Corporate Governance and the Sale of VC-Backed Firms

This post is by Jesse Fried of Harvard Law School.

Brian Broughman and I have written a paper, Deviations from Contractual Priority in the Sale of VC-Backed Firms, that examines how corporate governance arrangements in VC-backed firms that are sold affect the allocation of the sale proceeds between preferred shareholders (the VCs) and common shareholders (including the founders, employees, and angel investors).

It is often assumed that VC cash flow rights–including their right to liquidation preferences when the firm is sold–are fully respected.  However, we are unaware of any study that examines whether VCs’ contractual priority rights over common shareholders are, in fact, fully respected.  And there is reason to suspect that they may not be.  In other settings, such as bankruptcy, common shareholders are sometimes able to use holdup power to extract part of creditors’ cash flow rights, causing a deviation from contractual priority.  To the extent that common shareholders in a VC-backed firm have holdup power, they may similarly use that power to “renegotiate” the parties’ cash flow rights.

To investigate common shareholders’ ability to extract part of VCs’ liquidation preferences, we use a hand-collected database of 42 VC-backed Silicon Valley companies that were sold in 2003 or 2004 and, at the time of sale, had both preferred and common stock outstanding.  We find that in a majority of sales, VCs are able to receive the full amount of their cash flow rights.  However, they receive less than their contractual entitlement in over 25% of transactions.  The average carveout in these cases is approximately 11% of the VCs’ contractual payout rights.  In the aggregate, the VCs in our sample give up approximately 2-3% of their cash flow rights to common shareholders.

We also show that the likelihood and magnitude of deviations from contractual priority are larger when VCs have less power in comparison to common shareholders.  Deviations favoring common shareholders are more likely to occur and to be larger when VCs lack board control: When the selling CEO is not a professional hired by the VCs but rather a founder (and therefore more likely to use his positional power to assist common stockholders).  However, the finding that may be of particular interest to lawyers is that the expected carveout to common shareholders is higher when the firm is incorporated in California rather than Delaware.  While there is some evidence suggesting that, within the U.S., state corporate law affects the value of common stock in public companies, our study may be the first to demonstrate that the choice of corporate law affects financial outcomes in private firms.

Brian and I are continuing to work on this paper and a number of related projects, so any comments would be most welcome.

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