Venture Capital, Agency Costs, and the False Dichotomy of the Corporation

An implicit dichotomy of the corporation exists in legal scholarship. On one side of the dichotomy rests the publicly held corporation suffering from a significant conflict of interest between its managers and dispersed shareholders; on the other side, the closely held corporation plagued by intershareholder conflict. This Article argues that understanding the agency problems that can exist within a firm demands a rejection of this traditional dichotomy and the theories of the firm built upon it. Using venture capital (VC) finance, this Article demonstrates how this dichotomy obscures how all firms -- public and private -- often face the same agency problems. Start-up companies receiving VC investment are uniquely situated to examine this dichotomy, as they represent closely held firms structured to transition quickly to public equity markets. Additionally, by separating investment from company management, VC investment creates many of the investor-manager conflicts inherent in public companies. By analyzing VC investment contracts, this Article reveals that start-up companies are indeed plagued by both vertical agency problems between investors and managers, and horizontal agency problems among VC investors themselves. Significantly, academic scholarship has ignored the potential for interinvestor conflicts, using instead an analytical framework associated with public corporations that focuses exclusively on investor-manager agency problems. In so doing, VC scholarship provides a clear example of how the dichotomy of the corporation forces scholars to wear blinders in analyzing the agency problems in firms. To understand the full scope of these problems -- and their implications for corporate investors -- a new model of the firm is required that applies to all firms, public and private. This Article outlines this dynamic agency cost model and articulates its implications for corporate investors, corporate scholars, and corporate law in general

Understanding Price-Based Antidilution Protection: Five Principles to Apply When Negotiating a Down-Round Financing

As most venture capital investors are aware, the economic downturn of the past two years—and the concomitant decrease in private company valuations—has created an opportunity for significant returns on new venture investments seldom seen since the early 1990s. Yet while the investment opportunities of the current economic environment may have attractive financial valuations, they frequently come with the added cost of significant transactional complexity. In particular, the issuance of securities by a private company at a price that is below the price previously paid by the company\u27s investors (typically referred to as a “down-round” financing) may trigger one or more forms of price-based antidilution protection. Price-based antidilution protection, which is found in the charter documents of most venture-backed emerging growth companies, is used by many venture capital investors to minimize the dilution that occurs when a portfolio company issues stock in a down-round financing by increasing the rate at which the existing investors\u27 shares of preferred stock (which are typically purchased by venture capital investors) convert into shares of common stock. Upon receiving an “antidilution adjustment,” the holders of a company\u27s shares of preferred stock will thereafter be entitled to convert their shares into a greater number of shares of common stock, thereby diminishing the dilutive effect of the down-round financing. Given the significant effect an antidilution adjustment may have on a company\u27s capitalization following a down-round financing, understanding the application of a company\u27s antidilution protection has become a critical component of an investor\u27s due diligence review prior to a portfolio company investment. Despite the increased focus within the venture capital community on antidilution protection, there remains considerable uncertainty regarding the proper application of the various types of antidilution formulas. This uncertainty is made all the more troubling for venture capitalists and entrepreneurs in light of the considerable economic ramifications of antidilution protection. Absent a thorough understanding of a company\u27s antidilution protection, a new investor may find itself unknowingly diluted by prior investors\u27 antidilution adjustments. Likewise, the form of a company\u27s antidilution protection may place significant constraints on the form and valuation of a potential down-round financing. The intent of this Article is to clarify the operation of these ordinarily opaque provisions and to provide five guiding principles for venture capitalists and entrepreneurs to apply when negotiating a down-round financing

Managing Risk on a $25 Million Bet: Venture Capital, Agency Costs, and the False Dichotomy of the Corporation

An implicit dichotomy of the corporation exists in legal scholarship. On one side of the dichotomy rests the publicly-held corporation suffering from a significant conflict of interest between its managers and dispersed shareholders; on the other side, the closely-held corporation plagued by inter-shareholder conflict. This Article argues that understanding the agency problems that can exist within a firm demands a rejection of this traditional dichotomy and the theories of the firm built upon it. Using venture capital finance, this Article demonstrates for the first time how this dichotomy obscures how all firms - public and private - often face the same agency problems. Companies receiving venture capital (VC) investment are uniquely situated to examine this dichotomy, as they represent closely-held firms structured to transition quickly to public equity markets. Additionally, by separating investment from company management, VC investment creates many of the investor-manager conflicts inherent in public companies. By analyzing VC investment contracts, this Article reveals that start-up companies are indeed plagued by both “vertical” agency problems between investors and managers and “horizontal” agency problems among VC investors themselves. Significantly, academic scholarship has ignored the potential for inter-investor conflicts, using instead an analytical framework associated with public corporations that focuses exclusively on investor-manager agency problems. In so doing, VC scholarship provides a clear example of how the dichotomy of the corporation forces scholars to wear blinders in analyzing the agency problems in firms. To understand the full scope of these problems - and their implication for corporate investors - a new model of the firm is required that applies to all firms, public and private. This Article outlines this model and articulates its implications for corporate investors, corporate scholars and corporate law in general

Shareholder Wealth Maximization as Means to an End

In several recent cases, the Delaware Chancery Court has emphasized that where a conflict of interest exists between holders of a company’s common stock and holders of its preferred stock, the standard of conduct for directors requires that they strive to maximize the value of the corporation for the benefit of its common stockholders rather than for its preferred stockholders. This article interrogates this view of directors’ fiduciary duties from the perspective of incomplete contracting theory. Building on the seminal work of Sanford Grossman and Oliver Hart, incomplete contracting theory examines the critical role of corporate control rights for addressing conflicts that arise between a firm’s investors so as to maximize firm value. It therefore provides a natural starting point for examining how the control rights residing in a company’s board of directors should be used for resolving conflicts between common and preferred stockholders. This analysis highlights the utility of a default fiduciary duty that prioritizes common stockholder welfare for maximizing the value of the corporation. In particular, such a duty helps facilitate Coasian bargaining among investors to resolve unanticipated conflicts that can arise while also minimizing the risk of bargaining failure. Critically, however, a dictate for directors to maximize stockholder welfare can operate in this fashion only to the extent it exists as a default rule that a director can opt out of when elected to represent the interests of a particular investor or group of investors, as is common among preferred stockholders. Moreover, close inspection of Delaware case law highlights how such a dynamic is consistent with Delaware’s corporate jurisprudence which has historically viewed stockholder wealth maximization as ultimately a means to maximize the value of the corporation. To ensure the continuing vitality of the corporate form, Delaware courts should, accordingly, abandon any pretense that corporate directors have an immutable duty to maximize common stockholder value and revert to their traditional focus on policing against the bargaining failures that can occur when investors use directors to address the incomplete contracting challenges that are replete in corporate finance

Law and Corporate Governance

Pragmatic and effective research on corporate governance often turns critically on appreciating the legal institutions surrounding corporate entities – yet such nuances are often unfamiliar or poorly specified to economists and other social scientists without legal training. This chapter organizes and discusses key legal concepts of corporate governance, including statutes, regulations, and jurisprudential doctrines that “govern governance” in private and public companies, with concentration on the for-profit corporation. We review the literature concerning the nature and purpose of the corporation, the objects of fiduciary obligations, the means for decision making within the firm, as well as the overlay of state and federal law pertaining to how that decision-making authority is exercised within publicly traded companies. A core feature of this analysis is that while the basic structures pertinent to corporate law and governance are familiar and in some ways predictable, they are also in a constant state of flux, shaping and being shaped by institutional adaptations of firms, regulators and courts. This chapter is most appropriate for social science researchers and/or students who are new to the legal dimensions of firm governance

Modernizing Odd Lot Trading

Traditional odd lot trades (i.e., trades involving fewer than 100 shares) now comprise over half of all equity trades on U.S. exchanges. Under Regulation National Market System, however, these trades are excluded from a market center’s trade execution statistics. In addition, while brokers are required to consider odd lot quotes as part of their duty of best execution, odd lot quotes are formally excluded from the calculation of the national best bid and offer. This Article, written for a symposium on the Future of Securities Regulation at Columbia Law School, examines whether these regulatory exclusions for odd lot trades and quotes increase trade execution costs for retail trades filled in non-exchange venues. Across more than 3 billion trades during 2020, odd lot trades filled in nonexchange venues received ten percent less price improvement than non-odd lot trades. In addition, using order book data from Nasdaq, examination of a sample of retail, non-exchange trades in two popular retail stocks—Amazon and GameStop— on January 27, 2021 reveals that thirty-one to forty-six percent of odd lot trades would have received better pricing had the venue filled the order at the Nasdaq odd lot quote. These results suggest that the differential treatment of odd lots and round lots in the regulation of U.S. market structure may impair the execution quality of marketable odd lot orders from retail traders

A generalization of Schur-Weyl duality with applications in quantum estimation

Schur-Weyl duality is a powerful tool in representation theory which has many applications to quantum information theory. We provide a generalization of this duality and demonstrate some of its applications. In particular, we use it to develop a general framework for the study of a family of quantum estimation problems wherein one is given n copies of an unknown quantum state according to some prior and the goal is to estimate certain parameters of the given state. In particular, we are interested to know whether collective measurements are useful and if so to find an upper bound on the amount of entanglement which is required to achieve the optimal estimation. In the case of pure states, we show that commutativity of the set of observables that define the estimation problem implies the sufficiency of unentangled measurements.Comment: The published version, Typos corrected, 40 pages, 2 figure

Gas phase RDX decomposition pathways using coupled cluster theory

Electronic and free energy barriers for a series of gas-phase RDX decomposition mechanisms have been obtain using coupled cluster singles, doubles, and perturbative triples with complete basis set (CCSD(T)/CBS) electronic energies for MBPT(2)/cc-pVTZ structures. Importantly, we have located a well-defined transition state for NN homolysis, in the initial RDX decomposition step, thereby obtaining a true barrier for this reaction. These calculations support the view that HONO elimination is preferred at STP over other proposed mechanisms, including NN homolysis, “triple whammy” and NONO isomerization. Indeed, our calculated values of Arrhenius parameters are in agreement with experimental findings for gas phase RDX decomposition. We also investigate a number of new pathways leading to breakdown of the intermediate formed by the initial HONO elimination, and find that NN homolysis in this intermediate has an activation energy barrier comparable with that computed for HONO elimination

Random subspaces for encryption based on a private shared Cartesian frame

A private shared Cartesian frame is a novel form of private shared correlation that allows for both private classical and quantum communication. Cryptography using a private shared Cartesian frame has the remarkable property that asymptotically, if perfect privacy is demanded, the private classical capacity is three times the private quantum capacity. We demonstrate that if the requirement for perfect privacy is relaxed, then it is possible to use the properties of random subspaces to nearly triple the private quantum capacity, almost closing the gap between the private classical and quantum capacities.Comment: 9 pages, published versio

Comment on the Definition of Eligible Organization for Purposes of Coverage of Certain Preventive Services Under the Affordable Care Act

This comment letter was submitted by U.C. Berkeley corporate law professors in response to a request for comment by the Health and Human Services Department on the definition of eligible organization under the Affordable Care Act in light of the Supreme Court\u27s decision in Burwell v. Hobby Lobby. Eligible organizations will be permitted under the Hobby Lobby decision to assert the religious principles of their shareholders to exempt themselves from the Affordable Care Act\u27s contraceptive mandate for employees. In Hobby Lobby, the Supreme Court held that the nexus of identity between several closely-held, for-profit corporations and their shareholders holding “a sincere religious belief that life begins at conception” was sufficiently close to justify granting such corporations an exemption from the Affordable Care Act\u27s contraceptive mandate pursuant to the Religious Freedom Restoration Act of 1993. More specifically, the Court ascertained that the overall interests of the corporations and their natural-person shareholders were sufficiently identical to warrant ascribing the religious commitments of the shareholders to their corporations. Notably, the Court stopped short of articulating a diagnostic test for determining when a sufficient overlap of interests exists; instead, it concluded that well-established principles in state corporate law should provide such guidance. We believe that state corporate law does in fact provide the diagnostic test the Court desires for determining when it is appropriate to disregard the distinct identity of a corporation for the identity of its shareholders. This test is rooted in the long-standing case law that constitutes the alter ego doctrine (commonly referred to as “veil piercing”). To sustain a claim of veil piercing, state corporate law uniformly requires there to be “unity of ownership and interest” between the corporation and its shareholders. If a corporation is operated as the effective alter ego of its shareholders to such an extent that its separate corporate existence ceases to exist as a practical matter, then a veil piercing claim can be established that effectively attributes the corporation’s legal rights and obligations to its shareholders, and vice versa. A veil piercing conclusion effectively holds that there is no practical difference between the corporation and the shareholders themselves. We therefore propose that for purposes of defining an “eligible organization” under Hobby Lobby, the HHS and other federal organizations should follow the corporate law doctrine of veil piercing. Indeed, to make this doctrine administratively feasible, we further suggest that shareholders of a corporation should have to certify that they and the corporation have a unity in identity and interests, and therefore the corporation should be viewed as the shareholders’ alter ego