Renegotiation of Cash Flow Rights in the Sale of VC-Backed Firms

This post is by Jesse Fried of Harvard Law School.

In our paper “Renegotiation of Cash Flow Rights in the Sale of VC-Backed Firms”, which was recently accepted for publication in the Journal of Financial Economics, Brian Broughman and I investigate the performance of VCs’ cash flow rights in sales of portfolio firms.

When VCs seek to sell a portfolio firm, the firm’s executives and other common shareholders may try to use their board seats and other control rights to hold up the sale of the firm, particularly when satisfaction of VCs’ liquidation preferences would leave little for common shareholders. The threat of holdup may lead VCs to “carve out” part of their cash flow rights for common stockholders. Unfortunately, there is little evidence on how VCs’ cash flow rights perform in private sales. Are VC cash flow rights renegotiated in private sales, and, if so, are such renegotiations caused by common stock’s holdup power?

To answer these questions, the paper uses a hand-collected dataset of 50 VC-backed Silicon Valley firms sold to acquirers in 2003 and 2004. For each firm, we gather data on the allocation of control rights and cash flow rights from the initial VC financing to the sale. We then document the distribution of sale proceeds among the VCs and the original common shareholders. We can thus compare VCs’ cash flow rights at the time of sale to the amounts they actually receive.

We find that in most sales VCs receive their full cash flow rights. In 11 of the sales, however, VCs carve out part of their cash flow rights to common shareholders. In these cases, all of which involved the VCs exiting as preferred shareholders, the average deviation between the VCs’ cash flow rights and their actual payout is $3.7 million, approximately 11% of the VCs’ cash flow rights. Across all 50 firms, the average deviation was 2.3% (1.9% dollar-weighted). Our study thus suggests that VCs’ cash flow rights are quite reliable in private sales, even when the VCs exit as preferred shareholders and are most likely to be held up.

We also show that the likelihood and magnitude of deviations from VCs’ cash flow rights in favor of common shareholders are larger when common shareholders have more power vis-à-vis the VCs. Everything else equal, the expected deviation is about $1.5 million larger if VCs lack a board majority and roughly $1.6 million larger if the firm is incorporated in California (rather than Delaware), which gives common shareholders relatively more leverage against the VCs through that state’s bundle of common shareholder rights. This suggests that such deviations are driven, at least in part, by the allocation of control within the firm. Our findings linking common shareholder power to deviations from VCs’ cash flow rights are generally robust to alternative econometric specifications.

The full paper is available for download here.

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