Venture Capital on the Downside: Preferred Stock and Corporate Control

When stock indices drop precipitously, when the startup companies fizzle out, and when it stops raining money on places like Wall Street and Silicon Valley, attention turns to downside contracting. Law and business lawyers, sitting in the back seat as mere facilitators on the upside, move up to the front and sometimes even take the wheel. The job is the same on both the upside and downside: to maximize the value of going concern assets. But what comes easily on the upside can be dirty work on the down, where assets need to be separated from dysfunctional teams of business people to stem the flow of red ink to disappointed investors. The team members rarely go quietly, no matter how unsuccessful. The outcome can turn on provisions in contracts entered into on the upside – cookie-cutter paragraphs in boilerplate forms, barely noticed when the cash flows easily. This Article takes the occasion of the simultaneous collapse of the high technology stock market and the failure of the dot-com startups, along with the subsequent retrenchment of the venture capital business, to examine the law and economics of downside arrangements in venture capital contracts. The subject matter implicates core concerns of legal and economic theory of the firm. Debates about the separation of ownership and control, relational investing, takeover policy, the law and economics of debt capitalization, and bankruptcy reform, all grapple with the downside problem of controlling and terminating unsuccessful managers for the benefit of outside debt and equity investors (and the related upside problem of incentivizing effective but fallible managers). The factors motivating these debates also bear on venture capital contracting. But venture capital presents a special puzzle for solution. Convertible preferred stock is the dominant financial contract in the venture capital market, at least in the United States. This contrasts with other contexts in corporate finance, where preferred stock is thought to be a financing vehicle long in decline. The only mature firms that finance with preferred, which once was ubiquitous in American capital structures, tend to be firms in regulated industries having little choice in the matter. Tax rules favoring debt finance provide the primary explanation for preferred’s decline. But many corporate law observers would suggest dysfunctional downside contracting as a concomitant cause. Simply, preferred performs badly on the downside, where senior security contracts supposedly are at their most effective. Preferred stockholders routinely have been victimized in distress situations by opportunistic issuers who strip them of their contract rights, transferring value to the junior equityholders who control the firm’s management. The cumulation of bad experiences adds impetus to a wider trend in favor of debt as the mode of senior participation.