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"Venture
Capital Contracting in the Information Age" by
Law Professor D. Gordon Smith supports Sahakian |
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For
more info or to get on our mailing list, contact cpart@spamarrest.com
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Reply-To: "Chris Sorensen" Chris@lfvm.com Ron, After reading Curtis Sahakian's essays on "Vulture Capitalists," and the ensuing debate with Bob Geras, I decided to do a little research to see if I could find evidence to "debunk" Mr. Sahakian's claims. SUMMARY OF CLAIMS A paraphrasing of Mr. Sahakian's major claims include: 1. Staged funding gives the VC de facto control of the company regardless of its equity position. ("Even if the founders retain 80% of the voting stock, as soon as the transaction closes, they have ceded control over to the VC." 2. VC contracts tend to shift an "unfair" amount of risk to the entrepreneur while preserving the "upside" for the VC. ("These agreements are some of are some of the most unreasonable and one sided agreements that exist in the business world.") 3. VC often "take advantage" of the naiveté of founders. ("It's hard to believe that the founders were fully advised beforehand about what they were getting into. ") 4. There is a strong need for a more "efficient market of information" about VC reputation. ("One person that I talked to suggested what is needed is some type of consumer's reports on the VCs.") RESEARCH The most authoritative source I could find on this topic was an article titled "Venture Capital Contracting in the Information Age" by D. Gordon Smith, Associate Professor of Law, Northwestern School of Law of Lewis & Clark College. The essay appeared in The Journal of Small and Emerging Business Law in 1998. The complete article is lengthy - 29 pages but I would STRONGLY urge any capital seeker to read it BEFORE they sign a term sheet. The article can be read online at http://www.lclark.edu/~dgsmith/publications/venture1.html SUMMARY OF ARTICLE Mr. Smith's essay is based on several sources of direct and indirect research including a study that analyzed seventy-eight VC financing agreements related to California. While more scholarly, well-researched, and balanced than Mr. Sahakian's essays, the conclusions are surprising, but clearly similar. In essence, Mr. Smith argues that because of unequal ("asymmetrical") information and bargaining power, VCs are often in a position to "take advantage" of entrepreneurs, by creating agreements where the risks and rewards are also not shared equally. Mr. Smith conjectures that VCs' tendency towards "opportunism" at the expense of entrepreneurs is constrained by their great concern for their reputation, which has significant economic value. He proposes that the Internet may be able to put entrepreneurs on a more level playing field by creating a more efficient market for information about VCs and their reputations. Currently I am not aware of any publicly available website that tracks VC behavior or their reputations. SELECTED EXTRACTS I have included key passages below and with paraphrasing in square brackets [ ], and included my own commentary in cursive brackets { }. "This Article examines the risks facing entrepreneurs who "hire" venture capitalists to provide value-added services and considers whether technology--specifically, the World Wide Web --will change the relationship between venture capitalists and entrepreneurs with respect to such services. Entrepreneurs face three risks in their quest to obtain value-added services from venture capitalists. [1. "Shirking," - when venture capitalists promise to perform value-added services but simply fail to follow through.] [2. "Opportunism," - when VCs attempt to renegotiate& at a stage in the company's development when the entrepreneur has reduced bargaining power.] [3. "Incompetence," when VCs promise to perform value-added services but fail to perform up to the entrepreneur's standards.] {Support for claim 1: VCs have de facto control due to staged funding} "The most prominent risk to entrepreneurs is opportunism & [which] may take several forms. For example, venture capitalists may attempt to renegotiate the entrepreneur's employment contract to force the entrepreneur from the business. The power to fire entrepreneurs&is often granted by the explicit terms of venture capital contracts and when combined with the commonly awarded right to buy out the shares owned by the entrepreneurs, it allows venture capitalists to force entrepreneurs completely out of [their own] business." "But [the risks of] opportunism--are not usually addressed by venture capital contracts. Indeed, venture capital contracts often provide the mechanism (staged financing) that allows for opportunism. Even though venture capitalists often do not contract for outright control of a portfolio company, either through majority share ownership or control of the board of directors, venture capitalists exert tremendous power over the entrepreneur because of staged financing." "Entrepreneurs have no effective contractual counterweight to staged financing. Even if they have nominal control of their company, challenging a venture capitalist will not only ensure that the entrepreneur does not receive funding from that venture capitalist but may doom the entrepreneur with other venture capitalists." {Support for claim 2: VCs shift an "unfair" amount of risk to the entrepreneur} "[Entrepreneurs risks] are caused by informational asymmetries between the entrepreneur and the VC&contracts routinely fall short of fully protecting entrepreneurs." "Venture capital contracts shift risk from the venture capitalists to the entrepreneur. It would be foolish for the entrepreneur to accept such contract terms if they were not truly confident of their own abilities and deeply committed to the venture. Of course, it would be equally foolish for the entrepreneur to enter into such a contract without some assurance regarding the venture capitalist's commitment. "It is not obvious, for example, how entrepreneurs ensure that venture capitalists actually provide non-financial support to the enterprise because venture capital contracts rarely specify the non-financial obligations of venture capitalists." {Dispute over claim 3: Are entrepreneurs rational, irrational or just naive?} "The entrepreneur brings in the venture capitalist as a financial partner and consultant. The venture capitalist may have incentives to offer bad consulting advice to the entrepreneur, i.e., advice that suggests a course of action contrary to the interests of the entrepreneur, up to and including the abandonment of an investment that has economic value. Premature abandonment may come about because the venture capitalist has a diversified portfolio of opportunities and a high opportunity cost of time, whereas the entrepreneur is fully committed to the venture and in fact may choose to over-invest other people's money." "The fact that entrepreneurs are willing to cede such power to venture capitalists suggests either that they are irrational or that they [rely on other factors such as] the [VC's] reputation." {The author assumes that the entrepreneur is not naïve, and does in fact know all the implications of the VC agreement. In my own experience, however, this is rarely the case. To paraphrase P.T. Barnum: "There's another founder born every minute"} "Even if this [gambler's mentality] sort of irrationality can explain some venture capital contracts, however, it seems unlikely to explain the fact that almost *all* venture capital contracts fall short of fully protecting the entrepreneur. The idea that entrepreneurs would consistently enter contracts that are facially so lopsided strains credulity." {Mr. Smith rejects the notion that *all* entrepreneurs are irrational even though "all" VC contracts are "lopsided." He is compelled to seek an economically rational explanation for the entrepreneurs behavior. However, I have worked closely with many entrepreneurs and can attest that they are, and *must be* overly optimistic and somewhat economically irrational, otherwise they would never undertake the risks of starting a company. There are too many long odds against them to be strictly rational.} {Support for Claim 4. A Consumer's Reports on VCs is needed.} "If the explicit terms of venture capital contracts and the common law do not protect entrepreneurs [from VCs], why are entrepreneurs so willing to enter venture capital relationships? [One possible answer] is that entrepreneurs rely on the market for reputation to select and monitor venture capitalists. "The primary brake on venture capitalist opportunism is fear of diminishment of reputational capital: & Venture capitalists who abuse their power will find it hard to attract the best entrepreneurs, who have the option of approaching other venture capitalists or sources other than venture capital. In this regard, the decision to accept money from a venture capitalist can be seen as a conscious present-value-maximizing choice by the entrepreneur." "The Web will improve the efficiency of the market for venture capitalist reputation&and ultimately result in contractual innovations." {I believe that this is conclusion misses the point. Since VCs often specialize in a specific market space, entrepreneurs rarely have the luxury of "shopping" their plan to numerous other VCs. Additionally there is strong competition for VC funds in every niche. Thus entrepreneurs can rarely make a present-value-maximizing choice because often they have negligible bargaining power and are in a take it or leave it' position. In a market with little choice, a VC's reputation is irrelevant to the capital seeker.} FINAL THOUGHTS - NO LEGAL REDRESS "Lawsuits Over Venture Capital Contracts" Conventional wisdom has it that lawsuits in the venture capital community are rare. According to this view, entrepreneurs are loath to sue their venture capitalists for fear of gaining a reputation for recalcitrance and never receiving venture funding. On the other hand, venture capitalists are reluctant to sue entrepreneurs because they fear acquiring a reputation for abusiveness that will drive away future entrepreneurs. Regardless of whether conventional wisdom is correct, the general flow of such cases should not provide much comfort to entrepreneurs because the courts typically treat these disputes as entirely contractual. Venture capitalists do not owe any special fiduciary duties to entrepreneurs." Chris@LFVM.com |
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From: "Curtis E. Sahakian" cpart@spamarrest.com
Chris, Thanks for your supportive letter in the January 22, 2001 May Report I have something to supplement the article (http://www.lclark.edu/~dgsmith/publications/venture1..html ) you found. It's the following Q&A session with William "Boots" DelBiaggio, cofounder and CEO of Sand Hill Capital. How's this for a question: Question. I've been around the block a few times. (I'm 40 years old, a graduate of Harvard Law School and Cambridge University, an ex-McKinsey consultant, an ex-Salomon Brothers bond trader, and the founder and CEO of my own profitable dot com.) However, I am a little confused as to why three of the biggest VC firms couldn't come up with $5 million themselves [for Kozmo.com]. This is a little like Warren Buffet applying for a car loan. Did the VCs use the bridge loan as a negotiation tool to get the founders to accept a rather severe cram-down? That is: "Accept our valuation or let Sand Hill put you into Chapter 11." -- Hans Hsu DelBiaggio's answer? YES! (well, at least after you sort through his tap dance) Here is the link - take a look at DelBiaggio's complete answer: http://www.redherring.com/vc/2001/0124/vc-vcps012401..html By the way, it's great that the article you found provides almost point by point support for what I have said. It does have a number of flaws though (perhaps the result of a lack of personal experience). Mr. Smith spends only a few paragraphs talking about founder's remedies against their VCs. The little analysis he does is incomplete and just plain wrong. His supposition that there is no legal remedy for wronged entrepreneurs against their VCs is based on only two cases, neither of which are relevant to any legal theory I would ever use, and only one of the two cases involved a VC... and that VC was, surprisingly enough, suing as the wronged party. A key barrier to suing VCs is the one sided investment agreement that founders are required to sign. The second barrier is the opinion letters that their attorneys are required to issue. If their client were to subsequently successfully sue the VC, founder's law firm has to consider their potential liability under the opinion letter they had to issue to the VC. They have every reason to redirect any inquiries about such law suits in other "more productive" directions. That is the one-two punch that I suspect sand bags most disgruntled founders thinking about suing their VCs. There is precedent for overcoming stringent contractual protections by overreaching institutions taking advantage of sophisticated business people. In the late 70s a local Chicago area law firm (Hamman and Benn) filed a lawsuit against a then major computer company (Burroughs Corporation). It used to be the conventional wisdom that you couldn't successfully sue computer vendors because of their one-sided agreements. The contracts were airtight. Everyone assumed that you just couldn't win against them. It became a self fulfilling prophecy. No one tried... so everyone just assumed that it was true. It wasn't. Burroughs just dug in their heels and stiff armed them in this case. So they (well technically it was their client) placed an ad in the Wall Street Journal to the effect of "anyone else having problems with Burroughs... please tell us your story". It opened the floodgates. I'm told that they got over 300 clients from that advertisement alone (and one heck of a lot of incriminating evidence). Their ad basically started the field of computer law. Prior to this there wasn't much computer litigation... so there wasn't much need to hire lawyers to jockey around computer transactions... so there were very few lawyers doing this work. (by the way, Hamman and Benn is still, in my personal opinion, one of the top computer/technology litigation boutiques in Chicago, though most non-lawyers are unaware of them). Computer buyers then faced the same barrier that founders are facing today... one sided contracts. They just devised ways to sue computer vendors outside the contract. There is no reason the same thing can't be done with VC contracts. My observation is that VC firms are very private, don't like confrontation, detest personal participation in litigation, and value their time too highly to even think about wasting it by getting sucked into personal litigation. I don't think they want anyone poking around their old deals under court order, talking to any of their disgruntled founders, or placing any ads in the Wall Street Journal about them. If you present them a strong case, they will not be irrational. If they are faced with a fight that's not worth it, or one they can't win, they aren't likely to fight it over principle... they are just too darn rational. I find bogus all this uninformed blanket advice about how you can't sue your VC... particularly when the advice is made without looking at the facts of the particular case. People used to say this about computer disputes and more recently about the tobacco litigation. They were no more right in those instances than they are right in these instances. Curt Sahakian |
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