Jesse Fried is a Professor of Law at Harvard Law School, and Brian Broughman is an Associate Professor of Law at the Maurer School of Law at Indiana University, Bloomington.
Successful VC exits usually take one of two forms: an initial public offering (IPO) of a portfolio company's shares, followed by the sale of the VC's shares into the public market; or a "trade sale" of the company to another firm.
Trade sales are much more common than IPOs and, in aggregate, are more financially important to VCs. Unlike IPOs, however, trade sales do not trigger the intense public-disclosure requirements of the securities laws; they take place in the shadows. Thus, although trade sales play a critical role in the venture capital cycle, we know much less about them than about IPO exits.
In our paper, Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, which was recently cited in Carsanaro, et al. v. Bloodhound Tech., Inc. et al., C.A. No. 7301-VCL (Del. Ch. Mar. 14, 2013)(Laster, V.C.) shortly after being made public on SSRN, we seek to shine more light on the intra-firm dynamics around trade sales. In particular, we investigate how VCs induce the "entrepreneurial team" - the founder, other executives, and common shareholders - to go along with a trade sale that they might have an incentive to resist.
The entrepreneurial team is much more likely to oppose the typical trade sale than the typical IPO. In an IPO, executives keep their jobs and are subject to less direct oversight as shareholders become more diffuse. By contrast, in a trade sale, executives may lose their jobs or find themselves subject to more direct oversight as shareholdings become concentrated in the hands of a single shareholder (the acquirer). In an IPO, common shareholders tend to do quite well. In a trade sale, however, VCs often exit as preferred shareholders with liquidation preferences that must be paid in full before common shareholders receive anything; common shareholders may thus receive little (if any) payout.
If the entrepreneurial team opposes a trade sale, they may try to impede it in the hope that there will be a better trade-sale exit (or even an IPO) down the road. Executives may refuse to cooperate in the sale process. Common shareholders may try to block the sale by exercising their voting rights or by threatening litigation. To the extent some members of the entrepreneurial team are directors, they may use their board positions to try to block the sale.
To investigate how VCs overcome entrepreneurial-team resistance to trade sales, we hand-collect data on 50 VC-backed Silicon Valley high-tech firms that were sold to acquirers. We find, in these transactions, that VCs frequently rely on either inducements ("carrots") or coercive tools ("sticks") to get the deal done.
The use of carrots is quite common. To induce executives to cooperate, VCs frequently offer sale bonuses. In 16 of the 50 firms, VCs pay an average sale bonus of $1.63 million. Common shareholders as a class are also often given extra value. In 11 of the 50 firms, VCs provide "carve-outs" from their liquidation preferences to common shareholders that average $3.7 million. In 45% of the firms, VCs give at least one type of carrot, with these carrots amounting to 9% of deal value. Across all 50 firms in the sample, an average of 4.3% of deal value is used to finance sale bonuses and carve-outs to common.
VCs also rely on sticks. Among other things, VCs threaten to blacklist founders who refuse to cooperate and attempt to undermine common shareholders' voting rights. But the overt use of sticks is relatively infrequent. And although 60% of the founders in their firms are replaced before the exit, we find no evidence that VCs fire (or threaten to fire) founders to facilitate trade sales.
Our study makes three contributions. First, it sheds light on an important but underexplored aspect of corporate governance in private VC-backed firms. In particular, it highlights the potentially divergent interests of different players in VC-backed firms around trade-sale exits, and shows that VCs frequently must overcome potential opposition to these sales.
Second, our study provides additional evidence that managers of a target firm can extract value by holding up a sale of the firm. Researchers have reported on the use of side payments to executives in the sale of publicly traded firms. We show that such "bribes" are used not only in public firms with dispersed ownership but also in closely-held private firms.
Third, our study provides evidence on whether VCs are constrained from abusing their power in startups. The relatively infrequent use of sticks in the sample firms provides support for the view, often associated with Professors Bernard Black and Ron Gilson, that reputational or other non-legal considerations substantially constrain sharp-elbowed behavior by VCs in Silicon Valley.
The full paper is available for download here.
Jesse Fried is a Professor of Law at Harvard Law School.
Brian Broughman is an Associate Professor of Law at the Maurer School of Law at Indiana University, Bloomington.