The literature on venture capital contracting implicitly assumes that VCs' cash flow rights – including their liquidation preferences – are fully respected. Using a hand-collected dataset of Silicon Valley firms sold in 2003 and 2004, this paper is the first to document that common shareholders often receive payment before VCs' liquidation preferences are satisfied. We show these carveouts are larger when governance arrangements give common shareholders more power to impede the sale. Our study shows how VCs' control rights and cash flow rights interact to affect VCs' cash flow outcomes, and contributes to a better understanding of VC exits.
Venture capitalists investing in U.S. startups typically receive preferred stock and extensive control rights. Various explanations for each of these arrangements have been offered. However, scholars have failed to notice that when combined these arrangements result in a highly unusual corporate governance structure: one in which preferred shareholders, not common shareholders, control the board and the firm. The purpose of this Article is threefold: (1) to highlight the unusual governance structure of these VC-backed startups; (2) to show that preferred shareholder control can give rise to potentially large agency costs, and (3) to suggest legal reforms that may help VCs and entrepreneurs reduce these agency costs and improve corporate governance in startups.