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E-MailLuca Enriques is a Professor of Business Law at Bocconi University, Casimiro Antonio Nigro is an Invited Researcher at the Goethe University, and Tobias H. Troeger is a Professor of Law at Goethe University. This post is based on their recent paper, and is part of the Delaware law series; links to other posts in the series are available here.
Venture capital (VC) has been a driving force behind innovation and economic growth since the 1980s and is an established cornerstone of the U.S. economy. The success of the U.S. VC market hinges also on venture capitalists’ and entrepreneurs’ ability to leverage the flexibility of U.S. (Delaware) corporate law. This flexibility enables them to develop sophisticated contractual frameworks that economists consider the most effective real-world solution to market frictions in financing high-tech innovation—a model that has been widely adopted globally.
A key insight from the existing literature is that efficient VC contracting relies heavily on private ordering. A flexible corporate law framework, therefore, facilitates VC contracting, while rigid corporate laws can constrain it. While scholars have emphasized this point over the past two decades, the precise mechanisms by which rigid corporate laws influence the complex contracting dynamics of VC have received far less attention.
Our new paper, Venture Capital Contracting as Bargaining in the Shadow of Mandatory Corporate Law, addresses this gap by introducing a theoretical framework that provides a detailed understanding of what happens to VC contracting in countries where, unlike in the U.S., corporate law imposes numerous mandatory requirements. These requirements restrict contracting parties’ ability to design optimal VC contracts—both directly through prohibitions and indirectly through increased legal uncertainty surrounding the scope of private ordering. We test this theoretical framework by comparing VC contracts that venture capitalists and entrepreneurs negotiate under U.S. (Delaware) corporate law and European (German and Italian) corporate laws, that is, reach against the background of flexible and rigid corporate legal frameworks, respectively.
We start from the premise that sophisticated market participants, especially with specialized legal advisors, can effectively protect their interests and, thus, define corporate law as optimally flexible for VC contracting when it:
- Takes a hands-off approach toward the enforceability of private ordering solutions that structure VC transactions;
- Avoids ex-post gap-filling mechanisms that could retroactively limit contractual rights in ways inconsistent with the economic logic of VC agreements;
- Prevents the abusive exercise of contractual rights, where “abuse” means self-serving behavior that contradicts the economic rationale of the VC deal.
A legal framework that prioritizes private ordering enhances contracting parties’ ability to clearly define their rights and obligations, minimizing legal uncertainty.
Under such an ideal pro-VC corporate law model, sufficiently sophisticated contracting parties can engage in value-maximizing private ordering. Yet existing corporate laws often deviate from our pro-VC corporate law paradigm, imposing legal restrictions on venture capitalists and entrepreneurs that significantly affect their ability to reach a Coasean bargain. Especially if local rules of interpretation allow scholars and courts to identify implicit mandatory rules, these legal restrictions may prevent contracting parties not only from adopting optimal solutions but also from deploying functionally equivalent or even inferior alternative arrangements. If only inferior alternative arrangements are available, or worse, if even these arrangements prove unavailable altogether, corporate law constraints negatively affect parties’ ability to achieve their goals through private ordering, decreasing the value of contracts and affecting deal-making and ultimately innovation financing negatively.
Building on this framework, we outline the universal mechanisms by which rigid corporate law hinders efficient VC contracting and ultimately leads to welfare losses. We identify two types of constraints.
First, corporate law’s negative impact on private ordering can result from prohibitions that are either absolute or relative:
- Absolute prohibitions prevent contracting parties from incorporating a specific private ordering arrangement into their deal and—possibly with the support of general anti-evasion standards or other doctrines—any functionally equivalent solutions or even inferior alternative arrangements.
- Relative prohibitions rule out the viability of a specific private ordering solution but allow contracting parties to adopt inferior alternative arrangements.
Second, corporate law’s negative impact on private ordering can stem from uncertainty about the validity and/or enforceability of a private ordering solution and/or how contracting parties should exercise the resulting rights. The more pronounced the legal uncertainty, the more significant the litigation risk. And the more significant the litigation risk, the greater the decrease in contractual functionality and, eventually, contract value.
We test our theoretical framework by comparing VC contracting under U.S. (Delaware) and European (German and Italian) corporate laws. In the U.S., venture capitalists and entrepreneurs can negotiate under a corporate law regime that closely matches the pro-VC corporate law we envision. They can thus smoothly achieve their goals through private ordering. By contrast, venture capitalists and entrepreneurs in Germany and Italy must navigate corporate law regimes that significantly deviate from our ideal pro-VC corporate law. When structuring their deals, they must account for numerous mandatory requirements that prevent them from adopting not only U.S.-style contractual arrangements but also functionally equivalent solutions. Instead, they must resort to inferior alternative arrangements, if they are available at all. We assess the decrease in functionality of each individual contractual component and evaluate the “functionality gap” between the contractual frameworks governing VC deals in the U.S. versus Germany and Italy. Although we do not quantify this efficiency gap, our work suggests that rigid German and Italian corporate laws lead to a significant decrease in contract functionality, which can deter VC investments at the margin.
While we focus on U.S., German, and Italian corporate laws, our analytical framework can be applied to examine the corporate law-VC contracting relationship in any jurisdiction. The mandatory character of German and Italian corporate law is common to many non-U.S. jurisdictions. Therefore, as we argue in a companion paper, our discussion has important implications for the design of corporate law reforms to support the development of a vibrant VC market and provides valuable insights for policymakers interested in creating pro-VC corporate legal frameworks.
The complete paper is available for download here.
