ISSN 1936-5349 (print)
ISSN 1936-5357 (online)

HARVARD
JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESSCARROTS & STICKS:HOW VCs INDUCE ENTREPRENEURIALTEAMS TO SELL STARTUPS

Brian Broughman
Jesse M. Fried

Discussion Paper No. 742
03/2013Harvard Law School
Cambridge, MA 02138

This paper can be downloaded without charge from:The Harvard John M. Olin Discussion Paper Series:
http://www.law.harvard.edu/programs/olin_center/

This paper is also a discussion paper of theJohn M. Olin Center’s Program on Corporate Governance.

CARROTS & STICKS: HOW VCS INDUCE ENTREPRENEURIAL TEAMS TO
SELL STARTUPS
Brian Broughman* and Jesse M. Fried**
FEBRUARY 19, 2013

Abstract

Venture capitalists (VCs) usually exit their investments in a startup via a
trade sale. But the entrepreneurial team – the startup’s founder, other executives,and common shareholders – may resist a trade sale. Such resistance is likely to beparticularly intense when the sale price is low relative to VCs’ liquidationpreferences. Using a hand-collected dataset of Silicon Valley firms, we investigate
how VCs overcome such resistance. We find, in our sample, that VCs give bribes(carrots) to the entrepreneurial team in 45% of trade sales; in these sales, carrots total
an average of 9% of deal value. The overt use of coercive tools (sticks) occurs, but
only rarely. Our study sheds light on important but underexplored aspects ofcorporate governance in VC-backed startups and the venture capital ecosystem.
*

Associate Professor of Law, Indiana University
Professor of Law, Harvard Law School. For helpful conversations and comments, we are
grateful to Abe Cable, Herb Fockler, Darian Ibrahim, Jason Mendelson, Edwin Miller, Usha
Rodrigues, Ezra Roizen, Josh Wolfe, participants at the Cornell Symposium on Law, Innovation, andEntrepreneurship and, especially, Mike Kendall and Sarah Reed. We would also like to thank Meg
Burton, Albert Chang, Cynthia Chi, Edward Dumoulin, Jennifer Su, Bruce Sun, and Fennie Wang forvaluable research assistance. VentureReporter.net provided access to their database of mergers andacquisitions. This project was generously supported by a grant from the Kauffman Foundation
through the Lester Center for Entrepreneurship and Innovation at UC Berkeley while the two authors
were affiliated with UC Berkeley, as well as by the Harvard Program on Corporate Governance and
the John M. Olin Center for Law, Economics, and Business at Harvard Law School. Most
importantly, we thank the many entrepreneurs who agreed to provide data for our research.
**

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Carrots and Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups
Table of Contents
I.
II.

III.

IV.

V.

VI.

VII.

INTRODUCTION
VCS’ CASH-FLOW AND CONTROL RIGHTS
A. VCs’ Cash-Flow Rights
B. VCs’ Exit-Facilitating Control Rights
1. Board Seats
2. Shareholder Rights
POTENTIAL ENTREPRENEURIAL-TEAM
RESISTANCE TO TRADE SALES
A. Resistance by the Founder and Executives
1. Incentive
2. Ability
B. Opposition by Common Shareholders
1. Incentive
2. Ability
VCS’ POTENTIAL CARROTS AND STICKS
A. Founders and Executives
1. Carrots
2. Sticks
B. Common Shareholders
1. Carrot: Carve-out to Common
2. Sticks
C. Carrots vs. Sticks
RESEARCH SAMPLE
A. Sample Population
1. Data Gathering
2. Selection Issues
B. Sample Description
C. VCs’ Ex Ante Cash and Control Rights
1. VCs’ Cash-Flow Rights
2. Power of the Entrepreneurial Team
3. Founders’ Position in the Firm
ACTUAL CARROTS AND STICKS IN THE SALE OF
VC-BACKED STARTUPS
A. Carrots
1. Common Carve-outs
2. (Non-retention) Management Bonuses
3. Cost of Carrots
B. Sticks
1. Termination of CEO
2. Blacklisting
3. Cross-voting
4. Vote-buying
CONCLUSION

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I. Introduction
Venture capitalists (VCs) play a significant role in the financing of high-risk,
technology-based business ventures. Many of America’s best-known public companies
began as VC-backed firms: Amazon.com, Apple, FedEx, Intel, Microsoft, and Starbucks,
to name a few. Not surprisingly, venture capital is considered to be an important
contributor to economic growth in the United States and elsewhere. 1
The steps in the venture capital cycle are by now familiar. 2 A VC firm creates andraises capital for a limited-life fund. 3 The VCs select portfolio companies for the fund,investing in these companies over a number of rounds of financing. 4 Along the way, theVCs advise and monitor the portfolio companies, sometimes replacing their founders. 5
Before the end of the fund’s life, VCs “exit” their investments in the portfolio companies
and return capital to the fund’s investors. 6 The returned capital can then be recycled intoanother VC fund.
VC exits usually take one of three forms: an initial public offering (IPO) of theportfolio company’s shares, followed by the sale of the VC’s shares into the publicmarket; a “trade sale” of the company to another firm; or dissolution and liquidation of
the company. 7 Of these three types of exits, IPOs have received the most scrutiny. 8 This
1

See, e.g., Josh Lerner, Boom and Bust in the Venture Capital Industry and the Impact on Innovation, 87
FED. RES. BANK OF ATLANTA ECON. REV. 25 (2002) (concluding that venture capital is “an important
contributor to technological innovation and economic prosperity”).
2

For an overview, see PAUL GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE (2d ed. 2004).

3

See, e.g., Michael D. Klausner & Kate Litvak, What Economists Have Taught Us About Venture Capital
Contracting, in BRIDGING THE ENTREPRENEURIAL FINANCING GAP: LINKING GOVERNANCE WITHREGULATORY POLICY (Michael Whincop ed., 2001) (describing and analyzing terms of limited partnershipagreements with investors); William A. Sahlman, The Structure and Governance of Venture-Capital
Organizations, 27 J. FIN. ECON. 473, 473 (1990) (describing and analyzing relationship between investors
and VCs).
4

See, e.g., Paul A. Gompers, Optimal Investment, Monitoring, and the Staging of Venture Capital, 50 J.
FIN. 1461, 1461 (1995) (analyzing structure of VC investments and attributing staged financing to
information asymmetries and agency costs); Brian Broughman and Jesse M. Fried, Do VCs Use Inside
Rounds to Dilute Founders? Some Evidence from Silicon Valley, 18 J. CORP. FIN. 1104, 1104-20 (2012)(finding that VCs do not appear to use inside rounds to dilute founders).
5

George W. Fenn, Nellie Liang & Stephen Prowse, The Economics of the Private Equity Market, BD. OF
GOVERNORS OF THE FED. RESERVE SYS., Staff Studies Series No. 168, 29 (1995) (studying private equity
markets and describing VCs’ investing activities including selecting, structuring, monitoring, and exiting).
6
7

Id.

Other forms of VC exit include the VC’s sale of its interests in the startup to one or more private equity
firms, and one VC’s sale of its interest to another VC (a “secondary”). See Darian M. Ibrahim, The New
Exit in Venture Capital, 65 VAND. L. REV. 1, 16-17, 19-20 (2012) (discussing how VCs are increasingly
becoming sellers on the secondary market, and how buyers on the secondary market include VCs andprivate equity funds). These forms of exit merely replace some or all of the firm’s existing VCs with newinvestors, without substantially altering the relationship between the startup’s investors and its
entrepreneurial team. Thus, they do not create the types of conflicts explored in this paper – those that canVersion 2/19/13

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attention is not surprising. IPO exits tend to involve the largest and most visible VCbacked firms. And, perhaps just as importantly, the IPO process triggers public-disclosure
requirements under the securities laws, making data on IPO exits easily accessible toresearchers.
But trade sales are actually much more common than IPOs and, in aggregate, arelikely to be almost as financially important to VCs. Indeed, in certain industries (such as
medical devices) and in certain periods (such as the last decade, when the IPO market has
been tepid), trade sales, compared to IPOs, are likely to be more important to VCs. 9
Unlike IPOs, however, trade sales do not trigger the intense public-disclosure
requirements of the securities laws; they take place in the shadows. 10 Thus, although
trade sales are important to the venture capital cycle, relatively little is known aboutthem.
The purpose of this paper is to shine a light on how VCs arrange to sell startups intrade sales. In particular, we seek to 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.
We begin by describing the standard cash-flow and control rights that VCs
receive when investing in startups. VCs almost always invest through convertible
preferred stock. In a trade-sale exit, VCs choose between retaining their preferred shares(and capturing most or all of the proceeds through their liquidation preferences), or
converting into common shares. In an IPO, VCs (as a practical matter) must convert toarise in sales of the portfolio company to another operating company. Less commonly, a VC may exit byhaving the portfolio company redeem the VC’s shares.
8

See, e.g., Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets:
Banks Versus Stock Markets, 47 J. FIN. ECON. 243, 243 (1998) (analyzing VCs’ exits through IPOs andrelation between stock market and the VC market); Malcolm Baker and Paul A. Gompers, The
Determinants of Board Structure at the Initial Public Offering, 46 J.L. & Econ. 569, 569 (2003) (findingthat VC-backed IPO firms have more independent outside directors).
9See, e.g., News Release, Thomson Reuters & National Venture Capital Association, Venture-Backed
Exits Enjoyed Higher Average Values on Lower Total Volumes in 2012 2 (Jan. 2, 2013), available at
http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=929&Itemid=317(reporting that M&A deals have exceeded IPOs in terms of both deal number and dollar amount yearly
between 2007 and 2012); Nils Behnke & Norbert Hültenschmidt, New Path to Profits in Biotech: Taking
the Acquisition Exit, 13 JOURNAL OF COMMERCIAL BIOTECHNOLOGY 78, 79-80 (2007) (reporting that VCs
in medical device companies traditionally exited via trade sale and that VCs in biotech companies are
increasingly choosing trade sales over IPOs).
10

If the acquirer is publicly-held and the acquisition is deemed a “material” agreement then the acquirer
must disclose in Form 8-K “a brief description of the terms and conditions of the agreement . . . that arematerial to the company.” See SEC Final Rule Release 34-49424, Additional Form 8-K Disclosure
Requirements and Acceleration of Filing Date, available at http://www.sec.gov/rules/final/338400.htm#seciic. Form 8-K disclosure only applies, however, to material transactions and the acquirer
does not need to file the actual merger agreement or provide other details about the target firm. See id.

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common stock. 11 VCs also seek board seats and shareholder-voting rights, in part tomake it easier for them to exit and realize their cash-flow rights.
We then explain why founders, executives, and common shareholders are more
likely to oppose a trade-sale exit than an IPO exit. In an IPO, the founder (if still theCEO) can continue running the firm and will face less direct oversight as shareholdings
become more diffuse. 12 Other executives can typically keep their jobs, also with lessshareholder oversight than before. And the original common shareholders of firms
conducting IPOs generally do well; VCs would not push for an IPO exit unless thecommon shares (to which the VCs must convert in an IPO) have considerable value.
By contrast, in a trade sale, the founder (if still the CEO) and other 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 other words,
they become “mere” employees. And, because VCs in trade sales often exit as preferredshareholders with liquidation preferences that must be paid in full before commonshareholders receive any payout, common shareholders may receive little (if any)
payout. 13 At the same time, the sale eliminates any “option value” (upside potential) of
the common stock held by the founder, other executives, and employees. 14 For all thesereasons, VCs pushing for a trade sale may face resistance from the entrepreneurial team,particularly when common shareholders receive very little.
Two points are worth emphasizing here. First, an entrepreneurial team resisting a
trade sale may not necessarily believe that, if the startup remains independent, the startup
has a reasonable chance of going public. Rather, they may resist a trade sale today
because they believe that, if the startup remains independent, there is a good chance thatit can exit in the future via a more attractive trade sale – one that provides significantly
better employment opportunities for the entrepreneurial team and more value forcommon shareholders. 15

11

In an IPO, VCs typically convert their preferred stock into common, either because it is contractuallyrequired, or because preferred shares almost never survive an IPO given market resistance. Thus, VCs arelikely to push for an IPO only when the common stock they would receive upon converting their shares isworth more than the preferred stock’s liquidation preferences (plus, where relevant, the preferred stock’s
participation rights).
12Black & Gilson, supra note 8, at 260-61 (noting that an IPO returns effective control of the firm to theCEO/founder).
13

Of course, if the trade sale is at a high price relative to aggregate liquidation preferences, commonshareholders may well receive a large payout even if the preferred shareholders do not convert to common.
1415

For a discussion of the “option value” of common stock in VC-backed firms, see infra Part III.B.1.

VCs, on the other hand, may want to sell the firm now and capture most of the sale price through theirliquidation preferences. Should the firm remain independent, it might end up being sold for a much lower
price than is currently being offered. Thus, the VCs bear the downside risk associated with keeping thestartup independent. See Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control inStartups, 81 N.Y.U. L. REV. 967, 978-79 (2006). In addition, or alternatively, VCs may wish to sell the firmVersion 2/19/13

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Second, there may well be situations where the entrepreneurial team favors a
trade sale opposed by the VCs. For example, the entrepreneurial team might wish to
accept an offer that is lucrative for them personally (given the short amount of time they
have spent on the venture) but that provides only a very modest return to the VCs. 16
Thus, we do not claim that the entrepreneurial team will always oppose a trade sale.
Rather, our claim is that there are likely to be many scenarios where VCs will favor a
trade sale opposed by the entrepreneurial team.
After describing the entrepreneurial team’s potential incentive to resist a tradesale, we discuss the various strategies they might use to impede the sale. The executives
and common shareholders can impede a trade sale through their influence over the board,which must approve the transaction. The common shareholders can try to block the saleby exercising their voting rights or by threatening litigation. And the executives canrefuse to cooperate in the sale process (or, if the acquisition requires their continued
participation in the enterprise, refuse to commit to such participation).
Next, we identify the various bribes (carrots) and coercive tools (sticks) that VCs
can use to induce a reluctant entrepreneurial team to support, or at least not impede, a
trade sale. For the founder and other executives, the VCs can offer bonuses for a
successful sale (carrot). The VCs can also threaten termination or blacklisting if theexecutives do not cooperate (sticks).
For common shareholders, VCs can offer to share part of the VCs’ cash-flow
rights with the common shareholders through a “carve-out to common” (carrot). They
can also use vote buying, or other transactions that dilute common shareholder voting
rights, to undermine common shareholders’ ability to block a transaction via their voting
rights (sticks).
To investigate the use of carrots and sticks in trade sales, we use a hand-collected
database of 50 VC-backed Silicon Valley firms sold to acquirers in 2003 and 2004. The
firms are primarily in the biotech, telecommunications, software, and internet sectors.
The average sale price is $55 million, but there is considerable variance in outcomes. A
number of sales are essentially liquidations, while other sales are for well over $100
million; one firm is sold for over $500 million. For each firm, we collect data on the
carrots and sticks used in connection with the sale. 17
now to show prospective investors for their next fund that the VCs can successfully exit their investments,
or because the fund in which the portfolio company is held is coming to the end of its life.
16

17

See, e.g., Darian Ibrahim, The New Exit in Venture Capital, 65 VAND. L. REV. 1, 28-29 (2012).

This paper builds on earlier work using portions of the same dataset. See Brian Broughman & Jesse M.
Fried, Renegotiation of Cash Flow Rights in the Sale of VC-Backed Firms, 95 J. FIN. ECON. 384, 384-399(2010) (showing that common shareholders’ ability to extract carve-outs from VCs depends on the
allocation of control rights within the firm as between common shareholders and preferred shareholders). In
this paper, we use additional information gathered in our study to provide a more complete picture of VCs’
efforts to induce entrepreneurial teams to sell firms by describing (1) the carrots given to both commonshareholders and executives; and (2) VCs’ use of various sticks, including blacklisting threats, vote buying,and vote dilution.

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We find, in our sample, a heavy reliance on carrots. To induce executives tocooperate in selling their firms, VCs frequently offer sale bonuses. In 16 of the 50 firms,
VCs paid an average sale bonus of $1.63 million. In 11 of the 50 firms, VCs gave
common shareholders as a class an average of $3.7 million extra. In 45% of the firms,
VCs gave at least one type of carrot, with these carrots amounting to 9% of deal value on
average for such firms. Across all 50 firms in our sample, an average of 4.3% of deal
value (2.4% on a dollar-weighted basis) was used to fund these two types of carrots: salebonuses and carve-outs to common. 18
We also find some use of sticks, such as threats to blacklist founders who refuse
to cooperate and attempts to undermine common shareholders’ voting rights. But theovert use of these sticks is relatively infrequent. And although 60% of the founders in ourfirms were replaced before the sale, we find no evidence that VCs fired or threatened tofire founders to ease the sales of firms.
Our study makes three important contributions to the literature. First, it sheds lighton 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 canextract value by holding up a sale of the firm. Researchers have reported on the use ofside payments to executives in the sale of publicly traded firms. 19 We show that such“bribes” are used not only in public firms with dispersed ownership but also in closelyheld private firms.
Third, our study provides some evidence on whether venture capitalists areconstrained from abusing their power in startups. The relatively infrequent use of sticks
in our sample provides support for the view that reputational or other non-legal
considerations substantially constrain (but do not completely prevent) sharp-elbowed
behavior by venture capitalists in Silicon Valley. 20
The remainder of the paper is structured as follows. Part II describes the typicalstructure of VC cash-flow and exit-facilitating control rights in startup firms. Part III
explains why founders, other executives, and common shareholders may wish to impedea trade sale, as well as the means they have to do so. Part IV describes the carrots and18

The use of carrots is greater in the 42 firms in our sample where the VC investors did not convert tocommon stock, and thus where the conflict between the entrepreneurial team and VCs was likely to be thegreatest. In this subsample of 42 firms we find that 5.0% of deal value (3.1% on a dollar-weighted basis)
was used to fund carrots.
19

See, e.g., Hartzell, Ofek & Yermack, What’s In It for Me? CEOs Whose Firms Are Acquired, 17 REV.
FIN. STUD, 37, 37-61 (2004) (finding, in a sample of acquired firms, that target managers frequently receive
non-retention bonuses in connection with the sale of the firm and that such payments average $1.2 million).
20

See, e.g., Black & Gilson, supra note 8, at 262-83 (1998) (suggesting that reputational considerations
constrain misbehavior by venture capitalists in Silicon Valley).

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sticks that VCs may use to overcome such resistance. Part V presents our dataset. Part VI
describes carrots and sticks actually used by VCs in our sample. Part VII concludes.
II. VCs’ Cash-Flow and Control Rights
A. VCs’ Cash-Flow Rights
In the United States, VC-backed startups almost always issue two classes ofstock: common and convertible preferred. The founders and employees hold the common
stock. The convertible preferred stock is held by VCs, who invest in startups almost
exclusively through this type of security. 21 Most venture-backed startups issue a newseries of preferred stock for each round of financing. 22
Like most preferred stock, VCs’ preferred shares carry a liquidation preference
and are convertible into common. 23 If VCs retain their preferred stock, and preserve theirliquidation preferences, those preferences must be satisfied before common shareholders
receive any payment. In this scenario, VCs’ cash flow rights are debt-like. 24 If the VCs
convert their preferred shares to common, giving up their liquidation preferences, theVCs have the same cash flow rights as common stockholders. 25 Thus, convertible
preferred stock combines downside protection with upside potential.
21

See Steven N. Kaplan & Per Stromberg, Financial Contracting Theory Meets the Real World: An
Empirical Analysis Of Venture Capital Contracts, 70 REV. ECON. STUD. 281, 313 (2003). VCs’ use ofpreferred stock may have desirable screening, incentive, and tax-reducing effects. See, e.g., Fried & Ganor,
supra note x, at 983-86.
22

While some of the rights of the preferred stockholders may be class rights, each series of preferred stockis assigned its own exclusive rights and preferences, including liquidation preferences that may be senior or
junior to those of other series. This, in turn, may give rise to conflicts within the preferred class over exits
and other transactions. Indeed, in certain situations, the interests of the most junior preferred may be closer
to those of common than to those of the most senior preferred. In this project, we implicitly assume that
all of a firm’s VCs share the same interests (vis-à-vis common shareholders, the founders, and otherexecutives) around the potential sale of the firm.
23

See Kaplan & Stromberg, supra note x, at 285, Table 1 Panel G (finding that almost all VC financings in
the U.S. involve securities senior to common).
24

Unlike the liquidation preferences of most public-company preferred stock, VCs’ liquidation preferences
can easily exceed the original purchase price of the stock: the liquidation preference of VC preferred stock
sometimes confers the right to be paid a multiple of the purchase price before common shareholders may
receive any payment. See, e.g., Vyvyan Tenorio, VCs Reconsider Tough Terms for Entrepreneurs, THE
DAILY DEAL, Jan. 28, 2002 (reporting deal with liquidation preferences of 12 times original purchaseprice). When the preferred shareholders are entitled to cumulative dividends, the liquidation preferences
are even larger because they include, in addition to the multiple, any unpaid dividends (even if notdeclared). See Michael Woronoff & Jonathan Rosen, Effective vs. Nominal Valuations in Venture Capital
Investing, 2 N.Y.U. J.L. & BUS 199, 218 (2005).
25

VCs’ convertible preferred stock may have “participation rights” that entitle holders not only to aliquidation preference, but also to share (with common shareholders, on a pro-rata basis) in any additional
value available for distribution to shareholders, usually up to a specified amount (say, three times theoriginal investment amount). Thus, the VCs will convert their preferred shares into common stock only if

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In a trade sale, VCs will choose whether to exit as preferred shareholders and reap
the benefits of their liquidation preferences or to exit as common shareholders. If VCs
exit via an IPO, underwriters will typically insist that the VCs convert to common sharesand give up their liquidation preferences and other rights. Thus, the firm’s charter will,with respect to the holders of each series of preferred stock, generally either (a) require
the holders of that series to convert to common or (b) allow a majority of the holders ofthat series to forcibly convert all holders of that series to common stock, preventing
holdouts. 26 One way or the other, VCs will typically exit via the IPO as commonshareholders.
B. VCs’ Exit-Facilitating Control Rights
To exit their investment, VCs must arrange an IPO, trade sale, or dissolution of
the firm. Below, we describe the two types of control rights most relevant to facilitating
an exit: (1) the right to board seats and (2) shareholder voting rights. 27
1. Board Seats
The board is responsible for managing the day-to-day business and affairs of thecompany. 28 Critically, the board is also the only corporate body that can initiate
fundamental transactions, such as mergers, IPOs, or dissolutions. 29 Because thesetransactions are almost always necessary for VC exit, we will call them “VC exit
transactions.” VC exit transactions (including trade sales) thus cannot go forward withoutboard approval. But, as we will see, board approval alone is not sufficient. Shareholder
approval is also necessary.
the amount they would receive as common stockholders exceeds the sum of their liquidation preference andthe value of their participation rights. For ease of exposition, our discussion of VCs’ cash-flow rights
assumes that VCs’ preferred stock is non-participating.
26

See Thomas Hellmann, IPOs, Acquisitions, and the Use of Convertible Securities in Venture Capital, 81
J. FIN. ECON. 649, 650 (2006) (discussing the requirement of automatic conversion in the event of an IPO).
For an example of a mandatory conversion provision see Section B.5 of the model “Certificate ofIncorporation” provided by the National Venture Capital Association (NVCA), at 29-32, available at
http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136.
27

VCs also negotiate for numerous protective provisions that enable them to block a variety of corporate
actions. See Fried & Ganor, supra note x, at 987. By tightly constraining the firm, these provisions givesignificant leverage to VCs and make it harder for founders and other common shareholders to resist
demands that the firm be sold. Staged financing – the ability to withhold needed cash – also gives VCs
substantial influence over corporate decision-making and increases their ability to sell the firm. Id.

28
29

See, e.g., 8 DEL. CODE ANN. § 141(a) (2001); CAL. CORP. CODE § 300(a) (West 1990).

Shareholders, on the other hand, usually cannot initiate fundamental transactions even when theirapproval is required to effectuate the transactions. See, e.g., Robert B. Thompson & D. Gordon Smith,
Toward a New Theory of the Shareholder Role: “Sacred Space” in Corporate Takeovers, 80 TEX. L. REV.
261, 301-03 (2001) (noting reactive nature of shareholder voting to board actions).

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The board, in turn, is elected — and can be replaced — by shareholders. 30 In the
typical public company, default statutory voting rules give each share one vote for each
open board seat. By contrast, in a VC-backed firm, the parties typically negotiate avoting agreement that overrides default statutory voting rules. 31 The agreement specifies
the allocation of board seats among: (1) representatives of common shareholders; (2)representatives of VC investors; and (3) so-called “independent directors,” typicallyindustry experts or other outsiders with valuable experience and connections who are
mutually appointed by the common shareholders and the VCs. 32
Because board approval is necessary for VC exits, VCs negotiate aggressively forboard seats when investing in startups. 33 While data on board composition in private VCbacked firms are scarce, two persistent patterns emerge from various small-scale studies
of VC contracting documents and VC-backed firms. First, VC board representation tends
to increase with new financing rounds, especially outside rounds that bring in new VCs.34
Second, in a plurality of firms, neither common shareholders nor VC-appointed directors
ever achieve outright control; the swing vote is in the hands of an independent director.35
Keeping the swing vote in the hands of an independent director makes it more difficultfor either the common shareholders or the preferred shareholders to act opportunisticallywith respect to the other class of shareholders. 36 But, as one of us has argued in other30

DEL. CODE ANN. tit. 8, § 141(k)(2001).

31

William W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, 100
MICH. L. REV. 891, 899 (2002) (describing how venture capital transactions provide tailored voting
arrangements for director elections).

32

Kaplan & Strömberg, supra note x, at 287-89.

33

VC board control serves other important purposes besides facilitating exit. It allows the VCs to monitor
the operations of the firm, control entrepreneur opportunism, replace the entrepreneur with a professional
manager should the founder not prove up to the task, and prevent the board from taking actions that benefit
common shareholders at the expense of the preferred. See Fried & Ganor, supra note x, at 989-993.
34

D. Gordon Smith, The Exit Structure of Venture Capital, 53 UCLA L. REV. 315, 324 (2005) (studying
exit provisions in VC contracting and finding increase in VCs’ control over exit with the stage ofinvestment).

35

Cf. Steven N. Kaplan, Berk A. Sensoy & Per Strömberg, Should Investors Bet on the Jockey or theHorse?Evidence from the Evolution of Firms from Early Business Plans to Public Companies 64 J. FIN. 75(2009) (reporting that, by time of IPO, median VC directorship is 3, median management directorship is 2,
and median outside directorship is 2). Kaplan & Strömberg, supra note x, at 287 (finding, in a survey of
118 startups, that in 60%, neither VCs nor common shareholders had control).

36

See generally Brian J. Broughman, The Role of Independent Directors in Startup Firms, 2010 UTAH L.
REV. 461 (showing that independent directors as tie-breakers can limit opportunistic conduct that may
occur if entrepreneurs or investors were to control the board); Brian Broughman, Independent Directors
and Shared Board Control in Venture Finance (April 6, 2012), R. L. & ECON. (forthcoming) (providing aformal model of decision-making under shared board control with an independent director holding the tiebreaking seat).

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work, these studies (and the outwardly neutral appearance of independent directors) may
understate the extent of de facto VC control over startup boards. 37
2. Shareholder Rights
As noted above, for VCs seeking an exit transaction, board approval is not
sufficient. Shareholder approval is also necessary.
As a matter of corporate law, some shareholder approval is always required. The
nature of that approval will depend on the corporate law of the state in which the firm is
domiciled as well as the firm’s charter and other organizational documents. In somestates, such as Delaware, the default arrangement is that a majority of preferred andcommon shares (voting together) must approve exit transactions. 38 But alternative
arrangements, including provisions giving particular series of preferred stock veto rights,
are common. 39 In other states, including California, a majority of each class of shares(including common stock) must approve exit transactions. 40
As a matter of business practice, the buyer in a trade sale may also insist on
shareholder approvals not required by corporate law or the firm’s organizational
documents. For example, a buyer might be concerned about appraisal rights. Under
corporate law, dissenting shareholders in a merger (those voting against the transaction)
can exercise appraisal rights and have a court determine the “fair value” of their shares;
the buyer is then forced to pay fair value to these dissenters. 41 If the court’s determinationof fair value is much higher than the amount paid per share in the transaction, the cost of
acquiring the target could rise substantially. To minimize potential appraisal claims, anacquirer may insist that a super-majority of shareholders approve the transaction. 42 The
bottom line is that corporate law may provide only a floor for shareholder-approvalrequirements.
37

See Fried & Ganor, supra note x, at 988-89 (noting that (1) at least one director designated as arepresentative of the common shareholders will be the CEO, and if the CEO is not the founder but an
executive hired by the VCs, he or she may feel some loyalty to the VCs rather than to commonshareholders generally, and (2) so-called “independent directors” may not be truly independent of the VCs,
even if nominally approved by both common shareholders and VCs, if they are drawn from the VCs’
professional network and expect to interact with them in the future).
38

See, e.g., DEL. CODE ANN. tit. 8, § 251 (2010 (requiring, for a merger, approval by holders of majority ofoutstanding stock).
39

See Fried & Ganor, supra note x, at 970-71.

40See, e.g., CAL. CORP. CODE § 1201(a) (2012) (requiring, for a corporate reorganization, approval by amajority of each class of outstanding shares).
41

42

See, e.g., DEL. CODE ANN. tit. 8,. § 262 (2010); CAL. CORP. CODE § 1312 (2012).

Historically, another reason for seeking a high percentage of target shareholder votes was to obtainfavorable accounting treatment for the transaction. See, e.g., Orban v. Field, NO. 12820, 1997 Del. Ch.
LEXIS 48 (Apr. 1, 1997) (acquirer of VC-backed startup insists on 90% common-shareholder approval toobtain pooling-of-interests accounting treatment for acquisition).

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Because common shareholders’ approval is sometimes needed as a matter ofcorporate law (in states where approval by each class of stock is required) or businesspractice, VCs can (and sometimes do) negotiate for “drag-along” rights that allow them
to force common shareholders to vote for any transaction favored by the VCs. 43 If thecommon shareholders have agreed to vote their shares as directed by the VCs, theycannot block an exit transaction via a class vote. 44 They must then seek other means tostop the transaction.
III. Potential Entrepreneurial-Team Resistance to Trade Sales
This Part explores why the entrepreneurial team may resist a trade sale that theVCs propose. Section A explains why founders and other executives may oppose, andmay be able to impede, a trade sale. Section B explains why common shareholders may
oppose, and may be able to impede, a trade sale.
A. Resistance by the Founder and Executives
The founder and other executives may have both reasons and the means to oppose
a trade sale.
1.

Incentive

Consider a founder who is still the CEO. The founder/CEO may have ambitious(perhaps grandiose) financial and non-financial aspirations for the startup. He or she may
believe that these aspirations can be realized only if the startup remains independent andhe or she remains in control. A trade sale may well snuff out these aspirations (imagine if
Facebook had been sold in a trade sale to, say, Google or Microsoft). To the extent thefounder/CEO wants to keep the startup independent so that it can realize its full“potential,” he or she may oppose a trade sale.
Whether or not the founder is still part of the management team, the firm’s
executives might have two very practical reasons to oppose a trade sale. First, theexecutives may well be replaced or subject to tighter supervision as the firm comes under
the control of a single shareholder (the acquirer). Executives could thus be forced to give43

See Robert P. Bartlett, III, Venture Capital, Agency Costs, and the False Dichotomy of the Corporation,
54 UCLA L. REV. 37, 62 n.98 (2006)(describing drag-alongs). Depending on its terms, the drag-along may
not be effective unless the board has also voted to approve the sale.
44

To the extent common shareholders have agreed to vote their shares as directed by the VCs, and theshares are voted in favor of a transaction, the common shareholders may lose their right to appraisal, whichis generally available only to shareholders who vote against the transaction. See, e.g., 8 DEL.C. § 262(a)(2010). Cf. Corp. Law Comm. of the Assoc. of the Bar of the City of N.Y., The Enforceability andEffectiveness of Typical Shareholders Agreement Provisions, 65 Bus. Law. 1153, 1183-84 (2010)(reporting that, as of 2010, "[n]either New York nor Delaware courts have explicitly ruled whether a waiverof appraisal rights in the context of a drag-along sale is enforceable.").

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up the pay, perquisites, and prestige associated with their positions – or to work harderfor them. 45
Second, executives may own substantial amounts of common stock in the firm,
especially if they are part of the founding team. As we discuss below, a trade sale may
yield little for common shareholders while eliminating the option value of their stock. 46
To the extent executives own common stock that they will be forced to give up for lessthan its option value, they have another reason to try to block a trade sale.
2.

Ability

Executives of VC-backed firms seeking to block a trade sale have three potential
means to do so. First, and most importantly, they can refuse to cooperate in the sale of the
firm. They can refuse to report acquisition interest to the VCs, they can drag their feet indealing with a potential acquirer, they can refuse to provide information (and emphasize
negative aspects of the business) to a potential acquirer. Moreover, if a potential acquirer
wants members of the executive team to stay on after the acquisition (for example, tocontinue developing a startup’s technology), executives can block the deal by refusing towork for the acquirer. In short, executives can use their positional power in the firm toundermine and sabotage efforts to sell it.
Second, to the extent executives have seats on the board, they can threaten to voteagainst a sale and try to persuade independent directors to oppose the transaction.
Attorneys advising a board may prefer a vote to be unanimous because it reduces
litigation risk. The desire for a unanimous vote would increase the ability of even a
minority of directors to impede a sale.
Third, if common-shareholder approval is necessary for the deal, and executives
own a large block of common shares, they can threaten to vote their shares against thedeal and lobby other common shareholders to oppose the deal. This brings us tocommon-shareholder opposition to trade sales.
B. Opposition by Common Shareholders
Common shareholders, like executives, may also have an incentive (and someability) to impede a trade sale.
1.

Incentive

VCs exiting via trade sale always have the ability to retain their preferred sharesrather than converting them into common shares. In this scenario, the VCs have
45

Executives of VC-backed startups facing potential trade sales are in the same position as the executivesof publicly traded companies facing takeover attempts or merger proposals. See generally Hartzell, Ofek &Yermack, supra note 19, at 38. Of course, in some cases a trade sale might make the executive team better
off. In those cases, executives would not oppose the sale.
46

See infra Part III.B.1.

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liquidation preferences that must be paid in full before common shareholders receive any
payout. Thus, common shareholders may not receive much, if anything, in a trade sale.
However, even if the VCs’ liquidation preferences exceed the sale price, the common
stock might have, at the time of sale, considerable “option value:” if the firm is not soldnow, it might later hit a home run and be sold later for a price that exceeds the preferredshareholders’ liquidation preferences, giving a large payout to common shareholders.47
The less common shareholders receive, and the greater the loss of option value, the morecommon shareholders will wish to block a trade sale.
In blocking a sale, the common shareholders may not be trying to keep the startup
independent so that it can go public. Rather, they may resist a trade sale today because
they believe that, if the startup remains independent, there is a good chance that it canexit in the future via a more attractive trade sale – one that provides significantly morevalue for common shareholders.
2.

AbilityCommon shareholders can block a trade sale in three ways: (a) using theirshareholder voting rights; (b) litigating or threatening litigation; and (c) using theirinfluence over the board.
(a) Shareholder voting rights
As we explained in Part II.B.2, common-shareholder approval may be necessary
to conduct a trade sale. In particular, such approval will be necessary if (1) commonshareholder approval is required by corporate law and/or the acquirer, and (2) the VCs
fail to negotiate effective drag-along rights enabling them to force the commonshareholders to vote for a VC-favored sale. If neither corporate law nor the acquirer
demands common-shareholder approval, or the VCs have effective drag-along rights,
then common shareholders cannot threaten to hold up the deal through their voting rights.
(b) Fiduciary-duty and other litigation
To try to block a deal, common shareholders can also threaten to sue the board or
the VCs directly for, among other things, breach of fiduciary duties under corporate law.
Common shareholders’ litigation leverage will depend in part on the corporate laws of
the state in which the firm is domiciled. The easier it is to demonstrate breach offiduciary duty under that state’s corporate law, the more leverage common shareholders
will have.

47

Consider, for example, a startup with $50 million in aggregate liquidation preferences. Assume there is a
50% likelihood that, within one year, the firm will be worth $90 million and a 50% likelihood that it will beworth $0. A hypothetical risk-neutral buyer content to earn a 0% return would pay $45 million for all of
the equity of the startup. Preferred shareholders would get $45 million; common shareholders would get $0.
But if the startup were to remain independent, the common stock would have an expected value of $20
million because there is a 50% likelihood of a $90 million sale yielding $40 million for common
stockholders. That $20 million is the “option value” of the common stock that is lost in the sale of the firm
today for $45 million.

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But two limits to common shareholders’ ability to credibly threaten litigation are
worth noting. First, aggrieved common shareholders will often lack the financial ability
to sue VCs. 48 Second, there may well be large reputational costs to litigating against
VCs. 49 All in all, the actual likelihood of litigation is likely to be low.
(c) Board Influence
A third mechanism by which common shareholders can impede a trade sale is byasking their representatives on the board (if there are any) and any independent directors(if there are any) to vote against the transaction. Common shareholders will haveconsiderable influence on board votes if a majority of the board seats are not held by the
VCs, but rather by common-shareholder representatives and/or independent directors.
Indeed, given directors’ preference for unanimous board votes, even a stubborn minorityof directors who care about the interests of common shareholders might be able to block
a sale that is unfavorable to common shareholders.
IV. VCs’ Potential Carrots and Sticks
In Part III, we saw that founders, other executives and common shareholders of VCbacked startups may have the incentive and ability to resist a trade sale. In this Part, we
describe the potential carrots and sticks that VCs can use to induce founders and otherexecutives (Section A) and common shareholders (Section B) to go along with tradesales. 50 Section C explains that, from the VCs’ perspective, both carrots and sticks entail
costs.

48

See Fried & Ganor, supra note x, at 1000-01. Lawyers will generally not take such cases on acontingency basis because the amounts involved in any given case are likely to be relatively small. The
plaintiffs would thus need to finance the potentially extensive litigation themselves. Defendants, whose
litigation will be financed by the target’s D&O insurance policies, can be expected to engage in a scorchedearth defense to financially exhaust the common-shareholder plaintiffs. Members of the entrepreneurial
team, even collectively, are unlikely to have the substantial resources necessary to finance such litigation.
49

See Fried & Ganor, supra note x, at 1000-01. The founders and employees holding common stock may
wish to raise money from VCs in the future for other ventures, or work at other VC-backed startups.
Acquiring a reputation as a “troublemaker” who sues VCs is likely to make it more difficult to raise funds
from VCs or to get positions at VC-backed firms in the future. Consider the story of Epinions.com, whose
founders, including Naval Ravikant, filed suit against several prominent VC firms for fraud in connection
with a 2004 merger that wiped out the value of their common shares. After the merger but before thelawsuit, Ravikant had become a partner at another VC firm, Dot Edu Ventures. Shortly after the lawsuit
was filed, Dot Edu Ventures expelled Ravikant under pressure from other VC firms, which may well havethreatened to exclude Dot Edu Ventures from deals unless it pushed out Ravikant. According to one personclose to the situation: “[Ravikant] had better win this suit and he better hope that he makes enough for life,
because he'll never work as a VC again.” See Constance Loizos, VC Gets Frozen Out After Joining Suit,
EQUITY
WEEK,
Feb.
4,
2005,
PRIVATE
http://www.privateequityweek.com/pew/freearticles/1107338724787.html (alteration in original).
50

Because VCs provide financing in stages, and have the ability to prevent the firm from getting debt orequity financing elsewhere, they can always wield an “implicit” stick of starving the company of cash until
management and common shareholders agree to sell the company. However, use of such a stick might also
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A. Founders and Executives
To induce founders and other executives to facilitate rather than impede a tradesale, VCs may offer carrots or deploy various sticks.
1. Carrots
For founders and other executives, the VCs can use direct carrots (management
bonuses) or indirect carrots (carve-outs to common shareholders).
(a) Management Bonus
The direct carrot is a “management bonus” triggered by the sale (and, perhaps,with an amount tied to the sale price). The bonus may be structured in a variety of ways.
For example, executives can be promised ex ante (even before an acquirer is identified) a
portion of the sale proceeds. Alternatively, executives may be given a contemporaneously
negotiated payment labeled as a “bonus” or instead characterized as part of a noncompete agreement or consulting agreement. 51
The cost to VCs of using a management-bonus carrot will depend on the saleprice relative to aggregate liquidation preferences at the time of sale. If the sale priceexceeds aggregate liquidation preferences, most or all of the carrot will be paid for by theoriginal common shareholders, not the VCs. 52 If the sale price is less than aggregateliquidation preferences, the VCs will pay for the carrot.
(b) Carve-out to common
The indirect carrot is a carve-out to the common shareholders as a class. A carveout entitles common shareholders to a portion of the trade-sale proceeds even if the firm
is sold for less than the VCs’ liquidation preferences. To the extent the founders andexecutives own shares of common stock, they will share pro rata in the carve-out. For
example, if founders and executives own 50% of the common stock, a carve-out tocommon of $10 million will yield founders and executives $5 million.
2. Sticks
VCs facing recalcitrant founders and other executives have two potential sticks attheir disposal.

expect to get little in the sale, the threat of destroying the firm may not induce them to support the sale. For
these two reasons, there are limits to the power of this stick.
51

A retention agreement with the acquiring firm may also function as a carrot if its actual purpose is to
overcome the executive’s resistance to the sale rather than to increase the value of the acquirer by binding
valuable human capital to the acquiring firm.
52

If the VCs have participating preferred stock, they will pay for part of the carrot. If the VCs have nonparticipating convertible preferred stock, the common shareholders will bear all of the cost of the carrot.

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Carrots & Sticks(a) Termination

First, VCs could threaten to fire the founder and other executives if they refuse tocooperate in a trade sale. Termination would cut off future compensation and perhaps
cause the forfeiture of unvested equity. Such a step would be quite painful for the
executives.
But such a tactic would also be quite costly to the VCs. The startup would lose its
management team, which may be crucial to a potential buyer, the VCs would be forced tospend time and energy finding a replacement, and the new team would then need to bebrought up to speed and adequately incentivized to sell the firm. As a result, we would
expect this stick to be wielded rarely, if at all.
(b) Blacklisting
Second, VCs could threaten to “blacklist” founders and other executives who
refuse to cooperate in a trade sale. VCs are repeat players in both funding entrepreneurs
and hiring professional executives for startups. Neither entrepreneurs nor professional
managers will want to displease the VCs, everything else equal.
B. Common Shareholders
To induce common shareholders to support a trade sale, the VCs have one carrot
at their disposal, and a number of sticks.
1. Carrot: Carve-out to Common
The carrot VCs can offer common shareholders is a carve-out from theirliquidation preferences (or other cash-flow rights) so that common shareholders receive
more than they are contractually entitled to receive. Such a carve-out to common canboth induce common shareholders to vote for the sale and cause them to refrain fromsuing.
2. Sticks
VCs can wield a number of sticks to compel common shareholders (as a class) tovote for the trade sale. However, these sticks cannot prevent a lawsuit and, in fact, may
increase the likelihood of one.
(a) Cross-voting
To eliminate common shareholders’ ability to block a trade sale, VCs canpartially convert their shares into common stock, or exercise warrants to buy common
stock, thereby acquiring a sufficient amount of common stock to achieve the necessary
approval threshold. Consider the transactions in Orban v. Field, 53 a Delaware caseinvolving a common-shareholder lawsuit against a VC-controlled board. Office Mart, a
53 No. 12820, 1997 Del. Ch. LEXIS 48 (Apr. 1, 1997).

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Delaware corporation, arranged to be acquired by Staples in a merger providing nopayout to common shareholders. 54 The charter allowed preferred shareholders to votealongside common shareholders on an as-converted basis (as if their stock had been
converted into common shares), and the preferred shareholders had enough votes toensure shareholder approval of the transaction for corporate-law purposes. However, foraccounting reasons, Staples insisted that at least 90% of Office Mart’s common shares bevoted in favor of the transaction. 55 Common shareholders, led by Office Mart’s founderand former CEO George Orban, refused to back the deal, demanding $4 million in
exchange for their votes. 56
Office Mart’s board refused to provide a carve-out to common. Instead, the board
arranged a series of transactions that, in essence, assisted the VCs in converting a portionof their preferred stock into common, thereby diluting the original common position
down to less than 10% of the class. 57 The VCs, now holding over 90% of the common
stock, voted their common stock in favor of the merger, which allowed the transaction togo forward and wiped out the common shareholders. The maneuver cost the VCs
nothing; although the partial conversion into common reduced the VCs’ aggregateliquidation preferences, it still left them with enough liquidation preferences to absorb allof the merger consideration. Orban sued, arguing that Office Mart’s board had violated
its fiduciary duties to common shareholders. The Delaware Chancery ruled in favor of theboard, concluding that the “common stockholders had no legal right to a portion of themerger consideration under Delaware law or the corporate charter” 58 and noting that“[t]here is no claim that the challenged transaction was not in the ‘best interests of thecorporation.’” 59

54 See id. at *2.
55 Id. at *17.
56 Id. at *22.
57 Id. at *22-24.
58

Id., at *32. Of course, the issue here was not, as the court implies, how to divide the proceeds of analready-effected merger. In fact, the merger had not yet taken place. Rather, the issue was whether apreferred-controlled board could use corporate resources to dilute the voting power of commonshareholders objecting to a proposed merger that benefitted the preferred shareholders and left the commonshareholders with nothing.
59

For an analysis of how Orban can be reconciled with cases finding that boards controlled by commonshareholders can advance the interests of the common shareholders at the expense of the preferredshareholders, see Fried and Ganor, supra note x, at 991-93 (suggesting that Delaware courts have adopted a“control-contingent” approach to fiduciary duties in which boards controlled by preferred shareholders canadvance the interests of preferred shareholders at the expense of common shareholders as long as thechallenged decisions can be defended as in the “best interests of the corporation” and boards controlled bycommon shareholders can advance the interests of common shareholders at the expense of preferredshareholders as long as the preferred shareholders’ contractual rights are respected).

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VCs can also overcome common-shareholder opposition by buying the votes ofstockholders, such as executives, who already own a large block of common stock. For
instance, assume that three executives of a startup collectively hold 55% of the common
stock, and that a trade sale cannot occur without approval by 50% of the commonshareholders. Rather than providing a carve-out to all common stockholders, the VCs
could simply award each of these three individuals a lucrative cash bonus or otherpayment in connection with a trade sale in exchange (implicitly) for voting their commonshares in favor of the transaction. Vote-buying via payments to executives can thus kill
two birds (executive opposition and common-shareholder opposition to the trade sale)with one stone.
Alternatively, a VC-controlled board can issue additional common shares tocertain executives or employees who expect to gain from the board’s proposedtransaction, and will thus vote these common shares in favor of the transaction. 60
Although vote-buying in some (or all) of these cases may violate the board’s duty to
refrain from improperly tampering with the shareholder vote, 61 it is very difficult to provethat the purpose of a particular payment or equity issuance to executives or employees is
to buy votes.
C. Carrots vs. Sticks
We have seen that VCs have at their disposal both carrots and sticks to induce
entrepreneurial teams to cooperate in trade sales. Carrots tend to involve out-of-pocket
costs. For example, carve-outs to common come solely at the VCs’ expense. 62 But many
sticks, such as threats to terminate or blacklist a founder or other executives, do not
involve any cash outlay. 63
60

For example, the plaintiffs bringing suit in Kalashian v. Advent VI L.P., No. CV-739278, 1996 WL
33399950 (Cal. App. Dep’t Super. Ct. Oct. 4, 1996) (in re Alantec) alleged (among other things) that the
VCs had given common stock to new management solely to undermine the voting power of the original
common shareholders and prevent them from blocking an economically dilutive financing. After trial, theVCs ended up settling for $15 million. See Kenton J. King, Warning: Rescue May Risk Risks, NAT’L L. J.,
Nov. 24, 1997.
61

See Portnoy v. Cryo-Cell Int’l, Inc., 940 A.2d 43, 67 (Del. Ch. 2008) (citing Schreiber v. Carney, 447
A.2d 17, 25-26 (Del. Ch. 1982) for the proposition that vote buying, where the purpose is to defraud or insome way disenfranchise other stockholders, is per se illegal).
62

Management bonuses would come solely at the expense of the VCs if the firm is sold for an amount lessthan aggregate liquidation preferences. However, if the firm is sold for an amount greater than aggregateliquidation preferences, management bonuses would be subsidized by common shareholders, either
partially (if VCs have participating preferred stock) or completely (if VCs have non-participating preferredstock).
63

Vote-buying and cross-voting might require dipping into the VCs’ pockets, but not always. Consider firstvote-buying. Vote-buying can be done completely at the expense of common shareholders if value theoriginal common shareholders would otherwise (absent the vote-buying) have received is used to pay forVersion 2/19/13

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However, sticks can give rise to substantial indirect costs. First, although
litigation is unlikely in any given case, the use of sticks may well increase the risk oflitigation, which can be very costly (should it occur) in terms of VCs’ time andreputation. 64 Second, VCs may be deterred from “misbehaving” because of reputational
considerations. 65 As websites like thefunded.com make the world smaller and moretransparent, and serial entrepreneurs play a more important role in startups, thereputational costs to VCs who bully entrepreneurial teams with sticks are likely to
become higher. Thus, both carrots and sticks can be costly to VCs.
V. Research Sample
A. Sample Population
We study the use of carrots and sticks in trade sales of VC-backed startups using ahand-collected data set of VC-backed Silicon Valley firms. This section describes thedata collection process and provides descriptive statistics for the firms in our sample.
1. Data Gathering
The data used for this project were collected in 2005-2007 as part of a study
supported by the Kaufmann Foundation and UC Berkeley. We obtained from
VentureReporter.net a list of VC-financed companies located in California that were soldin trade sales in 2003 or 2004. We filtered out all firms except those located in andaround San Francisco, San Jose, and Oakland (broadly defined as “Silicon Valley”),66
leaving a population of 193 firms.

the votes. For example, suppose that absent vote-buying, common shareholders as a class would receive$5m in a sale and a majority of the common shareholders would oppose such a sale. The VCs then pay
executives a net amount of $4m to exercise underwater options to acquire (on a post-exercise basis) 50% of
the outstanding common shares and vote their shares in favor of the transaction. Common shareholders as
a class now receive $1m, with 50% of that $1 million going to the executives.
Next consider cross-voting. Again, cross-voting can often be done at no out-of-pocket cost to VCs.
Suppose, for example, that VCs’ liquidation preferences are $50m and the sale price is $40m. The VCs canconvert 20% of their shares into common stock and vote these common shares without reducing the valueof their liquidation preferences and their payout in the sale.
64

See Vladimir Atanasov, Vladimir Ivanov, & Kate Litvak, Does Reputation Limit Opportunistic Behavior
in the VC Industry? Evidence from Litigation Against VCs, 67 J. FIN. 2215, 2226-27, 2244 (2012).
65

See Black & Gilson, supra note 8, at 262-63 (arguing that geographical proximity between VCs andinvestment portfolio companies gives rise to reputational constraints, deterring opportunistic acts by VCs);
Sahlman, supra note 3, at 513 (arguing that VCs refrain from abusing their power because they wish to
attract the best entrepreneurs who can choose other VCs or alternative sources of capital).
66

We used LinkSV to filter out firms not meeting these criteria. LINKSV, http://www.linksv.com (lastvisited Feb. 4, 2013). LinkSV profiles all companies located in Silicon Valley (in or around San Jose, San
Francisco, and Oakland) that received VC funding. Companies not appearing on LinkSV were removed
from our sample.

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For each firm we sought to locate and obtain data from one or more persons
knowledgeable about the firm’s life – including the circumstances surrounding its sale.
We identified current business addresses for the founders or executives (all of whom wecall “entrepreneurs” for convenience) of 141 of the 193 companies. We mailed letters
asking entrepreneurs from each firm to provide us with data, promising to keep
confidential the identity of the entrepreneur and the startup firm.
Entrepreneurs from 57 of the 141 firms agreed to provide us with data – aresponse rate of 40.4%. The information obtained, supplemented by publicly filed
corporate charters, covered each firm’s entire lifespan. Among the data gathered were thestate of incorporation, cash-flow rights, and control rights negotiated in each VC
financing round; the identities and backgrounds of the CEO and directors; and thecircumstances and terms of sale, including amounts paid to various classes ofshareholders and managers.
From the original set of 57 firms, we removed seven for lack of adequate data,
leaving us with 50 firms. In most of these sales (42 out of 50) the VCs exited as preferredshareholders. In the remaining eight firms, the VCs converted into common stock inconnection with the sale, giving up their liquidation preferences.
2. Selection Issues
Because our sample is limited to Silicon Valley firms sold in 2003 or 2004, onemust be somewhat cautious about extrapolating from our firms to VC-backed firms
generally. Silicon Valley is a close-knit community with its own norms and ways of
doing business. 67 Our sample firms were sold several years after the tech bubble
collapsed, a period in which VCs lost considerable amounts of money. These losses may
have heightened the conflicts between VCs and entrepreneurial teams around exit events.
The use of carrots and sticks within our sample firms could thus be a function of the postbubble time period and/or factors unique to Silicon Valley, limiting the generalizabilityof our results. 68

67

See, e.g., Mark C. Suchman & Mia L. Cahill, The Hired Gun as Facilitator: Lawyers and theSuppression of Business Disputes in the Silicon Valley, 21 L. & SOC. INQUIRY 679 (1996).

68

In addition, our sample consists only of companies whose entrepreneurs voluntarily responded to ourrequest for information. There could be systematic differences between firms whose entrepreneurs
responded to our inquiries and firms whose entrepreneurs did not. While we sought to minimize suchbiases by soliciting data from every entrepreneur we could locate, and by offering confidentiality, oursample might not even be completely representative of Silicon Valley firms sold in 2003 and 2004. One
reason to think our sample might be unrepresentative, for example, is a higher incidence of litigationcompared to other firms. Among the 50 sample firms, there were three lawsuits filed by founders against
VC investors, a litigation rate of approximately 6%. (Two of these lawsuits related to the sale of the firm;
one did not. For confidentiality reasons, we cannot disclose any more information about these lawsuits).
Among the 143 out-of-sample firms, there was only one founder who filed a lawsuit against VC investors,
a litigation rate of less than 1%. This suggests that the frequency of sticks outside our sample might belower than the frequency of sticks in our sample.

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B. Sample Description
Our sample firms are ‘high-tech’ businesses, primarily in the biotech, software,
telecommunications, and internet sectors (Panel A of Table 1). The concentration of ITrelated businesses is representative of VC-financed firms generally. 69 At the time of sale,the firms had received an average of $42 million in VC funding and had been operating
for an average of approximately five years. The mean sale price is $55 million. Panel B
of Table 1 provides information on the amount invested, financing rounds, years ofoperation, and sale price.
[INSERT TABLE 1 HERE]
C. VCs’ Ex Ante Cash and Control Rights
We now turn to describe, for the firms in our sample, (1) the VCs’ cash-flow
rights; (2) the entrepreneurial teams’ board seats and shareholder-voting rights; and (3)the identities of the CEOs at the time of sale.
1. VCs’ Cash-Flow Rights
Across all 50 firms, VCs’ aggregate liquidation preferences at the time of sale are,on average, $47 million. In the first round of financing, the liquidation preference usuallyequals the amount invested (a ‘1x preference’), while the liquidation preference insubsequent rounds is more likely to be a higher multiple (i.e., 2x or 3x) of the amountinvested (Panel C). 70 At sale, aggregate liquidation preferences are on average somewhat
greater than the amount invested (Panel B).
When VCs retain their preferred stock rather than converting to common stock,
the allocation of the sale proceeds depends on the relationship between liquidationpreferences and the sale price. If liquidation preferences exceed the sale price andcontractual priority is fully respected, common stockholders get nothing. Liquidationpreferences exceed the sale price in 31 of the 42 firms in which VCs exit as preferredshareholders (Panel D). Absent a carrot, common shareholders (as a class) have little
incentive to approve a merger when their equity is underwater. In eight firms, it was in
VCs’ interest to convert to common stock rather than maintain their liquidationpreferences, meaning that the sale proceeds were allocated pro rata among all commonshareholders (the original common shareholders and the converting VCs).

69
70

Kaplan & Strömberg, 2003, supra note x, at 284.

Liquidation preferences from early rounds of financing are sometimes waived or otherwise reduced in a
subsequent round of financing (a “recap” financing). A recap financing may occur as part of a voluntary
recapitalization of the firm, perhaps to eliminate “debt” overhang from relatively large liquidationpreferences, or alternatively, a pay-to-play contractual provision may force a VC to convert to common
stock (and thereby give up its preferences) if it fails to participate in a subsequent financing round. In our
sample of 50 firms, there were 13 recap financing rounds (Panel C).

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2. Power of the Entrepreneurial Team
This section describes the extent of the entrepreneurial teams’ blocking power –their board seats and corporate law rights – in our sample firms. The data aresummarized in Table 2.
(a) Board Seats
Recall that board approval is required for a trade sale. Thus, the entrepreneurial
team may be able to impede a sale through its influence on the board. We divide directors
into three categories: (1) VC appointed, (2) common-shareholder appointed, and (3)independent (outside). If a particular outside director had been selected exclusively by theVCs (or the common shareholders), we designate this person as a VC (or commonshareholder) director, regardless of how contracting documents label the board seat. 71
Panel A reports the allocation of board seats. At the time of sale, 56.5% of all
directors are appointed by the VCs, and 22.8% are appointed by common stockholders.
Panel B shows that the VCs controlled the board in 29 of the 50 (58%) firms. In our
sample, common stockholders rarely controlled the board at the time of the sale (3 of the
50 firms). However, in 21 of the 50 firms, the combination of independent directors andcommon stockholders could have blocked a sale.
[ADD TABLE 2 ABOUT HERE].
(b) Shareholder Rights
All our companies were incorporated in either California or Delaware at the timeof their sales, consistent with findings that most VC-backed firms incorporate either intheir home state or in Delaware. 72 Panel C shows that 35 out of 50 firms wereincorporated in Delaware at the time of the sale. As we explain below, California law
may give the entrepreneurial team somewhat more power vis-à-vis VCs through bothvoting rights and the threat of fiduciary litigation.
(1) Voting rights. California and Delaware provide different voting rights forshareholders. In Delaware, sales need only be approved by holders of a majority of thefirm’s outstanding stock, both preferred and common. We find that, at the time of sale,
VCs almost always have sufficient voting power to dictate the outcome of a stockholderwide vote. 73 California, on the other hand, requires a separate vote for each class ofshareholders, including common. Thus, when the VCs remain preferred shareholders,71

Our “de facto” classification of directors differs from the “formal” classification used by Kaplan &Strömberg (2003), supra note x, which treats any board seat intended for a director who is not a VC or arepresentative of common shareholders as held by an outside director. As one of us has explained
elsewhere, nominally independent directors may not be truly independent tie-breakers as between the VCs
and common shareholders. See Fried & Ganor, supra note x, at 988-89.
72

See BRIAN J. BROUGHMAN, JESSE M. FRIED & DARIAN M. IBRAHIM, DELAWARE LAW AS LINGUAFRANCA:
THEORYANDEVIDENCE
25(2012)(working
paper)(availableat
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2117967).
73

Our findings are consistent with those of Kaplan & Strömberg (2003), supra note x.

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common shareholders of California-domiciled firms can more easily impede a sale they
oppose.
But it is not that simple. California purports to subject ‘quasi-California’
corporations (corporations doing business in California but incorporated elsewhere) to therequirement of separate class votes. 74 While California’s legal ability to impose thisrequirement on firms incorporated elsewhere is contested, many (but not all) Delawareincorporated companies located in California are advised by lawyers to hold separate
class votes. In our sample, all but one Delaware-incorporated firm held a separate classvote for the common.
Thus, as a practical matter, California (rather than Delaware) incorporation may
not give common shareholders much more power through voting rights. Nevertheless,common shareholders’ ability to impede a transaction is still likely to be somewhat
greater in a California-incorporated firm, where a separate class vote is indisputably
mandatory. 75(2) Fiduciary litigation. Delaware law appears to permit a VC-controlled board
to make decisions that favor preferred shareholders at the expense of the commonshareholders, as long as the decisions can plausibly be defended as in the “best interestsof the corporation.” 76 In contrast, California law generally affords stronger protection tominority shareholders, including common shareholders in firms with VC-controlled
boards. 77 Thus, directors of California-domiciled firms may believe they face greater riskof liability for harming common shareholders. 78

74

See CAL. CORP CODE § 2115(b) (West 1990).

75

As noted earlier, if the common shareholders have subjected themselves to drag-along rights, they cannot
use their voting rights to block a sale. Three entrepreneurs in our sample (2 California-domiciled firms, 1
Delaware-domiciled firm) indicated that drag-along rights limited their ability to vote against a trade sale.
We have been told by VC lawyers that drag-along rights are now used much more frequently, especially indeals involving East Coast VC firms.
76

See Orban, supra note x. One might think that Orban is no longer good law in light of In re Trados
Incorporated Shareholder Litigation, 2009 WL 2225958 (Del. Ch. July 24, 2009). In Trados, the plaintiff
common shareholders sued the preferred-affiliated directors for breaching their fiduciary duties to commonshareholders by selling the company in a transaction that cashed out the preferred shareholders at an
amount close to their liquidation preferences and wiped out common shareholders. The court denied
defendant’s motion to dismiss under Rule 12b-6, citing earlier cases for the general proposition that
directors owe fiduciary duties to the common shareholders and concluding that “it is possible that a director
could breach her duty by improperly favoring the interests of preferred shareholders over those of thecommon shareholders.” But the court did not overturn or limit Orban. Rather, the court said that it refused
to dismiss the case because, at the 12b-6 motion-to-dismiss stage, there was not yet enough information in
the record to determine that the Trados board, like the board in Orban, had acted “both in good faith andreasonably.” As of this writing, the litigation in Trados is continuing. Meanwhile, Orban appears to remain
good law.
77

Cf. Jones v. H. F. Ahmanson & Co., 460 P.2d 464, 471 (Cal. 1969) (holding that majority shareholders
have a fiduciary responsibility to minority shareholders to use their ability to control the corporation in afair, just, and equitable manner); DiLillo v. Ustman Techs., Inc., No. B148198, 2001 Cal. App. Unpub.
LEXIS 1527 (Nov. 19, 2001) (determining that VC was a controlling shareholder and that plaintiff

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3. Founders’ Position in the Firm
The entrepreneurial team is likely to have a greater incentive to block a trade sale
if the founder is still the CEO. First, a founder-CEO is likely to own more common stock
than a replacement CEO, and any option value of the common shares will be destroyed if
the firm is sold. Second, a founder-CEO may derive greater non-financial benefits fromthe business, and thus may have additional incentive to keep the firm independent.
The entrepreneurial team may also have greater ability to impede a sale if thefounder is still CEO. A founder-CEO is likely to have substantially more common stock
than a hired CEO, giving him more shareholder-blocking power. The founder-CEO isalso likely to have longer and deeper relationships than a hired CEO with other directors
and common shareholders. As a result, the founder-CEO is likely to have influence overdirectors and other common shareholders, increasing the likelihood that directors will
resist the trade sale and further increasing the likelihood that common shareholders will
vote against the transaction.
To reduce resistance to a trade sale, a firm’s VC investors may use their control
over the board of directors to replace the CEO before the planned exit. In our 50-firmsample, 29 of the founders (58%) were replaced as CEOs before the firm was sold.
(However, as we will discuss shortly, none of these replacements appeared to be made to
overcome resistance to a trade sale).
VI. Actual Carrots and Sticks in the Sale of VC-Backed Startups
Part IV described the potential carrots and sticks that could be deployed by VCs
to induce entrepreneurial teams to sell the firm. Here, we describe the actual carrots(Section A) and sticks (Section B) used in our sample. We also describe the total cost to
the VCs of the carrots provided in connection with trade sales.

common shareholders could sue VC directly for breach of fiduciary duty in connection with the sale of thefirm’s assets).
78

However, a quirky feature of California corporate law may make it difficult for common shareholders toprevail against VCs on corporate-law claims when the VCs exit via a merger. Under California law, afirm’s insiders have been permitted to eliminate personal liability for violations of corporate law byconducting a merger with an unrelated entity; once the firm has merged, shareholders’ only remedy forcorporate law violations, even for alleged fiduciary violations that occurred prior to merger, is appraisal.
See CAL. CORP. CODE §1312 (West 2006); Steinberg v. Amplica, Inc., 729 P.2d 683, 693-94 (Cal. 1986).
Delaware law, which is generally considered to be more insider-friendly, does not shield insiders in thismanner in ordinary mergers. DEL. CODE ANN. tit. 8 § 262 (2010) Rabkin v. P.A. Hunt Chemical
Corporation, 498 A.2d 1099 (Del. 1985) (holding that courts should examine allegations of “specific actsof fraud, misrepresentation, or other items of misconduct” in connection with a merger even if appraisal isavailable to plaintiffs as a remedy).Thus, if a California court today were to follow Steinberg, commonshareholder plaintiffs would be worse off, in some respects, than if the firm had been subject to Delaware
corporate law.

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A. Carrots
1. Common Carve-outs
In our sample, 11 sales (22% of 50) feature carve-outs to common shareholders –extra value above the amount to which they were contractually entitled. To measurethese carve-outs, we compare the actual payout received by VCs to the VCs’ contractual
entitlement. When the VCs convert to common shares, their contractual entitlement
equals their pro rata share of the sale price. When the VCs exit as preferred shareholders,
their contractual entitlement is the lesser of their liquidation preferences and the saleprice. 79 Any excess payment received by the original common shareholders is treated as
a common carve-out.
Table 3 describes the common carve-outs in our sample. Limited to the 11 sales
in which a carve-out occurred, the average carve-out to common stock is $3.7 million, or
approximately 10% of the total purchase price. Though most firms do not provide acarve-out, carve-outs can be substantial when they occur. In our sample, one saleprovided a $10 million carve-out to common stockholders, and in two deals the carve-out
was at least 25% of the total purchase price.
Common carve-outs only occurred in the 42 firms where the VCs exit holding
preferred stock. Limited to the subsample of 42 firms where VC investors did not convert
to common shareholders, we find that common stockholders receive, on average,$969,000 more than their contractual entitlement, or approximately 2.5% of the totalpurchase price. Among all 50 companies, common stockholders receive, on average,$810,000 more than their contractual entitlement, or approximately 2.2% of the totalpurchase price.
Carve-outs to common shareholders are illustrated in Figure 1. Each bar
represents a firm’s total sale price (in millions of dollars). The sale price is divided into
four components: (i) the amount actually paid to VCs (in black); (ii) the contractual
entitlement of the original common stockholders at the given sale price (in white); (iii)the carve-out given to the original common stockholders (in dark grey); and (iv) nonretention bonuses paid to senior management in connection with the sale (in light grey).
[INSERT FIGURE 1 HERE][ADD TABLE 3 HERE]
In our sample, common carve-outs are used, at least in part, to overcome commonshareholders’ opposition to trade sales. We showed econometrically elsewhere that thesecarve-outs are more likely to occur when: (1) VCs lack de facto board control (and thus
need to convince other directors, such as independent directors and common-appointed
directors, to support the sale); (2) the firm is domiciled in California, rather thanDelaware, and therefore common shareholders’ rights are likely to be slightly stronger;
79

The sale price is defined as the amounts paid to VCs and common shareholders. In those cases where (a)the sale price exceeds the liquidation preferences and (b) the VCs exit holding participating preferred stock,
we define VCs’ cash-flow rights as the sum of the liquidation preferences and the participation rights.

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and/or (3) common shareholders would otherwise be wiped out and receive none of thesale proceeds. 80
Qualitative interview data confirm that carve-outs to common shareholders aredesigned to induce common shareholders and their allies on the board to support the sale.
In one California-domiciled firm, for example, the VCs carving out a portion of theirliquidation preferences for common shareholders required each common stockholder tosign a liability waiver before receiving a portion of the carve-out. According to theentrepreneur, the carve-out was offered only because the VCs were concerned about apossible common shareholder suit challenging the terms of sale. In another case, where
the VCs lacked board control, the entrepreneur told us that the VCs were forced to give a
carve-out payment to common shareholders to obtain the support of other directors.
Of course, some of the carve-outs to common might have had other motives. VCs
might have wanted to be “fair” to common shareholders or to build or maintain areputation as “friendly” VCs. However, the fact that these carve-outs are more likely tooccur when common shareholders have more power, or more incentive to block a sale,suggests that they are being used, at least in part, to induce common shareholders’cooperation with sales.
2. (Non-retention) Management Bonuses
Bonuses that do not require management to stay with the acquirer might be used
as carrots to induce executives to support a sale. 81 Of the 50 firms in our sample, 16offered various non-retention management bonuses in connection with the acquisition,with an average bonus in these 16 firms of $1.63 million (or 6.6% of the sale price).
Bonuses are sometimes given to a broad class of employees (5 firms), but in most cases
they are limited to key executives (11 firms).
Among all 50 companies, senior executives receive an average non-retention
bonus of approximately $520,000. Across all companies, these payments represent
approximately 2.1% of the total purchase price (or 0.95% on a dollar-weighted basis).82
Compared to bonuses awarded in connection with the sale of publicly held firms, the80

See Broughman & Fried, Renegotiation, supra note x, at 394.

81

Retention arrangements (arrangements that require executives to stay with the acquirer) could, in theory,
be used either as arm’s-length deals by the acquirer to keep target talent or as carrots to induce executives
to support the deal. In our sample, 19 founders reported that retention agreements or related compensation
arrangements (such as options for the acquirer stock) were negotiated in connection with the sale. Because
we were not given any reason to believe that these arrangements were designed to serve as carrots, andbecause their value is difficult to measure, we report data only on non-retention bonuses.
82

Most of these payments came at the expense of the VCs. Across the 50 firms in our sample, a total of $26
million was paid out in the form of non-retention management bonuses. Of this amount, $22.5 million cameat the expense of preferred stockholders, and only $3.5 million came at the expense of common
stockholders.

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payments we document are modest in dollar terms, but large as a fraction of deal size.83
Non-retention management bonuses are depicted in Figure 1.
Of course, VCs might have other reasons to give executives a management bonus
besides inducing them to sell the company. They may want to reward the executives for a
job well done, or to curry favor with executives whom they hope to hire in the future.
Thus, we cannot be certain that all of the non-retention bonuses observed were salerelated carrots.
3. Cost of Carrots
In our sample, 23 of the 50 firms offer a management bonus or common carveout. Limited to the group of 23 firms offering a carrot, Figure 2 illustrates the value ofthese benefits relative to the sale price. In most cases, total carrots represent between 5%
and 12% of the sale price, with a mean amount of approximately $2.9 million, or 9.4% ofdeal value (Table 3). In two firms, however, total carrots exceed 20% of the total deal
value.
Across all 50 firms, the total cost of carrots (those given to executives plus thosegiven to common shareholders) is about $1.33 million for the average sample firm (Table
3). Across all companies, the average carrot is approximately 4.3% of the purchase price(or 2.4% on a dollar-weighted basis). 84[INSERT FIGURE 2 HERE]
The use of carrots is greater in the 42 firms in our sample where the VC investors
did not convert to common stock, and thus where the conflict between the entrepreneurial
team and VCs was likely to be the greatest. In this subsample of 42 firms we find that the
total cost of carrots is about $1.51 million for the average firm and that approximately
5.0% of deal value (3.1% on a dollar-weighted basis) was used to fund carrots.
B. Sticks
As explained earlier,the two potential sticks available to VCs in dealing withrecalcitrant executives are firing them and threatening to blacklist them, and two sticks
that can be used against common shareholders are cross-voting and vote-buying. The
section below describes the use of such sticks in our sample.

83

See Jay Hartzell, Eli Ofek & David Yermack, What's in It for Me?: CEOs Whose Firms Are Acquired, 17
REV. FIN. STUD. 37, 43-46 (2004) (finding that CEOs of publicly held target firms, on average, receive a
non-retention merger bonus worth approximately $1.2 million; which is only about 0.1% of the averageacquisition price [$1.2 billion] of the deals in the Hartzell, Ofek & Yermack study).

84

Of the $1.33 million average carrot, $1.26 million was paid by the preferred shareholders and $70,000
was paid by the common shareholders.

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1. Termination of CEO
Recall that 29 of the 50 founders of our firms had been replaced before the sale.
But these replacements typically occurred well before the sale, usually in connection witha later round of financing. 85 After three years of operation, approximately 30% of thefirms in our sample had replaced the founder-CEO. Of those firms still in operation after
six years, approximately 63% of the firms had replaced the founder-CEO. 86 Data on thetiming of CEO replacement in our sample are summarized in Table 4.
[INSERT TABLE 4 HERE]
In fact, none of the entrepreneurs providing us with data indicated that any
founder (or other executive) was fired or threatened with being fired immediately inconnection with a contemplated sale. Moreover, while the impetus for replacing thefounder-CEO typically came from the VCs, there was little conflict over the replacementof the founder-CEO. 87 None of the terminated founder-CEOs reported that the VCs had
caused the firm to repurchase vested options, or had fired the founder-CEO to strip him
or her of unvested equity, a possibility raised by Michael Klausner and Kate Litvak. 88
Indeed, most of the replaced founders reported significant involvement with thefirm after the CEO change. The founder-CEO remained on the board following the CEO
replacement in almost 60% (17 out of 29) of our sample firms. Even when the founder
does not keep a board seat, he or she generally has some position with the firm after
replacement (often serving as the Chief Technology Officer or in some other executive
capacity).
To be sure, even if we do not observe forcible termination, the possibility of suchtermination is always present. The possibility of termination limits the value ofmanagement bonuses executives can extract from the VCs.
2. Blacklisting
In two firms [#35 and #50], VCs explicitly threatened to prevent a founder fromever raising money again in Silicon Valley if he or she did not vote (as a director) for the85

In 3 of the 29 firms where the founder was replaced as CEO, the founder-CEO was replaced inconnection with the first round of VC financing (meaning the founder agreed to resign as CEO in exchange
for the financing). In the other 26 firms, the founder-CEO was replaced at a later date, typically after
several rounds of financing.
86

Our evidence regarding the timing of CEO replacement is roughly consistent with Michael T. Hannan,
M. Diane Burton & James N. Baron, Inertia and Change in the Early Years: Employment Relations in
Young, High-Technology Firms, 5 INDUS. & CORP. CHANGE 503, 525-26 (1996) (finding that the likelihoodthat a non-founder will be appointed CEO is about 10% in the first 20 months of a company's life, 40%
after 40 months, and 80% after 80 months).
87

For more background on CEO replacement in startup firms, see discussion in Brian Broughman, Investor
Opportunism and Governance, in VENTURE CAPITAL: INVESTMENT STRATEGIES, STRUCTURES, AND
POLICIES (Douglas Cumming ed., 2010) at 355 - 357.
88

See Klausner & Litvak, supra note 3, at ___.

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sale. In each of these firms, the founder’s support was not necessary as a matter ofcorporate law to conduct the sale — the VCs had control of the board — but the VCs
wanted a unanimous board vote to reduce liability risk. And they got it.
Again, the fact that blacklisting was explicitly threatened in only two firms does
not mean that founders or executives in other firms were not affected by the possibility of
blacklisting. We have been told by venture capitalists and VC lawyers that entrepreneurs
are keenly aware, without being explicitly told, that if they behave “unreasonably”
toward the VCs backing their firm it will be very difficult for them to raise funds fromother VCs in the future. Our results thus understate the importance of blacklisting
constraints on the entrepreneurial team.
3. Cross-Voting
In one firm [#29], VC investors engaged in cross-voting (the scheme used in
Orban v. Fields). Firm #29, which was California-domiciled, received $50 million over3 rounds of VC financing and was sold in 2004 for $20 million. At the time of sale, theVCs already controlled the board of directors, the founder had already been replaced as
CEO, and the VCs collectively had liquidation preferences exceeding $100 million (thethird-round financing included a 3X preference). The founder refused to vote his
common stock in favor of the sale. 89 Because the firm was incorporated in California,
approval from a majority of voting common stockholders was necessary to sell the firm,
giving the founder some degree of blocking power. To eliminate this holdup, the VCs
converted a fraction of their preferred stock into common. This maneuver did not cost the
VCs anything because, as in Orban, the VCs were left post-conversion with liquidationpreferences far greater than the $20 million sale price.
Firm 29 was the only company in our sample where this form of cross-voting was
actually used. However, other founders, especially those of firms whose common stock
was far underwater, reported that they were aware that VCs could engage in this tactic.
Thus, demands for common carve-outs are made in the shadow of possible crossvoting. 90
4. Vote-Buying
Vote-buying reportedly occurred in one firm [#49] in our sample. The firm was
California-domiciled and there were no drag-along rights. The founder reported that the
VC-controlled board paid the CEO and other employees to exercise options that were
underwater 91 to acquire and vote common stock in favor of a trade sale for about $80
89

The VCs in this firm did not appear to hold drag-along rights that could compel a vote of common
stockholders.

90

The cost to VCs of cross-voting is higher if reduces their aggregate liquidation preferences below the saleprice. In such cases, cross-voting would effectively result in a carve-out for the original common
stockholders.
91

An option is considered to be underwater when its exercise price is higher than the value of theunderlying stock, and thus not worth exercising.

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million. The VCs used, in addition to this stick, a carrot: they also provided a $4 million
common carve-out. The founder sued the VCs, alleging vote-buying and improprieties
associated with a pre-sale financing round. The case was settled for an undisclosed
amount.
Of course, implicit and essentially undetectable vote-buying might be occurring
through management bonuses because of the considerable overlap between shareholders
and executives. Thus, we cannot rule out the possibility that vote-buying was occurring inother firms in our sample.
Part VII. Conclusion
Trade sales by VCs are actually much more common than IPOs and, in aggregate,
are likely to be as financially important to VCs as IPOs. However, unlike IPOs, tradesales do not trigger the intense public-disclosure requirements of the securities laws. As aresult, we know relatively little about them.
In this paper, we seek to shed light on how VCs arrange to sell startups in tradesales. In particular, we investigate how VCs induce the “entrepreneurial team” – thefounder, other executives, and common shareholders – to go along with a trade sale thatthey might otherwise have an incentive to resist.
We identified the types of bribes (carrots) and coercive tools (sticks) that VCs
might use to induce a reluctant entrepreneurial team to support, or at least not impede, a
trade sale. We then investigated the use of carrots and sticks using a hand-collected
database of 50 VC-backed Silicon Valley firms sold to acquirers in 2003 and 2004. We
find, in our sample, a relatively heavy reliance on carrots. Carrots are used in 45% of thefirms, with carrots averaging 9% of deal value in these firms. We also find some use of
sticks, such as threats to blacklist founders who refuse to cooperate and attempts toundermine common shareholders’ voting rights. But the overt use of these sticks isrelatively infrequent.
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 conflicting interests of different players in VC-backed firms
around trade-sale exits, and shows that VCs frequently must overcome potential
opposition to these sales by founders, executives, and common shareholders.
Second, our study provides further evidence that managers of target firms can
extract value by holding up a sale of the firm. Research has documented the frequent useof side payments to induce executives to participate in the sale of publicly traded firms.
We show that such “bribes” are used not only in public firms with dispersed ownershipbut also in closely held private firms.
Third, our study provides some evidence on whether venture capitalists areconstrained from abusing their power in startups. Although venture capitalists haveconsiderable power in startups, the relatively infrequent overt use of sticks in our sample
provides support for the view that reputational or other non-legal considerations constrain
the misbehavior of Silicon Valley venture capitalists. We hope that our work is useful toVersion 2/19/13

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practitioners and academics seeking to better understand the corporate governance ofVC-backed firms.

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Table 1: Descriptive Statistics and Liquidation Preferences
This table provides descriptive statistics for our 50 sample firms. Panel A shows industry distribution. The
industry for each company is determined by the sector classification provided by www.linksv.com. PanelB reports the mean and median period of operation, number of financing rounds, amount invested, and saleprice. Panel B also shows the aggregate liquidation preferences (“LP”) belonging to the VC investors at
the time of sale. Panel C shows the preferences given in each round of financing. The first column lists thenumber of financing rounds that use 1x preferences. The second and third columns list financing rounds
where preferences between 1x and 2x, and those greater than 2x, are used. The final column lists financing
rounds where the liquidation preferences of earlier investors are waived or reduced (a “recap” financing).
Panel D shows, at the time of sale, the number of companies where the LPs are greater or less than the saleprice.

Panel A: Industry Distribution of Companies
Sector
Biotech6

Telecom
13

Software
12

Internet
10

Other IT
9

Mean
5.1
3.0
42.2
55.0
46.9

Median
5
3
31
24.3
33.5

SD
1.6
1.1
36.7
103.9
38.9

Panel B: Financing Overview
Years of Operation
Number of Financing Rounds
Amount Invested (millions $)Sale Price (millions $)Aggregate LP (millions $)Panel C: Negotiated Preferencesst

1 round (n=50)
2nd round (n=39)
3rd round (n=24)
4th round (n=10)
5th round (n=5)

1x
46
25
15
2
1

≤ 2x
2
10
2
2
1

> 2x
2
3
2
2
0

Panel D: Relation of Liquidation Preferences to Sale price
LP > sale price31

LP < sale price
19

Recap
0
1
5
4
3

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Table 2: Control Rights
This table reports the distribution of corporate governance rights in our sample firms. Panel A reports themean and median board representation for (1) common shareholders, (2) VCs, and (3) independent(outside) directors. Panel B shows board control at the time of sale. If the VCs (or common) control morethan half the board seats, we classify this as “Control.” If the board has an even number of seats and theVCs (or common stockholders) appoint exactly half the directors, we treat this as “Blocking.” “Shared
Control” means that the VCs and the common each appoint fewer than half the directors, with outside
directors constituting the tie-breaking vote. Panel C shows the state of incorporation at the time of sale.

Panel A: Board Seats at Time of Acquisition
Mean
5.74
22.8%
56.5%
20.7%

Total number of board seats
Common seats (% of board)
VC seats (% of board)
Outsider seats (% of board)

Med.
5
20.0%
57.1%
20.0%

SD
1.52
0.137
0.172
0.185

Panel B: Distribution of Board Control
Board Control (n=50)

CommonControl3

CommonBlocking
0

SharedControl
12

VC
Blocking
6

VC
Control
29

Panel C: State of Incorporation
State of incorporation at time of sale

Delaware35

California
15

Other
0

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Table 3: Carrots
This table describes common carve-outs and management bonuses in our sample firms. Panel A provides
summary statistics for all sample firms. Panel B is limited to those firms that provided a common carveout
and/or a management bonus. Data are presented in millions of dollars and as a percentage of the sale price.
The included summary statistics are mean, dollar-weighted mean (DW Mean), standard deviation (SD),minimum, and maximum. DW Mean is weighted by the firm’s sale price.

Panel AAll Companies
Common Carve-out (millions $)Management Bonus (millions $)Combined Carrot (millions $)Common Carve-out (% of Sale Price)
Management Bonus (% of Sale Price)
Combined Carrot (% of Sale Price)# obs.
50
50
50

Mean
0.81
0.52
1.33

DW
Mean
-

SD
2.20
1.17
2.63

Min.
0
0
0

Max
10
6
10.31

50
50
50

2.2%
2.1%
4.3%

1.47%
0.95%
2.42%

.058
.039
.078

0
0
0

26.7%
16.7%
43.3%

# obs.
11
16
23

Mean
3.67
1.63
2.89

DW
Mean
-

SD
3.18
1.61
3.27

Min.
.03
.1
.03

Max
10
6
10.31

11
16
23

10.1%
6.6%
9.4%

8.91%
6.19%
9.19%

.088
.041
.093

1%
1.8%
1%

26.7%
16.7%
43.3%

Panel B
Companies with Common Carve-out
and/or Management Bonus
Common Carve-out (millions $)Management Bonus (millions $)Combined Carrot (millions $)Common Carve-out (% of Sale Price)
Management Bonus (% of Sale Price)
Combined Carrot (% of Sale Price)

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Table 4: The CEO Position
Table 4 records the identity of the CEO in our sample firms. The CEO position is held either by a founderor by a replacement, and is recorded as of the end of each year of operation for each firm. Panel B
illustrates CEO replacements over time. The horizontal axis represents the lifespan of each firm fromformation to sale, normalized to one unit, and the vertical axis shows the percentage of the sample firmsthat have replaced the CEO at each point.

Panel A
Year

Obs.

1
2
3
4
5
6
7
8
9+

50
50
48
42
31
19
11
5
3

Founder CEO
#
%
47
94%
42
84%
34
71%
26
62%
13
42%
7
37%
3
27%
2
40%
1
33%

Replacement CEO
#
%
3
6%
8
16%
14
29%
16
38%
18
58%
12
63%
8
73%
3
60%
2
67%

Replacement CEO (Non-Founder)0%

Percent of Sample Firms
20%
40%

60%

Panel B

formation

25%

50%
Percent of Firm Life

75%

sale

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Carrots & Sticks

Figure 10

Sale Proceeds (in Millions)
20
40
60
80

100

Using data from our sample firms, this figure shows the distribution of exit proceeds among VCs, common
stockholders, and senior management. Each bar represents a firm’s total sale price (in millions of dollars).
The sale price is divided into four components: (i) the amount actually paid to VCs (in black); (ii) thecontractual entitlement of the original common stockholders (in white); (iii) the carve-out given to theoriginal common stockholders (in dark grey), and (iv) non-retention bonuses paid to senior management inconnection with the sale (in light grey). For ease of presentation, all firms sold for more than $100 million
are normalized to a purchase price of $100 million.

Distribution of Sale Proceeds for Each Firm
Payout to Preferred StockContractual Entitlement of Common Stock
Carveout to Common
Management Bonus

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Figure 2
For each of the 23 firms in our sample that provided a common carve-out or management bonus, Figure 2
shows such payouts as a percentage of the total sale price. Common carve-outs are shown in dark grey andmanagement bonuses in light grey.

0

Percent of Sale Price
10%
20%
30%

40%

Common Carve-outs and Management Bonuses as a Percent of Sale Price

Firms offering Management Bonus and/or Common Carve-out
Carve-out to Common Stock (%)
Management Bonus (%)