. The goal is to shield incentive compensation from current tax at ordinary income rates, so managers can enjoy tax deferral (until the incentive compensation is sold, or longer) and a preferential tax rate. No tax rule explicitly connects the employee's tax treatment with the issuance of convertible preferred stock to venture capitalists. Rather, this link is part of tax "practice" - the plumbing of tax law that is familiar to practitioners but, predictably, is opaque to those, including financial economists, outside the day-to-day tax practice. Despite its obscurity, this tax factor is likely of first-order importance. Intense incentive compensation for portfolio company founders and employees is a fundamental feature of venture capital contracting.
Darian M. Ibrahim, Debt as Venture Capital, 2010 Ill. L. Rev. 1169 (2010).
This article examines how start-ups fund themselves with debt as well as well as with venture capital.
Darian M. Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 Vand. L. Rev. 1405 (2008).
Abstract (from author):
This Article's explanations for the rationality of both traditional angel contracts and angel group contracts fill important gaps in both the entrepreneurial finance and financial contracting literatures. They also inform contract/trust and costly contracting theories. The remainder of the Article is organized as follows. Part II examines the typical venture capital investment contract and reviews its mechanisms for reducing extreme levels of uncertainty, information asymmetry, and agency costs in start-up investments. Part III reveals the unique nature of angel investing, which explains what otherwise appears to be a puzzling, simple contract design on the part of traditional angels. Part IV examines changes in angel contract design corresponding to the recent professionalization of the field and shows that it is rational for these contracts to include more comprehensive terms. Part V concludes.
Andrew Kirkpatrick, The Shield of Unintended Consequences: Analyzing Venture Capital's Defense against Increased Carried Interest Taxation, 2 Brook. J. Corp. Fin. & Com. L. 483 (2007).
Abstract (from author):
To understand why the proposed carried interest taxation is reasonable, it is necessary to look at why capital gains taxation exists. Venture capitalists believe that their returns on investment are distinct from other common issues of carried interest compensation. However, the reality of an efficient market and underlying policy issues suggest that venture capital should not be treated differently. Part II of this note provides a survey of the venture capital industry, including its recent growth and role in the American investment marketplace and explains how the industry will be affected by increased taxation. It also examines the nature of risk-taking (an issue to be addressed further in Part V.A) and profitability in the venture capital industry. Part III provides an introduction to carried interest and the lower capital gains taxation rate. It explains which industries commonly structure their businesses to take advantage of lower taxation and the difference between the proposed bills on carried interest. Part IV gives a survey of recent tax reform that affected venture capital. Part V addresses the arguments made by venture capitalists against increased taxation. Part V.A addresses the effects of changing the cost/benefit equation established in the industry, which includes the risk-taking nature of the industry, the need for providing incentives to fund managers, and the likelihood that opportunities in the global investment landscape will encourage an exodus of American venture capital firms and managers. Part V.B provides justifications for altering the present definition of carried interest and treating it as income from services rendered as opposed to capital gain. Finally, Part V.C addresses the effects of shifting the tax burden, how other industries and investors will be affected, and how the policy reasons behind proposed legislation indicate that the venture capital industry is not an unintended casualty.
Michael Klausner & Stephen Venuto, Liquidation Rights and Incentive Misalignment in Start-Up Financing (Stanford Law and Economics, Olin Working Paper No. 454, 2013), available at http://ssrn.com/abstract=2342616.
Abstract (by authors): This article analyzes how the accumulation of liquidation rights over multiple rounds of investment in a start-up can result in an aggregate contractual arrangement among the company’s investors and its management team that is suboptimal. Liquidation rights determine the allocation of the proceeds when a start-up is sold. Because a sale is the most common form of exit for investors, these rights are a key factor in determining the return to investors, the return to the company’s management team and employees, and the incentives of all parties involved. The source of this problem is the sequential nature of the contracts involved. As new investors negotiate their rights, earlier investors’ rights are rarely renegotiated. In order to protect themselves from the impact of later investors’ liquidation rights, earlier investors often seek rights that turn out to be counterproductive. This article analyzes this phenomenon and suggests a contractual mechanism to coordinate liquidation rights over time so that the sequential negotiation of liquidation rights is less likely to result in a reduction in firm value.
Tom Lahti, Categorization of Angel Investments: An Explorative Analysis of Risk Reduction Strategies in Finland, 13 Venture Capital 49 (2011).
Abstract (from author):
Recent studies have proposed that future research on business angel typologies should focus on individual investments rather than investors. This study is a response to this proposal. It suggests that investments can be divided into subgroups in accordance with the comprehensiveness of business angels' due diligence and the strength of their involvement in the ventures. The sample comprises 53 investments by Finnish business angels. Four investment categories were identified: (a) gambles; (b) conventional angel investments; (c) due diligence-driven investments; and (d) professionally safeguarded investments. These investments are compared with respect to the general characteristics of the investors and investments, investment criteria and general investment preferences and to the level of relationship-specific investments by entrepreneurs. The results point to several substantial differences between these groups. The study helps entrepreneurs to understand what they can expect from angel investments.
Scott Ollivierre, The Influence of Taxation on Capital Structure in Venture Capital Investments in Canada and the United States, 68 U. Toronto Fac. L. Rev. 9 (2010).
Abstract (from author):
My obnoxious neighbor is paying my customers to take their business elsewhere. What can I do?’ In the common law jurisdictions of Canada, the answer is nothing. Although there is a tort of intentional interference with economic relations, it requires the plaintiff to show that the defendant used a separately unlawful means. This could include a crime, a tort or some other misdeed that the courts have had difficulty defining. In a number of recent cases, the scope of ‘unlawful means’ has given rise to problems: see Drouillard v. Cogeco Cable Inc. (2007), 223 O.A.C. 350, OBG Ltd. V. Allan,  4 All E.R. 545 (H.L.) and Correia v. Canac Kitchens (2008), 240 O.A.C. 153. In this article, the author argues that the unlawful means requirement should be abandoned in favor of a legal malice standard. That is, the defendant should be liable if she caused economic harm intentionally and without legal justification, such as free speech or business competition. The legal malice standard is already employed in the United States, France and Germany, as well as in other areas of Canadian law, e.g., malicious prosecution and civil conspiracy. The author argues that such a reform would be in keeping with the fact that ‘unlawful means’ has not been satisfactorily defined in over a century of jurisprudence, and the fact that reliance on a separately unlawful act produces a highly parasitic analysis. Permitting recovery for maliciously inflicted economic harm would also be sensible given the fact that Canada now permits recovery for negligently inflicted economic harm: see Canadian National Railway Co. v. Norsk Pacific Steamship Co.,  1 S.C.R. 1021. In this article, the author addresses arguments with respect to predictability and coherence, and concludes that a legal malice standard is to be preferred.
Brannan W. Reaves, Minority Shareholder Oppression in the Venture Capital Industry: What You Can Do to Protect Yourself, 61 Ala. L. Rev. 649 (2010).
Abstract (from author):
The venture capital company is a product of modern innovation. While the first venture capital company was organized in 1946, it was a far cry from what we think of today. In fact, it was not until the 1970s and 1980s that this type of alternative investment was really recognized as a viable method for entrepreneurial financing. Nevertheless, it took several more years for venture capital to hit its stride, which it finally did in the 1990s. The venture capital industry quickly evolved into the newest source of producing incredible profits for willing investors. Spurred on by the technology boom in Silicon Valley, venture capital became the growing choice of funding for high-risk businesses that would not, or, more often, could not, obtain financing through more traditional sources. Furthermore, with these successes came a growing impression on the rest of the world that the venture capital industry provided a never-ending stream of resources that was ripe for everyone to take from. From authors and economists arguing that a “third industrial revolution” was upon us to the Harvard Business School's change in curriculum, there seemed to be no downside for venture capital.
Brannan W. Reaves, Note, Minority Shareholder Oppression in the Venture Capital Industry: What You Can Do to Protect Yourself, 61 Ala. L. Rev. 649 (2010).
Abstract (excerpted from article):
This Note will begin in Part I by discussing the origins of the relationship between a startup company and venture capital financers and how the relationship may lead to minority shareholder oppression. Part II will examine the minority oppression doctrine and the differing perspectives on it throughout the United States. Part III will address the Alantec case as an example of more recent pro-protection development against minority shareholder oppression. Part IV will lay out several different ways minority shareholders can better protect themselves prior to engaging in litigation. Finally, the Conclusion will analyze the future of minority oppression in the venture capital industry and provide some simple tips that entrepreneurs will hopefully heed.
Zenichi Shishido, Does Law Matter to Financial Capitalism? The Case of Japanese Entrepreneurs, 37 Fordham Int’l L.J. 1087 (2014).
Abstract (adapted from author): This article considers why the venture capital industry in Japan has developed differently than its Silicon Valley counterpart. The most pronounced difference between these two situations lies in the incentive bargains between entrepreneurs and venture capitalists. It has been conclusively shown that U.S. entrepreneurs abandon control of their companies while Japanese entrepreneurs do not. In Part I, this Article focuses on the 2000s, during which rapid changes to the institutional infrastructures occurred that affect venture capital investments in Japan. Part II points out that even in Silicon Valley, entrepreneurs abandoning control to VCs is not a matter of course, and further reviews the different explanations given by Black and Gilson, and Hellmann. In Part III, the reason why control is so important from the point of the two-sided agency problem is expounded upon. Part IV reviews why Japanese VCs cannot gain enough control to resolve the two-sided agency problem, considering the four common methods used by VCs to gain control. Part V will conclude with a few words on the issues faced by those in the Japanese venture start-up community.
D. Gordon Smith, Independent Legal Significance, Good Faith, and the Interpretation of Venture Capital Contracts, 40 Willamette L. Rev. 825 (2004)
Abstract: Until the late 1800s, most corporation statutes in the United States required the unanimous consent of stockholders to authorize a merger. While protective of minority stockholders, this rule had a disabling effect on many corporations and gave minority stockholders enormous clout by permitting holdups. Gradually, state legislatures changed the voting rules for mergers, initially requiring a supermajority vote and later allowing for majority rule. Thus the modern rule for voting on mergers attempts to balance the legitimate interests of the majority stockholders in flexible administration of the firm against the legitimate interests of the minority stockholders in protecting their investment.
John S. Wroldsen, The Social Network and the Crowdfund Act: Zuckerberg, Saverin, and Venture Capitalists' Dilution of the Crowd, 15 Vand. J. Ent. & Tech. L. 583 (2013).
Abstract (by author): By virtue of Title III of the JOBS Act, signed into law on April 5, 2012, crowdfunding could become a powerful, even revolutionary, force to finance start-up companies. It democratizes entrepreneurs' access to seed capital and converts the masses of Internet users into potential retail venture capitalists. Many have cautioned, though, that crowdfunding poses serious investment risks of start-up companies failing, committing fraud, and being mismanaged. Accordingly, the JOBS Act includes numerous disclosure obligations designed to mitigate such downside risks. But what has been overlooked, and what this Article analyzes from a venture capitalist perspective, is that even if a crowdfunded start-up company is successful, crowdfunding investors can lose the value of their investment if they lack venture capital legal protections. When successful start-up companies raise additional funds from professional venture capitalists, the value of ground-floor investments can be severely diluted, as colorfully dramatized in The Social Network. In addition, when crowdfunded companies are acquired in private transactions, crowdfunders are at risk of being left out. Therefore, under a “qualitative mandates” regulatory philosophy that moves beyond securities law's status-quo disclosure requirements, this Article proposes substantive venture capitalist protections for crowdfunding investors. For example, down-round anti-dilution protection, tag-along rights, and preemptive rights should help safeguard the value of early-stage crowdfunding investments in successful start-up companies. Especially because many crowdfunding investors are likely to be inexperienced and unsophisticated in start-up-company investing, crowdfunding laws and regulations should go beyond disclosure requirements that warn investors of danger (to the extent investors even read or understand the disclosures) to help crowdfunders obtain market-based economic protections characteristic of venture capitalist investment contracts.
Brian J. Broughman, The Role of Independent Directors in VC-Backed Firms (2008).
Abstract: This paper seeks to explain the widespread use of independent directors in the governance of VC-backed firms, and in particular their use as "tie-breakers" on the boards of these firms. Allocating a tie-breaking vote to an unbiased "arbiter" commits the entrepreneur and VCs to more reasonable behavior and can reduce the opportunism that would result if either party were to control the board. Consistent with my theory, data from Silicon Valley startups illustrate several mechanisms entrepreneurs and VCs use to select an unbiased independent director. I conclude by considering implications for corporate law and fiduciary obligations in VC-backed firms.
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