Venture Capital-Backed Firms, Unavoidable Value-Destroying Trade Sales, and Fair Value Protections

Abstract

This paper investigates the implications of the fair value protections contemplated by the standard corporate contract (i.e., the standard contract form for which corporate law provides) for the entrepreneur–venture capitalist relationship, focusing, in particular, on unavoidable value-destroying trade sales. First, it demonstrates that the typical entrepreneur–venture capitalist contract does institutionalize the venture capitalist’s liquidity needs, allowing, under some circumstances, for counterintuitive instances of contractually-compliant value destruction. Unavoidable value-destroying trade sales are the most tangible example. Next, it argues that fair value protections can prevent the entrepreneur and venture capitalist from allocating the value that these transactions generate as they would want. Then, it shows that the reality of venture capital-backed firms calls for a process of adaptation of the standard corporate contract that has one major step in the deactivation or re-shaping of fair value protections. Finally, it argues that a standard corporate contract aiming to promote social welfare through venture capital should feature flexible fair value protections.

1 Introduction

Venture capital is disproportionately associated with innovation and, hence, economic growth.¹ Everyday life delivers tangible and compelling evidence of this correlation. Tellingly enough, today’s largest companies by market capitalization (i.e., Apple, Alphabet, Microsoft, and Amazon), like many other firms that have ended up disrupting market equilibria and consumer habits in recent times,² were once just nascent business opportunities that venture capital helped grow from trailblazing but insecure start-ups to their current level of deep-rooted global influence.³

Given venture capital’s importance to the economy, it is not surprising that the subject has attracted considerable interest from scholars and policymakers alike.

Social scientists, particularly economists and lawyers, have devoted significant attention to the various problems that emerge during the venture capital investment lifecycle,⁴ particularly as regards the dynamics unfolding throughout the entrepreneur–venture capitalist relationship.⁵ Above all, they have subjected the highly unusual financial structure and corporate governance model of venture capital-backed firms—well known for being the function a myriad of private ordering-based solutions that reshape the standard corporate contract almost in its entirety⁶—to extensive scrutiny. This strand of research has shed light, in particular, on the potentially significant impact that the resulting allocation of cash flow rights can have on the decision-making process that precedes so-called ‘trade sales’—roughly speaking, a variety of M&A transactions instrumental to carrying out the sale of the entire venture capital-backed firm.⁷ The key message that this scholarship has delivered is that the arrangements that are typical of venture capital-backed firms expose the entrepreneur to the risk that the venture capitalist ‘in control’⁸ may, under some circumstances, carry opportunistically out premature value-destroying trade sales.⁹ These transactions, in departing from the total shareholder value maximization norm that governs contract implementation,¹⁰ typically advance the interest of the venture capitalist, leaving the entrepreneur, qua shareholder external to decision-making, worse-off.¹¹

As part of a broader set of strategies to engineer a vivid venture capital market, policy-makers, particularly in Europe,¹² have drawn upon the debate stressing the importance of a flexible standard corporate contract for the facilitation of bargaining among entrepreneurs and venture capitalists to motivate their significant efforts towards modernizing it.¹³ Initiatives have in fact flourished to remove the rigidities of the standard corporate contract most manifestly incompatible with venture capital as a mode of financing and, thereby, encourage the formation of new partnerships between entrepreneurs and venture capitalists.¹⁴

Both the scholarly discussion and the policy debate have, however, been limited in scope. On the one hand, scholars have focused chiefly on explicit contractual contents and on addressing the threat of opportunism rather than discussing whether, due to implicit contractual contents,¹⁵ there might be instances of non-opportunistic value-destruction through trade sales. On the other hand, in their attempts to modernize the standard corporate contract, policy-makers have generally been concerned with making the room for the arrangements responsible for the static structure of venture capital-backed firms—namely, those that chiefly concern their financing.¹⁶ At least thus far, they have neglected to consider whether other terms of the standard corporate contract can prove problematic when the venture capital-backed firm is viewed in terms of its evolution. This is particularly true—as it will soon be clear—with regard to the way in which the standard corporate contract can distort the allocation of value generated through the transactions whereby the venture capitalist typically divests—particularly trade sales.

This piece of research aims to complement existing scholarship concerning the dynamics of venture capital-backed firms, particularly in the run-up to trade sales, while also engaging with the policy discussion concerning the optimal design of the corporate contract for the purposes of supporting venture capital investments.

To this end, it mounts an investigation into unavoidable value destroying trade sales and the role that the fair value protections contemplated under the standard corporate contract play in preventing the entrepreneur and the venture capitalist from designing the arrangements that fit their desiderata. ‘Unavoidable value destroying trade sales’ are trade sales that the venture capitalist in control executes towards the end of the lifetime of the venture capital fund to generate the liquidity needed to meet his obligations towards his own investors and which, due to various contingencies, end up sacrificing total shareholder value. ‘Fair value protections’, refer, in functional terms, to a number of safeguards and remedies entitling shareholders external to decision-making to claim the pre-transaction value of their shares (simply ‘fair value’), taken to be a function of firm value, vis-à-vis a given list of actually or potentially value-destroying transactions, so as to possibly escape their negative consequences.¹⁷

First, it demonstrates that the typical entrepreneur–venture capitalist contract goes to great lengths to prioritize the venture capitalist’s liquidity needs, allowing, under some circumstances, for instances of counterintuitive contractually-compliant value destruction. The venture capitalist is in fact endowed, by means of an implicit contractual term, with a ‘termination option’ that enables him, albeit only at a given point in time, to go for a timely divestment regardless of any contingency and any possibly ensuing consequence. Unavoidable value-destroying trade sales are the most tangible example. Next, it argues that fair value protections can prevent the entrepreneur and venture capitalist from allocating the value that these transactions generate as they would want. Then, it shows that the reality of venture capital-backed firms calls for a process of adaptation of the standard corporate contract that has one major step in the deactivation or re-shaping of fair value protections. Finally, it argues that a standard corporate contract aiming to promote social welfare should contemplate flexible fair value protections.

The analysis seeks to achieve two goals. It aims at providing a more granular theoretical understanding of the drivers behind value-destroying trade sales as well as delivering to policy-makers a suggestion for the optimal design of an important but thus far under-investigated term of the standard corporate contract. As such, it contributes to both the scholarly discussion about the dynamics unfolding in venture capital-backed firms and to the policy debate concerned with defining the recipe for modernizing the standard corporate contract with a view to delivering prospective entrepreneurs and venture capitalist with a more malleable product.

In addition to this introduction, this piece unfolds in six major steps. Section 2 offers a primer to the evolving structure of venture capital-backed firms and an account of the crucial role of the termination option in institutionalizing, though only partly, the venture capitalist’s interest to pursue his own liquidity needs. Building on this novel theorization of venture capital-backed firms, Sect. 3 sheds light on the dynamics underlying unavoidable value-destroying trade sales and accounts for their counterintuitive contractually-compliant nature. Section 4 projects the discussion into its legal dimension: it outlines the response of the standard corporate contract to value-destroying trade sales by addressing fair value protections. It then accounts for their problematic implications and the reasons for their potential ‘failure’ in the context of venture capital-backed firms. Section 5 focuses on one major step of the complex process instrumental to adapting the corporate contract to the specific features of venture capital-backed firms: the deactivation or re-shaping of fair value protections. Section 6 takes on a normative bent to argue that policymakers interested in attracting venture capital to promote social welfare should build flexibility into fair value protections. Section 7 concludes by summarizing the terms of the discussion and outlining avenues for complementary research.

Three important caveats narrow the scope of the discussion articulated herein. First, as the discussion is exclusively focused on unavoidable value-destroying trade sales and fair value protections, it is deliberately unconcerned with the opportunistic premature value-destroying trade sales that the venture capitalist in control may carry out and the fiduciary standards that are generally at work in protecting the entrepreneur from their negative effects.¹⁸ Second, as the discourse is merely conceptual in nature and aims to deliver only normative recommendations, it does not seek to extend its reach into the analysis of existing positive realities.¹⁹ Third, as the analysis is concerned with venture capital-backed firms, it does not address the implications that the flexibility of fair value protections has on other firms—say, somewhat generically but herein rather usefully, ‘ordinary firms’.²⁰

2 The Evolving Structure of Venture Capital-Backed Firms

A relatively recent scholarship has attempted to complement the extensive literature discussing specific moments within the lifecycle of the prototypical venture capital-backed firm²¹ by characterizing its evolving structure, that is, the organizational changes that occur within these firms over time.²² Time, however, also marks a progressive increase in the importance of divestment as venture capital-backed firms mature,²³ ultimately driving profound changes that, in addition to organizational modifications of the structure of these firms, eventually affect also their ‘existential purpose’. This transition has its origin in the unique contents of the contract negotiated by the entrepreneur and the venture capitalist.

2.1 The Entrepreneur and the Venture Capitalist

Much modern-day innovation owes itself to the entrepreneur²⁴: an agent of change eager to alter existing market equilibria with an ultimate view to capturing a discrete share of the ensuing wealth,²⁵ perhaps by selling his creature to a competitor.²⁶

The current entrepreneur looks more and more like an MBA, with an at least decent knowledge of the complexity of the entrepreneurial process and the resources that it requires.²⁷ He knows that the capital-intensive nature of his innovative project will soon require external capital.²⁸ Above all, he knows that, due to the high risk of his project and the failures that plague the market for entrepreneurial finance,²⁹ the viability of his potentially revolutionary idea will not hinge upon the traditional banking intermediation circuit. Rather, his ambition to actually bring down to the market his disruptive product or service will crucially depend on establishing a partnership with a venture capitalist.

The venture capitalist is a type of financier known, even among the uninitiated, for his informational advantage in selecting high-tech business projects and, above all, for committing to supporting them for a short-to-medium time-period.³⁰

The inherently transient nature of the venture capitalist’s commitment reflects the dynamics underlying the 5-to-8-year venture capital investment lifecycle.³¹ The prototypical venture capitalist begins by raising capital from a variety of investors,³² promising to deliver certain returns within a given period. Second, he carefully selects business projects based on their ‘exit potential’ so as to establish the preconditions for the punctual implementation of the promises that he has made to his own investors.³³ Third, he nurtures his portfolio companies by deploying a ‘hands-on’ approach that combines financial and non-financial contributions³⁴ so as to accelerate the value creation process within a given timespan. Fourth, the venture capitalist ‘harvests’ his portfolio through a variety of techniques,³⁵ including trade sales. A relatively small number of ‘winners’ will generally make up for the modest profitability or failure of the majority of his investments,³⁶ leading to overall healthy portfolio returns.

The exit-oriented approach that dominates the investment process has a clear efficiency-based rationale that has its ultimate roots in the organizational features of the venture capital industry. Venture capital funds typically take the form of a limited partnership with venture capitalists as general partners and investors as limited partners.³⁷ The choice of this scheme serves to give the venture capitalist full control over the wealth of fund investors so as to enable him to make decisions in a fast-changing business environment.³⁸ Although operationally efficient, the resulting control-related arrangements may generate room for the venture capitalist to engage in various forms of opportunism that contracts typically seek to counteract by way of a number of devices.³⁹ The most important such device is the provision stipulating a fixed term for the venture capital fund.⁴⁰ Much like a contractually imposed takeover, the fixed-term provision subjects the venture capitalist’s performance to a market assessment before investors come to a decision as to whether they want to re-entrust their capital in the next capital raising campaign.⁴¹

In order to encourage his investors to further extend their trust as the investment lifecycle begins anew, the venture capitalist must keep his promises from the capital raising stage⁴²: Yielding appropriate returns in a reliably timely fashion is then the essential precondition for the long-term viability of his business.⁴³

2.2 The Contract

The non-standardized contractual framework that the entrepreneur and the venture capitalist typically piece together plays a fundamental role in supporting the efficient implementation of the contract governing the venture capital fund.⁴⁴

Consistent with the two facts the negotiations among the contracting parties do take into consideration mainly the high riskiness of the project presented to the venture capitalist and the entrepreneur’s awareness that no forever marriage is in sight,⁴⁵ this contractual framework does in fact obeys a generally stable twofold functional logic.⁴⁶

First, the entrepreneur–venture capitalist contract is concerned with removing obstacles that stand directly in the way of financing innovative projects.⁴⁷ Contracts make recourse to a variety of private ordering-based solutions to mitigate the potentially deal-inhibiting implications of extreme uncertainty, informational asymmetry and moral hazard that typically emerge in this context.⁴⁸ Among these private ordering-based solutions are—inter alia⁴⁹—so-called ‘liquidation preferences’,⁵⁰ which grant the venture capitalist a senior financial claim with regard to an amount generally equal to their original investment.⁵¹ This amount must be paid out preferentially in a number of ‘liquidity events’, which can be defined as transactions whereby illiquid investments made in the firm are eventually turned into cash.⁵² Liquidation preferences can have different ‘sources’ (originating, from the contract, a mix of securities, or, most likely, security design), and exhibit different designs (i.e., be ‘non-participating’ or ‘participating’).⁵³ At their core, however, they all result from contracting parties’ choice to come to the uneven allocation of entrepreneurial risk that is typically observable in venture capital-backed firms.⁵⁴

On a more abstract level, the entrepreneur–venture capitalist contract is concerned with supporting the efficient implementation of the contract governing the venture capital fund.⁵⁵ This contract is the result of ‘braiding’—a technique deployed to informally intertwine its contents with those of the contract at the fund level,⁵⁶ so that, operationally, one becomes a sort of ‘extension’ of the other.

Braiding ensures that the contract governing the venture capital-backed firm will support the efficient implementation of the contract relating to the venture capital fund by defining its ultimate ambitions, determining its design, and tailoring the rule governing its implementation to the firm-specific reality.

2.2.1 Ambitions

Braiding defines, first of all, the fundamental goal of the entrepreneur–venture capitalist contract. It deprives this contract of its own ‘atomistic’ existential logic,⁵⁷ and substitutes it with one that conforms to the idiosyncratic timeline of the venture capital investment lifecycle.

To this end, the contractual framework governing venture capital-backed firms designs a governance model that seeks to strike a compromise between contracting parties’ shared ambition for value creation and, as is consistent with the venture capital fund’s timeline, the need to generate future liquidity.⁵⁸ Practically speaking, this implies that the entrepreneur–venture capitalist contract typically stipulates that the venture capital-backed firm will go through two stages: a ‘time to invest’ devoted to value-creation and an unavoidable ‘time to divest’ instrumental to value-realization.⁵⁹

Identifying the moment of transition from investment mode to divestment mode requires a context-specific reconstruction of the contractual contents.⁶⁰ Nonetheless, as is consistent with the logic of braiding, the moment of transition most often reflects the timeline of the venture capital fund, which is relatively consistent despite the non-negligible formal variations in contractual structures observable over space and time and the great diversity of industries in which venture capitalists invest.⁶¹ Roughly speaking, the rule of thumb seems to be that the standard venture capitalist will assign the first 5 years to value creation, and the subsequent 3 years to value realization.⁶²

2.2.2 Design

The logic that braiding injects into the entrepreneur–venture capitalist contract has tangible repercussions for formal contract structures: contracting parties’ ambition to imprint their relationship with a biphasic structure becomes in fact particularly evident along several contractual dimensions.

A number of contractual choices are to be taken as indicators of the contracting parties’ aim of value-creation. The lock-in effects associated with the choice of the corporate form provide a first, major indication of contracting parties’ will to stabilize their relationship with a view to facilitating the optimal level of investment.⁶³ The stipulation of the venture capitalist’s obligation to provide further support if the firm meets the agreed-upon milestones is also instrumental for value creation in that it serves as a credible commitment that productivity will come with the reward of extended support.⁶⁴ Negative covenants also indicate the venture capitalist’s concern for value creation and value preservation through the right to prevent premature value realization through, for instance, asset sales that may siphon-off non-negligible fractions of value.⁶⁵ The prospect of divestment also gives the entrepreneur a powerful performance incentive because he knows that, given the nature of his cash flow-rights, his returns are contingent upon value-creation exceeding a given threshold by the time it comes around.⁶⁶

Formal contract design does equally effectively support contracting parties’ ambition to ensure that, as times passes, value will be realized. The entrepreneur–venture capitalist contract, in fact, assigns the venture capitalist—irrespective of whether he holds residual control or not—a variety of exit-related control-rights to pave the way for the natural metamorphosis of the venture capital-backed firm into a liquidity-generating device. These exit-related control-rights include explicit prerogatives to divest by causing the firm to go public or by consummating the redemption of his shareholding, and, most importantly, by unilaterally bringing about a trade sale.⁶⁷ Although formally and operationally distinct, these exit-related control rights all seek to allow for the venture capitalist to engage in both adaptive and unilateral decision-making.⁶⁸ On the one hand, they aim to ensure that the venture capitalist will be able to make the best choice of divestment technique.⁶⁹ On the other hand, they aim to protect the venture capitalist’s vested interest in his authority to steer the divestment process without exposing himself to potentially unfavourable interferences that may alter the distribution of value realized through divestment or even hijack the process altogether.⁷⁰

2.2.3 Implementation

Not only is braiding responsible for defining the ultimate ambition and the formal design of the entrepreneur–venture capitalist contract, but it also re-shapes the rules governing its implementation so as to ensure that the venture capitalist will be able to exercise his explicit prerogatives to eventually generate timely liquidity—in any event and at any cost.

Like contracting parties in general, the entrepreneur and the venture capitalist would presumably agree to an implementation rule that commands to pursue total shareholder value.⁷¹ Yet, they would hardly choose to subject the implementation of their contract to the shareholder value maximization norm throughout its entire lifetime. This, in fact, would render braiding futile in practice, failing to account for its prevalence and ultimately jeopardising overall contractual consistency.⁷²

In order to preserve overall contractual consistency and thereby effectively respond to the efficiency-based rationale underlying braiding, an implicit ‘termination option’ must, then, necessarily be embedded within the contract governing the venture capital-backed firm. This termination option vests the venture capitalist with the prerogative to carry out a timely divestment and thereby generate timely liquidity irrespective of any contingency as the venture capital-backed firm enters its divestment mode and especially as the venture capital fund nears its end.⁷³

By institutionalizing, albeit only in part, the significance of the venture capitalist’ liquidity needs in the overall economy of the entrepreneur–venture capitalist business relationship, the termination option qualifies the shareholder value maximization along its diachronic dimension. It redefines the rule governing contract implementation so as to adapt it to the peculiar evolving structure of the venture capital-backed firm.

Practically speaking, it unfetters—so does the logic suggest—the venture capitalist from the exclusive end of shareholder value maximization, thereby making the room for instances of decision-making that may result in the sacrifice of a given fraction of total shareholder value.⁷⁴

Despite appearances, the divestment resulting from the exercise of this implicit contractual term then represents just another discrete moment of the process of implementation of the ex ante agreed-upon bargain. And nowhere is this more manifest than in those divestment transactions that take place as the venture capital fund nears its end, making the venture capitalist’s liquidity needs particularly compelling.

3 A New View of (Some) Value-Destroying Trade Sales

Because of braiding, the venture capital-backed firm exhibits an evolving structure that, in essence, hinges on a simple proposition prescribing that the contracting parties will seek value-creation within a given timespan. Eventually, the venture capitalist will be given free reins in realizing the value of the investments medio tempore made in the venture capital-backed firm.⁷⁵

So construed, the contents of the entrepreneur–venture capitalist contract provides the key to understanding a variety of transactions instrumental to divestment, grounding an alternative and counterintuitive explanation for their possibly value-destroying implications.

Although several opportunities to test this proposition may crop up as the prototypical venture capital-backed firm matures,⁷⁶ the ideal experimental laboratory for appreciating the peculiar dynamic stemming from the changing structure of the venture capital-backed firm, particularly as regards the practical impact of the theorization of the venture capitalist’s termination option, are so-called ‘trade sales’—the liquidity event par excellence.⁷⁷

3.1 Trade Sales: Logic, Forms, Significance

In the jargon of the high-tech entrepreneurial world, the term ‘trade sales’ refers, albeit non-technically, to a variety of M&A transactions instrumental to carrying out the sale of a venture capital-backed firm. Technically speaking, trade sales are transactions whereby a third-party acquirer, generally a strategic partner, secures full control over the venture capital-backed firm’s assets. By securing full control over the target’s assets, the acquirer creates the preconditions for appropriating any increase in the value of the target firm in its entirety⁷⁸—to the exclusion of the otherwise free-riding pre-acquisition shareholders.⁷⁹ Consistent with the ultimate aim of these transactions, cash is in principle the most appealing deal currency.⁸⁰

Trade sales, at least in theory, come in a number of functionally equivalent transactional forms—namely, asset sales, asset combinations, and share transfers.⁸¹ While functionally equivalent, the economics of these transactions partly differ because of their varying mechanics. Asset sales, for instance, typically feature higher transaction costs and an inherent inability to enable the seller to capitalize on the ‘organizational component’ of the target firm.⁸² From the perspective of the shareholders on the sell-side and particularly the venture capitalist, asset sales may therefore be less appealing than, say, asset combinations. Deal-specific contingencies or institutional variables may restrict some further the menu of available options. For instance, only venture capitalists who enjoy residual control over the firm will be able to steer decision-making at both the board and the shareholder levels and will thus be able to consummate a trade sale in the form of an asset combination (i.e., a merger or other equivalent transactional scheme).⁸³ Venture capitalists who lack residual control and are therefore unable to achieve that goal by causing the firm to take that action may instead need to resort to the corporate contract in order to receive the prerogative to bring about a trade sale unilaterally by dragging the entrepreneur’s shareholding along with their own in a so-called ‘compelled share co-transfer’.⁸⁴ Regulatory limitations regarding cash as the deal currency available in the event of asset combinations may also exist,⁸⁵ inducing contracting parties to resort, once again, to private ordering-based solutions in order to pave the way to other transactional schemes—in this case also in the form of compelled share co-transfers.

The economic importance of trade sales as a divestment technique for the venture capitalist is nowadays well established. In fact, although IPOs have long been considered the golden divestment technique for venture capitalists,⁸⁶ a different view has recently gained traction acknowledging that trade sales are actually much more common than IPOs and, in the aggregate, just as important.⁸⁷ The reasons behind venture capitalists’ reported increasing ‘preference’ for trade sales over IPOs, at least in recent times, are various. Trade sales may enable the venture capitalist to cash-in his investments more quickly than IPOs, to capture a fraction of the value that the acquirer transfers to the target in order to consolidate his market share by reducing competition.⁸⁸ Also, they may enable the venture capitalist to benefit in price-setting from the more accurate mechanisms operating in the M&A market relative to those in the IPO market, or to benefit from sparing the costs associated with the process of going-public.⁸⁹

3.2 Unavoidable Value-Destroying Trade Sales: Definition and Underlying Dynamics

The newfound importance of trade sales as a divestment channel has led to a significant increase in interest from academics—particularly legal scholars—in recent times. Attention has mostly been directed towards mapping the variety of conflicts of interests plaguing trade sales and singling out the instances of opportunistic decision-making that can lead to value-destruction through these transactions.⁹⁰

The centre of the debate has been, in particular, premature opportunistic value-destroying trade sales consummated by the venture capitalist.⁹¹ The discussion has only recently begun to (vaguely) include the scenario in which the venture capitalist sells ‘in the vicinity of the venture capital fund’s end’.⁹²

The focus here is precisely on the undertheorized unavoidable value-destroying trade sales that the venture capitalist may consummate as the venture capital-backed firm enters into its divestment mode and particulalry as the venture capital fund’s end approaches. These transactions are (1) unavoidable because they respond to the compelling need of the venture capitalist to carry out a timely divestment and, hence, generate timely liquidity. Additionally, as they are unavoidable and thus not deferrable, these transactions (2) may be value-destroying because of the contingencies affecting the process required to generate value through M&A transactions during the time-window in which these transactions need to be necessarily executed.

M&A transactions do generally succeed at generating value for target shareholders,⁹³ provided, broadly speaking, that some crucial factors exist. First and foremost, the M&A market must be inclined to assign valuations to a given firm that exceed firm value. Second, the seller must be in a good enough bargaining position to capture a given fraction of the additional value that the transaction can generate. The seller’s right to reject an offer and come back to the market at a more opportune time generally provides in any event (provided that no disturbing factor, such as conflicts of interests, alters the decision-making process) a relatively strong defence against value-destruction.⁹⁴

Enjoying flexibility in timing M&A transactions appropriately is accordingly crucial for prospective sellers to effectively engage with the market and deal with prospective buyers. The venture capitalist approaching the market to carry out an unavoidable trade sale does not always have this flexibility, though.

3.2.1 Unavoidability

Venture capital is a time-sensitive business.⁹⁵ Although it may sometimes be possible for the venture capitalist to buy some additional time from his own investors,⁹⁶ this is a stopgap at best. Divestment is an inevitable fact of life for a venture capital-backed firm, and, in spite of extensive contractual pre-planning,⁹⁷ trade sales often emerge as the best or even the de facto only available option to generate the liquidity that the venture capitalist urgently needs as the time to divest approaches.⁹⁸

In a manner similar to a mandatory go-shop provision contingent upon a future event, the prospects of having to pay back his own investors on time urges the venture capitalist to shop the firm immediately, rendering these transactions practically undeferrable.

3.2.2 Value-Destroying Potential

The unavoidable nature of these trade sales can have drastic implications for value creation. In a manner similar to so-called ‘fire sales’,⁹⁹ trade sales can in fact eventually fail to realize full firm value.¹⁰⁰

This can be attributable, broadly speaking, to two partly correlated factors with which the venture capitalist has possibly or necessarily to deal: a transiently unfavourable M&A market and a weak bargaining position.

3.2.2.1 An Unfavourable M&A Market

To begin, the venture capitalist may have to carry out an unavoidable trade sale in an unfavourable M&A market. Although valuations in the M&A market certainly tend to approximate firm value in the long-run,¹⁰¹ temporary situations can emerge in which valuations in the M&A market stand more or less significantly below firm value.

Various inefficiencies may be responsible for this fact. First, the M&A market may be going through a ‘cold’ phase because of an adverse macro-economic conjuncture. During a recession, steep declines in consumption levels can cause decreases in firm turnarounds, which may in turn lead more firms to generate liquidity by selling their assets. On the other hand, cash shortages and uncertain macro-economic prospects may actually induce other firms to reconsider their investment and expansion plans and hence their ambitions to pursue external growth strategies.¹⁰² Under such circumstances, it may prove impossible to resort to M&A transactions to realize firm value in full.¹⁰³

Second, competition on the buy-side may be temporarily ‘frozen’. Most assets exhibit a high degree of specialization. Accordingly, only a limited number of firms endowed with appropriate ‘absorptive capacity’ can profitably redeploy them.¹⁰⁴ To the extent that the most attractive strategic partners are temporarily unable or unwilling to invest money in the acquisition of some of these highly specialized assets, they would then need to be sold to industry outsiders who, due to their inability to use them to their fullest potential, would pay less than their full value.¹⁰⁵

3.2.2.2 A Weaker Bargaining Position

A seller who needs to sell now rather than tomorrow suffers from a competitive disadvantage. Empirical evidence confirms it, though indirectly.¹⁰⁶ The reason is straightforward: Prospective acquirers know that the seller does not have a ‘no-deal option’ at his disposal and that, accordingly, a sale at a price that neither includes a premium nor reflects the asset value in full is a superior option to a no-sale. Prospective acquirers can therefore exploit the uneven allocation of bargaining power resulting from the constraints affecting their counterparties to extract more favourable terms. Obviously, adverse conditions in the market may reinforce the effects of such uneven allocation of bargaining power—to the further benefit of prospective acquirers.

The market frictions described above can materialize during the time-window within which the venture capitalist must consummate an unavoidable trade sale. Venture capital-backed firms that are involved in unavoidable trade sales may accordingly have a difficult time attracting acquisition offers that incorporate a premium or even approximate firm value. Moreover, for a venture capitalist who is approaching the market under the liquidity pressure stemming from his time-sensitive business model, the need for deal completion outstrips the ambition for deal optimization.

Although the M&A market may provide solutions, these are occasional and not completely effective.¹⁰⁷ The combinations of market frictions and diminished bargaining power can, alternatively or cumulatively, effectively account—as the literature on fire sales indirectly confirms¹⁰⁸—for the temporary impossibility of realizing firm value in full on the M&A market. The discount that the acquirer has managed to secure stands as a proxy for the ensuing value-destruction.

In principle, any venture capital-backed firm is a potentially suitable ‘victim’ of these transactions. However, speculation would suggest that unavoidable value-destroying trade sales can concern particularly those venture capital-backed firms that, while staying afloat quite well, exhibit only slow and modest growth.¹⁰⁹ Perhaps allured by the prospects that the firm may successfully implement a ‘pivot’,¹¹⁰ the venture capitalist may be tempted to adopt a ‘wait-and-see’ strategy that could eventually lead him to delay divestment beyond the optimal moment. Besides, the limited growth potential may imply that these venture capital-backed firms attract only a few prospective buyers, leading, to the extent that this is the case, to suboptimal levels of competition—with all the ensuing consequences, given also the weak bargaining position of the selling venture capitalist, on the chances for value-creation or, conversely, value-destruction.¹¹¹

Whichever the driver behind the value-destruction associated with unavoidable value-destroying trade sales, their ultimate outcome is poised to generate harmful consequences sometimes only for the entrepreneur and sometimes also for the venture capitalist¹¹²—with correspondingly different implications given their differing exposures to firm risk.¹¹³

3.3 A More Thorough Assessment

At first glance, unavoidable value-destroying trade sales are all simply value-destroying trade sales: that is, they all are merely transactions that negatively affect total shareholder value. As such, unavoidable value-destroying trade sales may apparently have a somewhat ‘opportunistic aftertaste’. A combination of three elements may contribute to this potential perception. One element is general and it concerns the link between opportunism and value destruction. In the common discourse, value-destruction (if not stemming directly from bad luck) is often associated with opportunistic decision-making.¹¹⁴ As contracts are value-maximizing devices, the idea that a contract can contemplate instances of decision-making that may lead to value-destruction sounds puzzling, to say the least. Another element concerns the connection between opportunism and unavoidable value destroying trade sales. It is not rare for the venture capitalist to exit earlier than his contract suggests, sacrificing total shareholder value solely to his own advantage and to the detriment of the entrepreneur.¹¹⁵ A further element originates from the unequal impact that unavoidable valued-destroying trade sales may have on the wealth of the entrepreneur and the venture capitalist,¹¹⁶ with the venture capitalist possibly being able to maximize his wealth through these transactions.¹¹⁷

Unavoidable value-destroying trade sales are therefore tendentially grouped into the generic category of those transactions that venture capitalists carry out well before the potential of their portfolio companies has been fully realized.¹¹⁸ While describing the existing reality, this categorization rests on the observation of extrinsically identical outcomes, but it neglects to look deeper into the different drivers behind them.

A holistic assessment that factors in the peculiar contents of the entrepreneur–venture capitalist contract does reveal, however, a different reality. The contract governing venture capital-backed firms seeks to balance value creation and the venture capitalists’ future liquidity needs, exhibiting a formal design and obeying an implementation rule that vindicate this ambition.¹¹⁹ Under this contractual framework, the venture capitalist has the authority to carry out the timely divestment required to generate the timely liquidity needed to support the efficient implementation of the contract at the fund level and, hence, create the preconditions for his self-perpetuation: the termination option.¹²⁰ Unavoidable value-destroying trade sale are the most tangible manifestations of the venture capitalist’s decision to avail himself of this termination option.

As such, in spite of their appearance and even the fact that value-destruction may sometimes affect only the entrepreneur,¹²¹ unavoidable value-destroying trade sales do never contradict the contract governing the venture capital-backed firm. To the contrary, unavoidable value-destroying trade sales are just another moment of the process devoted to implement the terms of the agreed-upon bargain, regardless of how the value that these transactions generate is allocated between the entrepreneur and the venture capitalist.

4 The Standard Corporate Contract’s Response

In its ambition to imprint the venture capital-backed firm with its biphasic structure, the contractual framework governing the entrepreneur–venture capitalist business relationship assigns the venture capitalist the authority, at a given point in time, to cause liquidity-generating events irrespective of any contingency. The most manifest manifestation of the venture capitalist’s decision to exercise this termination option are unavoidable value-destroying trade sales.

These partial conclusions prelude to a crucial question that pertains the ways in which the standard corporate contract deals with the dynamics stemming from the contractual arrangements that are typical of venture capital-backed firms and, in particular, with the venture capitalist’s termination option. The question is, more precisely, as follows: how does the standard corporate contract ‘intercepts’, and ‘reacts’ to, unavoidable value-destroying trade sales?

Answering this question requires an incursion into its inner logic and, above all, into its basic contents.¹²²

5 Fair Value Protections

The standard corporate contract is written with ordinary firms in mind—firms that, whether held widely or closely, are supposed to operate for an indefinite period of time with a view to constantly maximizing the wealth of their participants throughout their entire lifetime.¹²³ Consistent with this general idea of firm reality, the standard corporate contract makes total shareholder value its ultimate and, above all, diachronically constant objective.¹²⁴

To facilitate the achievement of this objective, it first lays down the fundamental institutions required for the decision-making process to unfold.¹²⁵ However, taking—inter alia—the potential corruptive influence of the personal interests of decision-makers into consideration, it also seeks to protect shareholders external to the decision-making process¹²⁶ from harmful decisions by formalizing a variety of safeguards and remedies to neutralize the consequences of potential malfeasance.¹²⁷

Among these safeguards and remedies are—inter alia¹²⁸—fair value protections. Fair value protections entitle shareholders external to decision-making to receive the pre-transaction value of their shares vis-à-vis a given list of actually or potentially value-destroying transactions singled out for their potential or even likely harmfulness, so as to eventually escape their consequences.¹²⁹ The pre-transaction value of the shareholding is commonly referred to as ‘fair value’ and consists in the pro rata share of firm value.¹³⁰

Their fundamental logic is simple: they define firm value as the floor for the price that decision-makers can negotiate in a variety of transactions and, thus, for the price of each shareholding in that firm.¹³¹ Accordingly, if decision-makers sell the firm for a price that falls below this floor, aggrieved shareholders external to decision-making will have incentives to activate these fair value protections to neutralize the attempted predation.

In principle, fair value protections are available in connection with fundamental transactions that occur at the corporate level such as asset combinations (e.g., mergers).¹³² To the extent that the standard corporate contract treats asset sales like fundamental transactions, they can also trigger fair value protections.¹³³ The tendential correlation between fair value protections and the fundamental transactions that unfold at the corporate level does not imply that they cannot be made available for functionally equivalent transactions that unfold at the shareholder level such as compelled share co-transfers.¹³⁴

Fair value protections can exhibit different designs. One option is to grant shareholders external to decision-making a put-option against the company with a strike price set by reference to firm value.¹³⁵ A second option is to empower shareholders to sue the company for damages, which can amount to a sum equal to the difference between the fair value of their shareholdings and the post-transaction value that shareholders actually received.¹³⁶ A third option is to bring in an ex ante safeguard setting an explicit minimum price at which decision-makers can sell external shareholders’ holdings as long as the corporate contract vests them with the authority to do so.¹³⁷ The price can be set, once again, in reference to firm value.¹³⁸

Fair value protections may also differ along another significant dimension: the criteria according to which the firm value and, thus, the fair value of a given interest in it is determined. Firm value can theoretically be determined by resorting to a variety of methodologies reflecting, inter alia, the discounted value of the firm’s cash flow, and/or the value of its assets, and/or its market capitalization.¹³⁹ The standard corporate contract can take different stances with regard to how firm value and, hence, fair value should be determined. Among the options available, four are of significance here. A first option is to bring in a fair value protection that vests shareholders external to decision-making with the right to claim the fair value of their shareholdings without any further specification as to which methodology is to be deployed for its quantification, leaving it open for an ex post specification.¹⁴⁰ A second option is to mould fair value protections by delegating contracting parties to choose the methodologies that they find to be the most appropriate, but requiring them to write down these criteria ex ante.¹⁴¹ A third option is to shape a fair value protection in terms of the methodology to be deployed to determine firm value by specifying through mandatory legal terms the criteria to be applied for an estimate of the value of the firm and, therefore, the fair value of a particular shareholding.¹⁴² A fourth option is to bring in a fair value protection and allow contracting parties to specify the criteria and/or methodologies relevant for the determination of fair value while simultaneously resorting to more or less stringent criteria by setting a ‘floor’—i.e., a minimum price that shareholders claiming fair value have the right to receive ‘in any event’.¹⁴³

While choices as to these aspects of fair value protections’ design may vary due to variations (chiefly) in policy choices,¹⁴⁴ fair value protections do typically all exhibit one common and constant operational feature. They are the function of bright-line rules of the corporate contract that enable the aggrieved shareholder to claim the fair value of his shareholder based simply upon either the fact of the execution of a given type of transaction or its value-destroying implications.¹⁴⁵ As the fact that the transaction has taken place or the fact that value-destruction has ensued is enough to that end, no inquiry as to the drivers behind the transaction or the possibly ensuing value-destruction is required.

6 Fair Value Protections and Unavoidable Value-destroying Trade Sales

The safeguards and remedies seeking to protect fair value do fare well as long as ordinary firms are concerned.¹⁴⁶ In fact, in this context, the firm value-maximization norm holds without exception, giving operational legitimacy to devices that have the potential to tackle a number of value-destroying transactions indiscriminately, such as fair value protections.

The fair value protections that the standard corporate contract contemplates do apply to the trade sales of venture capital-backed firms in their various transactional forms¹⁴⁷: To the extent that this is the case, an entrepreneur faced with a value-destroying trade sale can claim the pre-transaction value of his shareholding.

In the context of venture capital-backed firms, however, the quest for total shareholder value-maximization suffers from the limitations originating from the time-constraints affecting the unfolding of the entrepreneur–venture capitalist business relationship.¹⁴⁸ The arrangements that govern the entrepreneur–venture capitalist relationship imply that value-destruction is not inherently ‘bad’: unavoidable value-destroying trade sales show that value-destruction can be the function of contractually-compliant instances of decision-making.¹⁴⁹

Being the function of bright-line rules that imprint into them their simple mechanics,¹⁵⁰ fair value protections are generally unable to appreciate the ultimate driver behind unavoidable value-destroying trade sales. As such, they tend to fail at recognizing the contractually compliant nature of unavoidable value-destroying trade sales, eventually proving irreconcilable with the logic of the contractual architecture that the entrepreneur and the venture capitalist typically conceive in order to adjust their relationship to the time-sensitive liquidity needs of the venture capitalist.¹⁵¹

The general availability of fair value protections does in fact enable the entrepreneur faced with an unavoidable value-destroying trade sale to claim the fair value of his shareholding, leading to an allocation of the value generated through this transaction that would then diverge from the allocation for which the entrepreneur and the venture capitalist typically bargain. That is, with fair value protections in place, the venture capitalist willing to carry out an unavoidable value-destroying trade sale would be able to do so only under the threat of an ‘exit penalty’. Such exit penalty would obviously take away from the venture capitalist a given fraction of the value generated through these transactions: a fraction of value that the terms of the typical entrepreneur–venture capitalist contract would enable him to capture, instead.

To appreciate the side effects that the fair value protections available under the standard corporate contract could have in the context of an unavoidable value-destroying trade sale as well as their practical implications, consider the two hypotheticals below, which build upon a set of assumptions¹⁵² and differ based on the design of the venture capitalist’s liquidation preferences.¹⁵³

Hypothetical 1—Alfa is a venture capital-backed firm in which the entrepreneur ‘EN’ holds a 40% plain-vanilla shareholding; and the venture capitalist ‘VC’ holds a 60% shareholding combined with a non-participating liquidation preference amounting to 60 million. VC has held a shareholding in Alfa for some 8 years. As the time to divest approaches, Alfa’s expected value stands at some 85 million. After extending his support by 1 year, VC’s fund has only a year left.¹⁵⁴ VC therefore goes shopping the firm in an adverse M&A market. Only one potential acquirer appears, delivering Alfa a 61 million acquisition offer. 61 million is, therefore, the best value realizable on the M&A market at the moment. The time constraints on the entrepreneur–venture capitalist relationship leave VC with no choice other than to opt for an immediate trade sale, with VC and EN accordingly receiving 60 and 1 million, respectively.¹⁵⁵ Based on the valuation of Alfa at 85 million as well as the fact that fair value protections are available, EN would refuse to accept 1 million and demand a much more substantial cheque reflecting the pre-transaction value of his shareholding amounting to 32 million. Because of the disbursement resulting from this claim, VC would receive 29 million instead of 60 (Table 1).¹⁵⁶

Table 1 Exit penalty with non-participating liquidation preference

The pattern is similar and the outcome is identical in situations in which VC holds participating liquidation preferences—as shown below.

Hypothetical 2—Alfa has two shareholders EN and VC here too: EN holds a 40% plain-vanilla shareholding in Alfa, and VC holds 60% shareholding combined with a participating liquidation preference amounting to 60 million. Alfa’s value stands, again, at some 85 million. VC invested 9 years ago and cannot postpone divestment any further. Such circumstances make the case for an immediate trade sale more and more compelling. Yet, due to temporarily depressed competition in the industry, the best acquisition offer from the few prospective buyers is in the form of a 61 million immediate cash-payment. Due to time-constraints VC cannot help but sell. VC and EN accordingly receive 60.6 and 0.4 million, respectively. As fair value protections are available, EN could reject the 0.4 million cheque and claim 20 million from VC, instead. By funnelling value towards EN, fair value protections lead to a situation in which VC’s net payoff is just 41 million—i.e., almost 20 million down from the much higher figure of 60.6 million (Table 2).¹⁵⁷

Table 2 Exit penalty with participating liquidation preference

As these examples show, the exit penalties in unavoidable value-destroying trade sales can be substantial, altering significantly the allocation of the value generated through unavoidable trade sales.¹⁵⁸

6.1 The Implications of Fair Value Protections’ Design

The potentially problematic nature of fair value protections in the context of venture capital-backed firms stems chiefly from the fact that they are simple functions of bright-line rules that do not require for an enquiry into the driver of the transaction.¹⁵⁹ However, their varying design also plays an important role: responsible for the exit penalty and the ensuing distributive consequences ultimately are, in fact, the criteria for the determination of fair value.

Depending on their prescriptive contents, these criteria can both narrow or widen the discrepancy between the fair value of the entrepreneur’s shareholding and the fraction of value generated by unavoidable trade sales that he would receive according to the entrepreneur–venture capitalist contract. By closing this discrepancy, these criteria can neutralize the threat stemming from fair value protections. Yet, by widening this discrepancy, they can render fair value protections more problematic. Obviously, the larger this discrepancy, the more worrisome the prospects of the exit penalty, and ultimately the potentially more problematic fair value protections.¹⁶⁰

The approach of the corporate contract to shaping this aspect of fair value protections may therefore have important consequences for the existence as well as the severity of the problem that they cause vis-à-vis unavoidable value-destroying trade sales. Recall that, when it comes to the criteria for the determination of fair value, the standard corporate contract can (i) leave the choice of these criteria open for ex post specification, (ii) delegate contracting parties to choose them ex ante, (ii) set them itself, or (iv) simply define a floor.¹⁶¹

All four approaches to fair value protections mentioned above can lead to situations in which the venture capitalist may have to compensate the entrepreneur for unavoidable value-destroying trade sales. Yet, a standard corporate contract that sets out its own criteria for the determination of fair value can make fair value protections more problematic. In fact, to the extent that these pre-set criteria can lead to firm valuations exceeding the value of the same venture capital-backed firm on the M&A market, the standard corporate contract sets itself the stage for an exit penalty for the venture capitalist. A standard corporate contract that omits these criteria does not lead per se to the same consequences, instead.

7 The Adaptation Process

The availability of fair value protections has the potential to prevent contracting parties from allocating the value generated through unavoidable trade sales in a manner that is consistent with the contents of the typical entrepreneur–venture capitalist contract, which—as discussed—contemplates some instances of decision-making that leads to value-destruction.¹⁶²

The entrepreneur and the venture capitalist may then want to adapt the contents of the standard corporate contract to the contents of the typical contractual framework governing venture capital-backed firms. The goal of the adaptation process would be to render the standard corporate contract ‘tolerant’ towards unavoidable value-destroying trade sales—or, more specifically, to ensure that the entrepreneur cannot claim more than the post-transaction value of his shareholding.

Although a complex process is involved in achieving this goal,¹⁶³ one major step would consist in designing the corporate contract so as to neutralize the impact of fair value protections. To this end, any solution that practically enables the venture capitalist to liquidate his investments without paying any exit penalty is in principle fit for the purpose.

To begin with, some expedients could prove useful. Granting the venture capitalist a call-option on the entrepreneur’s shareholding exercisable in the run-up to trade sales at a strike price that reflects the acquirer’s offer may be of aid. In fact, by enabling the venture capitalist to buy out the entrepreneur at a price below fair value, such a ‘pre-transaction squeeze-out’ may eradicate the preconditions for the entrepreneur to claim fair value in the aftermath of the trade sale.¹⁶⁴ The effectiveness of these arrangements is contingent upon two conditions: the arrangement must be enforceable and there cannot be a floor. Neither condition should be taken for granted.¹⁶⁵ Yet, if these two conditions coexist, this expedient may help circumvent the problem.

Rather than playing around the issue, more effective solutions would seek to address it by overcoming the risk that the entrepreneur claim more than the post-transaction value of his shareholding.

One solution would consist in defining ex ante a point in time when protections are no longer available so as to deprive fair value protections of their bite once the venture capital-backed firm enters its divestment mode, above all as the venture capital fund’s ends nears.

Another solution available to the entrepreneur and the venture capitalist would consist in relinquishing fair value protections altogether from the very beginning of their business relationship. Value-destruction through trade sales would then no longer be a concern. To this end, any private ordering-based solution with the effect of preventing the entrepreneur from availing himself of fair value protection would work. In particular, the contract can stipulate that the shareholder cannot avail himself of fair value protections—that is, he is banned from doing so. Alternatively but practically equivalently, the contract can determine that the entrepreneur must vote (if, depending on the trade sale’s form, he is required to do so) in favour of the transactions. In this case, the entrepreneur would no longer be eligible for availing himself of (at least some) fair value protections (namely, those that postulate that he has ‘dissented’ from the transaction the consequences of which he is now trying to escape).¹⁶⁶

Another solution would consist in leaving fair value protections in place but simultaneously ‘minimizing’ their impact. For this purpose, it would be sufficient to stipulate ex ante that the fair value is to be determined in reference to the value that the venture capital-backed firm has on the M&A market at the time of the unavoidable value-destroying trade sale. Under such arrangements, fair value protections would be available in theory, but would be bound to prove innocuous in practice. The implementation of this solution would partly vary depending on the design of fair value protections, particularly as concerns the way in which the standard corporate contract shapes the criteria for the determination of fair value.¹⁶⁷ If the standard corporate contract leaves the choice of these criteria open for ex post specification or requires contracting parties to choose them ex ante, they can simply define fair value in reference to the value that the firm will have on the M&A market. If, instead, standard corporate contract sets these criteria itself or defines a floor, contracting parties can ‘re-write’ its contents in parte qua.

Roughly speaking, these three different techniques do not lead to different results. The first seems the easiest to implement; the second appears more linear; the third looks instead like an inadequate cousin.

These possible solutions, however, all imply to some degree an intrusion in the standard corporate contract. Their feasibility accordingly depends, then, on the fact the entrepreneur and the venture capitalist can adopt those private ordering-based solutions that may alter the availability of fair value protections or at least the way in which they operate: that is, their feasibility depends on the flexibility of fair value protections as regards their an or at least their quomodo.

8 Implications

For the entrepreneur and the venture capitalist to design an efficient contract, flexible fair value protections are—as just discussed—required.

The quest for flexible fair value protections should, however, consider that these safeguards and remedies generally perform a crucial positive function in shielding shareholders external to decision-making from decision-makers’ opportunism. They are accordingly considered an essential—and thus, at least to some extent, ineliminable—component of the standard corporate contract.¹⁶⁸ And this may suggest to take an a priori adverse stance towards the possibility of making fair value protections flexible.

There may be good reasons to consider whether it is appropriate to overcome this sort of conviction, though. The choice between injecting into fair value protections a more or less significant dose of flexibility may have, in fact, different consequences on contract formation and, accordingly and above all, on social welfare.

8.1 Fair Value Protections, Contract Formation, and Social Welfare

Economic theory portrays contracts as the function of contracting parties’ ability to reach a given equilibrium.¹⁶⁹ Corporate contracts are no exception.¹⁷⁰ Their existence rests upon the successful outcome of a delicate bargaining process that seeks to reflect the unique nature of each business relationship.¹⁷¹

Insofar as the entrepreneur–venture capitalist relationship is concerned, bargaining is instrumental to endowing the venture capital-backed firm with their unique ‘behavioural temperament’,¹⁷² which needs to be such that the venture capitalist may be able to pursue, at a given point in time, his partisan interest to generate the timely liquidity that motivated investments in the first place.

A key to this outcome is the possibility to adapt the standard corporate contract to firm-specific realities.¹⁷³ Within some limits, contracting parties can sidestep the obstacles created by overly rigid isolated contractual terms of the corporate contract—leading to variations in deal structures, but leaving unprejudiced the formation of the business relationship and thus overall levels of general welfare.¹⁷⁴ Contracting parties’ ability to modify the contract is nonetheless finite: at some point, value redistribution through other contractual terms is simply undoable.¹⁷⁵

These general and essential notations as to how regulatory rigidities may affect contract formation help understanding the potential impact of fair value protection on the formation of the entrepreneur-venture capitalist contract. The premise is that fair value protections are poised to play a major role in the overall economy of entrepreneur–venture capitalist business relationships: as the grounds for a potentially substantial exit penalty, these safeguards and remedies have the potential to significantly affect firm value allocation ex post.¹⁷⁶

They therefore certainly have also the potential to affect investment decisions ex ante. And in fact, indications from transactional practice suggest that venture capitalists have a tangible interest in negotiating private ordering-based solutions with entrepreneurs that adapt this term of the corporate contract to the peculiar structure of venture capital-backed firms.¹⁷⁷ Moreover, anecdotal evidence relating to the litigation concerning private ordering-based solutions used to solve the problem at the contractual stage serves as corroboration.¹⁷⁸

Such indications from transactional practice do not warrant, however, the claim that fair value protections are necessarily deal-breakers, though. In some instances, the entrepreneur and venture capitalist may simply make up for the strictures stemming from the rigidities featuring such safeguards and remedies by redistributing value through other provisions of the standard corporate contract. In others, this option may simply be off.¹⁷⁹

To the extent that this is the case, the non-negotiability of fair value protections stands in the way of the formation of the entrepreneur–venture capitalist contract,¹⁸⁰ and, along with it, the creation of value, to the ultimate detriment of societal well-being.¹⁸¹

The potential adverse effect of fair value protections on contract formation recommends either making them just another default term of the standard corporate contract or at least allowing the re-shaping of the criteria used to determine fair value. Both solutions, as discussed earlier,¹⁸² would more or less linearly allow parties to neutralize the risk of a more or less substantial exit penalty that would clash with the logic of the typical entrepreneur–venture capitalist contract.

The additional value of increased flexibility in this area of the standard corporate contract is relatively straightforward. It would leave unimpaired the existing business relationships as well as the formation of those relationships that would be entered into in adherence under the corporate contract that makes fair value protections mandatory. However, it would also allow increased flexibility for those contracting parties that require it, and thus support the formation of those additional relationships that would be entered into only if fair value protection can be deactivated or at least reshaped. And even if only one additional value-creating deal were to fall under this umbrella, the resulting value-creation would be preferable to the status quo. It would in fact emerge as a superior option from a social welfare perspective.¹⁸³

8.2 A Novel Policy Recommendation (with a Warning)

The notations above support a novel, simple and clear-cut recommendation for policy-makers interested in drafting standard corporate contracts so as to better promote social welfare through venture capital¹⁸⁴: Making fair value protections just another default term of the standard corporate contract or at least injecting into their design a large dose of flexibility can help foster new business relationships.

It may come as a surprise that this policy recommendation is an entirely new one. Although policy-makers have started paying increasing attention to the problems that the strictures of the standard corporate contract can generate for prospective entrepreneurs and venture capitalists, they have thus far completely ignored the problem stemming out of fair value protections.¹⁸⁵

There may be a reason for this ‘indifference’. In their attempts to modernize the standard corporate contract, policy-makers have sought to remove those obstacles that were manifestly incompatible with the arrangements of the entrepreneur–venture capitalist contract responsible for defining the static structure of the venture capital-backed firm, with particular attention having been paid to the arrangements concerning the financing of the venture capital-backed firm.¹⁸⁶ Perhaps due also to the lack of any pertinent theorization, policy-makers have not focused on the explicit and implicit arrangements that shape the evolutionary trajectory of the venture capital firm, instead. They have paid even less attention to the implications that the changing structure of these firms may have on the dynamics underlying specific transactions, such as trade sales. They have not considered, in particular, whether, due to implicit contractual contents, instances of contractually-compliant value-destruction may exist.

Understanding these arrangements is nonetheless crucial for an appreciation of the problems that fair value protections may cause as the venture capitalist’s liquidity needs become increasingly compelling—and, more broadly speaking, as venture capital-backed firms enters into divestment mode.

Yet, policy-makers interested in modernizing the standard corporate contract to make it more amenable to prospective entrepreneurs and venture capitalists should not confine their attention to fair value protections. They should, instead, heed the following warning: The evolving structure of venture capital-backed firms requires a complex, multi-step adaptation of the standard corporate contract that also implies the re-moulding of fair value protections. However, other institutions of the standard corporate contract can also stand in the way of unavoidable value-destroying trade sales, neutralizing the advantage of increased flexibility in the design of fair value protections.¹⁸⁷

Unavoidable value-destroying trade sales therefore call for an injection of flexibility into various traditional institution of the the standard corporate contract. And more broadly speaking, conceiving a venture capital-friendly standard corporate contract should therefore be seen as an endeavour that can succeed only if, giving due consideration to the firm-specific reality of venture capital-backed firms from both a static and dynamic perspective, it does holistically aim at featuring appropriate levels of flexibility along all those dimensions that are generally affected by the pervasive adaptation process that the entrepreneur and the venture capitalist typically undertake.¹⁸⁸

9 Conclusions

This paper has analysed fair value protections in unavoidable value-destroying trade sales. The starting point of the discussion is the acknowledgment that the epicentre of the venture capital industry consists of venture capital funds with a fixed-term that serves an efficiency function. To support the efficient implementation of the contract governing the venture capital fund, the venture capitalist negotiates terms with the entrepreneur that may result in the braiding of their contract with that governing the venture capital fund.

Braiding informs contract ambitions, affects contract formal design, and defines the logic of contract implementation. As a result, venture capital-backed firms typically exhibit a biphasic structure with a time to invest preceding a time to divest, reflected in formal contract structures that vest the venture capitalist with a number of explicit prerogatives instrumental to divestment. More importantly, the venture capitalist receives also an implicit ‘termination option’ that, at a given point, enables him to divest irrespective of any contingency.

The core of the entrepreneur–venture capitalist contract is a straightforward agreement to pursue value creation but within a given timespan. Accordingly, the contractual framework contemplates instances that prioritize timely liquidity over value maximization, potentially resulting in value destruction.

Unavoidable value-destroying trade sales are perhaps the most apparent manifestation of the venture capitalist’s decision to exercise his termination option. The fair value protections that the standard corporate contract contemplates may expose the venture capitalist to the risk of an exit penalty that may alter the allocation of the value generated through these transactions that the typical entrepreneur–venture capitalist contract stipulates.

To avoid this outcome and pave the way for value allocation in line with the contents of the typical entrepreneur–venture capitalist contract, contracting parties may want to adapt fair value protections to the specific reality of venture capital-backed firms by resorting to expedients or a variety of more or less linear techniques. All these solutions do postulate, however, flexible fair value protections. They should be just another default term of the standard corporate contract or at least be largely malleable as regards the criteria according to which fair value is to be determined.

To the extent that the negotiability of fair value protections is a precondition for the formation of a given number of additional business relationships, a standard corporate contract contemplating flexible fair value protections does emerge, from a social welfare perspective, as a superior option.

The reasoning articulated herein adds a piece to both the scholarly discussion and the policy debate. On the one hand, it sheds light into our understanding of the dynamics unfolding as the venture capital-backed firm matures, particularly as regards the drivers behind the decision-making process observable in the run-up to the divestment, particularly through trade sales. On the other hand, it makes a recommendation to policy-makers interested in modernizing the standard corporate contract so as to support venture capital investments and, hence, promote social welfare.

This research is, however, just a first step taken on an unexplored path. Future complementary research—both theoretical and empirical—is required. To begin with, research should clarify the scope of the termination option. Chances are that the venture capitalist has more discretion in pursuing his own partisan interests than either currently supposed or explicit contractual contents suggest. The ‘expansion’ of the scope of the termination option would make room for additional instances of contractually compliant instances of decision-making with potentially value-destroying implications. This, in turn, would widen the universe of situations where overly rigid fair value protections may prove problematic. Also, empirical research should aim to clarify the impact of non-negotiable fair value protections on venture capital investments so as to build a more solid basis for compelling normative conclusions. Research should also map the stance taken by existing corporate laws with regard to fair value protections and the ultimate dynamics underlying these differences and their implications with a view to understanding what may possibly stand in the way of their modernization. More broadly speaking, the peculiar structure of venture capital-backed firms calls for an increase in attention with regard to how the standard corporate contract interacts with the firm-specific exigencies that emerge in this context, particularly as venture capital-backed firms evolves.

Efforts made in this direction will prove more profitable if placed in the context of broader research that seeks to make up for the under-investigated nexus between the standard corporate contract and venture capital investments, with a view to gaining a better understanding of how the former can support the latter—to the ultimate benefit of social welfare.