Don’t Go Chasing Waterfalls: Fiduciary Obligations in the Shadow of Trados

Sarath Sanga is Associate Professor at Northwestern University Pritzker School of Law, and at Kellogg School of Management (by courtesy); and Eric L. Talley is the Sulzbacher Professor of Law at Columbia Law School, faculty co-director of the Millstein Center for Global Markets and Corporate Ownership. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, by Jesse Fried and Brian Broughman (discussed on the Forum here); and Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley by Jesse Fried and Brian Broughman (discussed on the Forum here).

In a newly-released working paper, we tackle a fundamental financial and governance conundrum that nearly every venture capital (VC) backed company faces: when there are multiple classes of stock, how should directors discharge their fiduciary duties?

In a typical VC-backed firm, the founders and other early employees hold common stock while VC investors hold tranches of preferred stock. As preferred stockholders, VC investors enjoy a variety of special rights, which can include, for example, board representation, consent rights, priority payments upon exit, and options to convert preferred shares or redeem them for cash. But this arrangement bakes a shareholder conflict right into the firm’s capital structure: When strategic business decisions implicate preferreds’ special rights, the interests of preferred shareholders inevitably conflict with those of common. In such cases, what should the board of directors do?

In theory, directors are obliged to advance the joint interests of all shareholders. But practical realities often militate that they cater to the interest of the class of shareholders—be it preferred or common—that appointed them. This conflict between preferreds’ special rights on the one hand and directors’ fiduciary obligations on the other is in fact so prevalent that it has catalyzed an emergent judicial precedent: the Trados doctrine. Under Trados, boards must prioritize common shareholders’ interest and treat preferreds’ special rights as contractual claims. In the battle between preferred and common shareholders, the Trados doctrine effectively obliges directors to side with common.

Our paper evaluates the Trados doctrine from a theoretical point of view. We develop a model of startup governance that interacts capital structure, corporate governance, and liability rules. The nature and degree of inter-shareholder conflict turn not only on the relative rights and options of equity participants, but also on the firm’s intrinsic value, as well as its value to potential outside bidders. Certain combinations of these factors can cause both common and preferred shareholders’ incentives to stray from value maximization. Using standard tools from option pricing, we show that the Trados doctrine does not categorically resolve the preferred-common conflict efficiently.

We also show, however, that an “anti-Trados” rule does efficiently resolve the preferred-common conflict. An anti-Trados doctrine would simply reverse the legal status of common and preferred: instead of prioritizing common and treating preferred as contractual claimants, an anti-Trados doctrine would force fiduciary obligations to run to preferred shareholders and relegate common to the status of contractual claimants. In fact, we show that a rule that compensates common shareholders with expectation damages for wrongful decisions by preferred is always efficient. By contrast, under a Trados regime there may not even exist a liability rule that induces common shareholders to internalize the preferreds’ losses efficiently. And even when such a liability rule does exist, it often entails supracompensatory relief resembling punitive damages. Delaware courts (and those of many other states) would not even have the authority to grant such damages. Within our model, then, an anti-Trados rule is both practically and legally superior to the Trados doctrine, at least when it comes to exit decisions.

Notwithstanding its apparent suboptimality ex post, could Trados still be justified on ex ante grounds? We posit two possible arguments in the affirmative: First, by assigning control over exit decisions to common shareholders, Trados effectively forces VCs to compensate founders with control rights, and this could be optimal if founders have idiosyncratic private benefits of control. Second, because Trados credibly commits common to veto “lowball” bids by acquirers (even with the specter of damages), the rule may bolster the bargaining position of startups vis-à-vis potential acquirers; it thus (potentially) leads to higher expected acquisition premia upon exit. While each of these arguments seems plausible, neither is sufficiently general or compelling to justify the clear and direct costs that the Trados doctrine imposes.

Our analysis exposes the theoretical and practical limits of a mandatory fiduciary regime; at the same time, it also demonstrates the second-best nature of a regime in which shareholders can tailor fiduciary duties. VC-backed companies could enhance value if they could easily contract out of the Trados doctrine. The best way to do this would be to permit corporations to simply waive the Trados doctrine (much like they are able to waive other fiduciary duties such as the corporate opportunities doctrine).

More generally, our analysis demonstrates how corporate governance and capital structure jointly interact to determine firm value. Ignoring either can cause one to mis-specify valuation—and often significantly. Much of the theoretical and empirical literature, by contrast, studies financial- and governance-based sources of value in isolation. But in venture capital, where multiclass structures are commonplace, they must be considered together.

The complete paper is available for download here.

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