The Venture Corporation

Johnnie Pratt

Technological innovation is a powerful driving force for human advancement and welfare. Modern societies celebrate the numerous ways that innovative feats have contributed to the quality of life, from curing diseases to tackling global environmental challenges. Startups play an indispensable role in promoting innovation. The collaboration between entrepreneurs and venture capitalists (“VCs”) has been observed to incentivize disruptive research and development in a way that cannot be replicated within established firms, in academia, or elsewhere. In some nations, startups are also significant contributors to the economy. The United States is a striking example. Firms that launched as venture-backed startups dominate US capital markets in terms of market capitalization and proportional weight of leading market indexes, and significantly contribute to US job creation. Many economies strive to create a US-like startup ecosystem and reproduce its success locally.

Business organization law is one of the vital components that make the startup ecosystem tick. It provides the legal infrastructures that entrepreneurs and VCs use to facilitate their relationships. Different industries have varying needs for structuring businesses effectively and state legislatures often craft specialized business entities to meet such needs. Surprisingly, this has not been the case for startups and the VC industry. VCs and entrepreneurs were left to use generic structures that loosely fit startups’ unique business model. More specifically, startups organize themselves as corporations, and while corporations serve many kinds of businesses well – either as private or publicly-traded firms – they are unsuitable for startup structuring. My new paper invites legislatures to think of this unmet market demand as an opportunity.

VCs invest in startups that show a potential to create exponential growth followed by an early, highly profitable exit opportunity. Corporations, however, are a doubtful choice for running such exit-driven, short-term ventures. Incorporation requires shareholders to relinquish direct control over the startup’s exit strategy and authorize the board to decide when and how they may withdraw equity capital and disengage. This distinctive corporate feature is known as capital lock-in, and its effects are intensified in startups due to the limited secondary trading options for startup equity. While both VCs and entrepreneurs appoint their representatives to the board, corporate directors are obliged to disregard their appointors’ particular needs and manage equity capital to serve the interests of shareholders as a whole. Moreover, startup directors cannot account for the interests of all startup shareholders equally. In the case that the interests of entrepreneurs and investors diverge, Delaware law would often require the board to prioritize the interests of entrepreneurs, as common shareholders, over the competing interests of investors, who typically hold preferred stock.

Startups apply a variety of methods to make corporations better suited to meet their needs. Using sophisticated contracting, they attempt to shift control over the startup’s exit strategy from the board to shareholders in general and preferred shareholders in particular. These contractual workarounds, however, have limited success in emulating the freedom that unincorporated entities allow in allocating exit control. Not only are they costly to draft and review, but they may also have questionable practical utility due to legal or business constraints.

This discrepancy between startups’ business trajectory and business structuring comes at a cost. VCs and entrepreneurs rely on their power to initiate or veto exits to support their relationship’s unique collaborative nature, which requires continuous active involvement on the part of providers of both human and financial capital. Their limited freedom to allocate exit control under corporate structures burdens VCs’ and entrepreneurs’ efforts to engage and collaborate efficiently. Nevertheless, startups continue to incorporate for lack of a better option. Corporations remain the best-available alternative when accounting for all considerations involved in startup structuring, from non-passthrough taxation to universal limited liability.

The corporation’s poor fit for startup structuring has drawn the attention of scholars. Various suggestions were made to reform corporate law and make it more startup-friendly. The paper takes a different approach. It suggests that the right way to satisfy startups’ unmet structuring needs is by providing them with a custom-made business entity, not stretching the corporate structure to fit both startups and non-startups. The novel structure introduced in the paper – “venture corporations,” or “v-corps” – would be designed to serve startups’ exit-driven character. The paper envisions v-corps as specialized corporations in which capital lock-in is an opt-out feature rather than a mandatory one, thus allowing for the creation of more reliable exit control instruments. Using these instruments would allow VCs and entrepreneurs to create highly-effective governance structures that would ensure all-hands commitment to the startup’s success on the way up, while allowing efficient disengagement should its agreed-upon objectives prove out of reach.

The paper further describes the advantages of introducing the v-corp over solutions based on effecting across-the-board corporate law reforms. First, applying the doctrinal changes to v-corps exclusively would neither send unnecessary shockwaves across the market nor provide non-startup shareholders with new rights and protections they do not value. Second, the existence of the v-corp alongside the legacy corporation would allow entrepreneurs to credibly signal to VCs their capabilities and motivation. By actively waiving the inherent protections that standard corporations offer entrepreneurs and forming a v-corp, entrepreneurs could assure VCs that their ex-ante exit strategies are sufficiently aligned. Lastly, the VC industry is prone to contractual innovation and tends to create novel financing structures that raise unique questions of law. V-corps could serve as a convenient platform for further specialization of startup law and providing tailor-made solutions to the industry-specific problems that these financing instruments engender.

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