“Venture capital is essentially an arbitrage opportunity between the different values ascribed to an asset by the private and public markets.”1
“Joseph ‘Joe Bananas’ Bonanno Sr., former head of one of New York City’s five original Mafia families, .. . described himself… as a ‘venture capitalist’ who invested in businesses with owners who invited him to become a partner because of his connections.”2
I. INTRODUCTION
Both of the above quotations contain essential truths about the nature of the venture capital industry. The first emphasizes the role of the venture capitalist in identifying and investing funds in young privately-owned companies, the value of which might increase tremendously in the future. The venture capitalist earns her profit several years down the line when some of the companies in her portfolio enter the public market in initial public offerings, or through other exit mechanisms, and are sold for more than she initially invested. Described as such, the function of the venture capitalist is not terribly different from that of other professional investors who use their expertise to identify, buy, and sell equities.
Allowing for a broad definition of “connections,” the second quotation reveals a keen understanding of the important role of the venture capitalist once she has made her initial investment in a start-up company. After all, venture capitalists do not invest only money in start-ups; they also invest their own expertise, managerial skills, time and connections in nurturing a company into profitability.3 The success of the best venture capital firms derives not only from their ability to spot promising young companies, but also from their ability to add value to the everyday running of those companies. In this way, venture capital is much less like a bet on the future prospects of a business, and much more like a helping hand from a talented and well-connected individual with an established reputation for success.
The 1990s were blissful days for both venture capitalists and the investors who funded them. Typically raising money through venture capital funds organized as Delaware limited partnerships,4 venture capitalists invested nearly $100 billion in 2000.5 With returns reaching a reported average of 163% in 1999,6 the top venture capital firms were in the enviable position of having a huge surplus of investors vying to act as the limited partners who would provide up to 99% of the funding in each newly raised venture capital fund. Further, after a decade of wildly successful investing, the venture capitalists became able to dictate the terms of the limited partnership agreements governing their relationships with investors, retaining virtually all of the decision-making power, and insisting on increasingly better terms of remuneration for themselves.7
A study of the venture capital industry suggests that, as their reputations grow and demand for their services increases, venture capitalists are able to negotiate limited partnership agreements that impose fewer legal restrictions on themselves.8 Investors willingly entered into such seemingly imbalanced limited partnership agreements because, in a market that produced huge valuations for unproven and still-unprofitable companies, the terms were favorable enough.9 Throughout the 1990s, litigation over disputes between investors in venture capital funds and venture capitalists who controlled those funds was virtually nonexistent. Indeed, the industry as a whole long had a reputation as one in which disputes rarely arose, and were even more rarely resolved through litigation.10 One obvious explanation for this is that even if there were abuses by the general partners, the limited partners had no reason to sue since they were regularly enjoying high returns.11
Another explanation for the absence of litigation in the industry is that the parties, both the limited and the general partners, developed a culture that relied on a powerful non-legal enforcement mechanism: reputation.12 Like all businessmen who rely on repeat customers, the best venture capital firms consistently behave in ways designed to induce their limited partners to invest in subsequent funds raised by the same firm. Similarly, the limited partners behave in ways that will encourage the general partners to invite them to join a future limited partnership. For example, they readily agree to contracts that allow the venture capitalists the kind of discretion they demand and need to carry out their function as advisors and managers of the companies in their portfolios. Until recently, limited partners seemed reluctant to second-guess-much less to sue-the venture capitalists because they did not want to develop a reputation for being excessively involved in the day-to- day work of the VCs. Further, in a market in which the venture capitalists had their pick of investors, no potential limited partner would want a reputation for being litigious.
The bubble burst in 2001, and the market for companies funded by venture capital plummeted. The Wall Street Journal reported that, for the twelve months ending September 30, 2002, venture capital funds lost an average of 32.4%.13 Some venture capital firms responded to the downturn and the accompanying “backlash” from investors by voluntarily modifying the terms of the limited partnership agreements into which they had already entered. For example, according to The Economist, three leading venture capital firms took unilateral action, essentially agreeing to lower the management fees charged to their investors although they had absolutely no legal obligation to do so.14 Some firms received commitments of millions of dollars but no longer intend to invest such funds in now-extremely risky high-tech start-ups. These firms modified their contracts to avoid charging investors management fees for money that will not be invested.15 The plain explanation for such seeming generosity is the venture capitalists’ desire to maintain sound relationships with the parties who provide the capital for their portfolios.
An impartial observer of the situation would correctly assume that the industry’s downturn is due largely to cyclical changes in the market-or even bad luck-and not to the incompetence, bad faith, or malice of the venture capitalists. At least there does not appear to be any evidence that venture capitalists suddenly became dishonest or incompetent at the turn of the millennium. Given the importance of reputation in the venture capital world, the history of the industry would suggest that disgruntled limited partners who desire to remain active players in venture capital would simply accept the fact that they took a calculated risk and lost. And indeed, many investment managers have done just that.16 On the other hand, some investors are showing an increasing willingness to raise public disputes with venture capitalists, and even to litigate.17 A pattern has plainly emerged of limited partners not merely accepting their losses and seeking better terms for their current or future contracts,18 but of limited partners attempting to stem their losses by alleging misconduct by the general partners of venture capital funds that have performed poorly in recent years.
Disputes with business partners can be resolved in many ways short of litigation. Many of the prominent disputes in the venture capital industry will likely be resolved through modification of existing contracts and through agreements to modify the terms of future partnerships. However, the limited partners in some venture capital funds still seem eager to use the threat of litigation as a weapon in their negotiations with their venture capitalist partners. This Article will describe why that threat is largely hollow, and why such behavior is inconsistent with the prevailing practices of the industry that made it so successful for investors, venture capitalists, and entrepreneurs.
II. THE LEGAL AND NON-LEGAL FOUNDATION OF THE RELATIONSHIP BETWEEN VENTURE CAPITALIST AND INVESTOR
Examination of the evolving dynamics of the relationship between venture capitalists and their investors over the last two decades reveals that the investors have virtually no legal foundation for causes of action against the venture capitalists whom they are now threatening to sue. The current disputes (which will likely pass when the market for high-technology and initial public offerings returns) represent attempts by dissatisfied limited partners to deny the enforceability of contracts into which they freely and knowingly entered. Their allegations that such contracts are, for example, “unreasonable,” contradicts the free-market freedom of contract principles which brought them so much wealth in past years. Persisting with lawsuits arising from poor fund performance, rather than manifest breach of contract or duty, threatens to undermine the culture that contributed to the extraordinary success of the venture capital industry over the last two decades.
Much has already been written about the specific provisions of venture capital limited partnership agreements.19 These contracts contain numerous specific covenants that restrict the behavior of the general partners in various ways.20 Enforcement of such covenants is generally not a complicated legal matter. When the meaning of a covenant is unambiguous, courts will simply enforce it according to its terms, even if itconflicts with the default rules under Delaware law.21 As an explicit and unambiguous term of a freely negotiated contract, a covenant is plainly enforceable.22
In addition, a great deal of scholarship has focused on the ways that the venture capital limited partnership agreements align the interests of both the investors and the venture capitalists.23 Such studies describe, among other things, how venture capital limited partnership agreements provide a strong incentive for the managing general partners to work in the best interests of the limited partners by linking the general partners’ compensation to the actual performance of the companies in their portfolios.24 The venture capitalists will only receive significant financial reward if the value of the companies they have invested funds in increases and they are able to exit those investments through an IPO or other mechanism.
The entire process of venture capital takes place in a cycle25 in which venture capitalists raise funds from investors, use these funds to provide capital for a portfolio of young companies, foster the growth of those companies as advisors, and through their power as sources of further funding and as substantial stockholders, attempt to exit through initial public offerings or other mechanisms, and then return to the original investors for further funding for a new cycle. The desire to renew the relationship encourages the parties to act in good faith and discourages the parties from resolving disputes through such extreme measures as litigation.26 And experience has shown that-until recently-neither party tended to resort to litigation to enforce the terms of the limited partnership agreements into which they entered.27
The most powerful control mechanism over the relationship between investors and venture capitalists is an implicit agreement that is not legally binding over either party. Described by Black and Gilson as “an implicit contract in which capital providers are expected to reinvest in future limited partnerships sponsored by successful venture capital funds,”28 this understanding forms the backbone of the ongoing relationship between investors and venture capitalists.29 The key term here is “ongoing.” Even though the investors and limited partners are only legally committed to each other for the duration of the current fund, the success of both parties’ long-term commitment to investment in venture capital depends on their having the confidence that the relationship will in fact continue for years, through the creation of new venture capital limited partnerships involving the same parties. Investors would not tolerate venture capitalist behavior that is not specifically designed to benefit the current limited partnership without this implicit contract. For example, the implicit agreement is necessary to justify the modest returns achieved by venture capitalists who have not yet established track records for success and who, therefore, are less able to attract the most talented entrepreneurs.30 Further, in order for new venture capital firms to succeed in the business, they must find investors who are willing to tolerate their lack of experience during the life of their early funds to benefit from their acquired experience several years down the line. The implicit contract provides some assurance to the investors that their participation in risky early funds will give them the right to participate in later funds managed by the same more experienced venture capitalists.
Bankman and Cole fleshed out the role of the implicit contract in a recent article.31 Their findings bear out the proposition that bilateral adherence to the implicit contract is essential to the healthy functioning of the venture capital industry. Attempts to gain leverage over venture capitalists through the threat of lawsuits by investors will ultimately harm the ability of those investors to continue to be active participants in future venture capital limited partnerships.
In contrast to ownership of shares in a corporation, an investment in a limited partnership gives the investor an interest in the venture capitalist’s future profits that is only guaranteed for a finite period of time, usually ten years.32 Unlike the value of shares in a corporation, the apparent value of an interest in a limited partnership derives only from the potential profits earned by that limited partnership during its fixed life. The limited partner investor does not have the legal right to participate in future venture capital funds raised by the general partners with whom he has currently invested.33 Bankman and Cole conclude that venture capitalists do not charge market rate for participation in each fund, but they do demand something else of value from the investor: an implicit promise to invest with them again.34 Breach of that promise by either party will cause severe damage to its reputation in the marketplace, and its ability to enter into venture capital limited partnership agreements in the future.
Under this vision of the venture capital limited partnership, both parties are plainly receiving more than the explicit contract dictates. The venture capitalist is getting the promise of a return investor in future funds. The investor is entering a potentially long-term relationship, the greatest benefits of which will accrue to him at a time beyond the fixed life of the limited partnership itself. Adherence to the implicit contract is necessary for the limited partner to tolerate behavior by the venture capitalist that is not specifically designed to benefit the current fund, but that will benefit the venture capitalist and her future partners in some future fund.35 For example, decisions based on the need to maintain the long-term reputation of a venture capital firm are not necessarily designed to produce the maximum profit for a current limited partnership.36 Indeed, such activity might lead to greater losses for the current limited partnership. However, if the investors honor their obligation under the implicit contract, the enhanced reputation of the venture capitalist will ultimately benefit them because the venture capitalist will be, among other things, more attractive to the very best entrepreneurs seeking funding in the future. Similarly, in order for a venture capital firm to become a successful player in a particular industry in which it has not participated before, it must gain experience in that industry by making at least some tentative initial investments, knowing that its lack of experience makes those investments riskier than usual propositions. Such investments might be beneficial in the long run, however, because the experience gained by early failure will benefit the venture capitalist, his portfolio companies, and his investors in some future fund. That limited partners tolerate such behavior is strong evidence that they expect the general partners to honor the implicit contract to include them in future limited partnerships.
III. VENTURE CAPITAL IN A DOWN MARKET
Like any industry, venture capital experiences good and bad markets. In a down market, investors have several options regarding their relationship with venture capitalists who manage their funds. They might simply accept their losses and preserve their ability to participate in future funds with the same venture capitalists under the terms of the implicit contract. Investors will, of course, have some leverage in negotiating the terms of any future fund given the poor performance of the last one. For example, the management fee, the “carried interest,” and other terms might become more favorable to the investors. Before agreeing to the terms of a new fund, investors might even be able to renegotiate the terms of funds that have already been raised although the venture capitalist will not be legally obligated to agree to any new terms.37
Other investors will take more drastic action. They may forego participation in a future limited partnership with a less successful fund even though this could be understood as breach of the implicit contract,38 and possibly result in a reputation for disloyalty. Such a reputation on the part of investors would likely lead to their exclusion from future funds when the market turns.
Finally, some unhappy investors may sue the general partners whose management of their money led to unprecedented losses. Unlike in other industries, litigation is an extremely rare method for active members of the venture capital world to resolve disputes, or to lessen the losses incurred through bad investments.39 The current threat of litigation by disgruntled investors in venture capital funds has been greeted with surprise by those familiar with the culture and practices of the industry.40
To succeed in any cause of action for breach of contract, the investors must prove that the venture capitalists breached a duty to which they were bound explicitly under the limited partnership agreement, or that the venture capitalists breached a duty imposed upon them by Delaware law. If the limited partners allege breach of a specific covenant,41 the legal issues involving that alleged breach are a fairly straightforward matter. For example, if the limited partnership agreement forbade the general partners from investing more than a certain percentage of funds in a particular industry, then a cause of action alleging breach of that particular restriction would simply depend on a jury’s findings of fact regarding a fairly narrow and mundane body of evidence.
Reports from the venture capital industry indicate, however, that many unhappy limited partners are considering suing the general partners under more general causes of action such as breach of fiduciary duty, mismanagement, and, in extreme cases, gross negligence and fraud.42 However, an examination of the prevailing practices in the industry and the law of Delaware, which governs most ventur\e capital funds, suggests that investors’ attempts to narrow their losses by suing the venture capitalists for conduct that falls short of gross negligence, fraud or other tortious activity, will be largely fruitless. Indeed, the funds have for many years been structured in a way deliberately designed to avoid the possibility of holding general partners liable for good faith decision-making involving risky investments, or during periods in which the economic cycle causes lower valuations and losses for investors. If investors succeed in recovering from venture capitalists for such losses, it could deal a blow to the resilience, flexibility and health of the industry.
IV. DEFINING THE DUTIES OWED BY THE VENTURE CAPITALIST
Investors regularly put millions of dollars in the hands of venture capitalists because the investors wish to benefit from the expertise and skills that the venture capitalists have to offer.43 A defining feature of the limited partnership relationship that the parties enter into is that the limited partner has little control over the activities of the general partner.44 As discussed above, the investors in a venture capital fund use a number of devices to ensure that the venture capitalists behave in a way that protects their interests. The grant of a stake in the outcome of the fund (“the carried interest”) aligns the interests of the investors and the venture capitalists substantially. Further, the explicit covenants which form a part of every limited partnership agreement provide a restraint on the scope of activity available to the venture capitalists, some of which would doubtless work against the interests of the investors.45 Finally, certain more general duties, such as the fiduciary duties of care and loyalty, exist either as default rules under Delaware law or, as is usually the case in a venture capital limited partnership, as duties specifically outlined in the limited partnership agreement.
Fiduciary duties, when they exist, protect principals from the possibility-in some cases the likelihood-that their agents will not act in the principal’s best interest either as a result of the agent’s selfishness or lack of care. Such duties can arise under law when two parties enter into a business relationship that involves the grant of agency power. When investors entrust their money with venture capitalists through the terms of a limited partnership agreement, the venture capitalists become the agents of the investors and plainly have the opportunity to take action that might not be designed entirely to benefit the investors. Aware of this risk, the investors nonetheless enter into the bargain because they believe the possible economic benefits of such a relationship outweigh the risks involved in entrusting millions of dollars to other people who have almost total control over the way the money is managed. Traditionally, fiduciary duties have been regarded as important mechanisms that serve to reduce this risk.46 As Larry Ribstein put it, “fiduciary duties are designed to compensate for the owner’s inability directly to observe, evaluate and discipline the controller’s performance.”47 Arguably, the default fiduciary duty in a limited partnership should be very strict since the limited partners have so little control over the general partners.48
At first glance, it would appear that fiduciary duties should play an important role in regulating the relationship between venture capitalists and their investors. However, an examination of the true nature of such duties in venture capital limited partnership agreements under Delaware law reveals that fiduciary duties, as they are traditionally understood, play only a marginal role in controlling the behavior of venture capitalists.
It is well-settled that, absent a contractual modification of the duty, the general partners of a Delaware limited partnership owe a fiduciary duty to the limited partners to “manage the partnership in its interest and in the interests of the limited partners.”49 Leaving aside for the moment the possibility of modifying this duty, it includes two crucial prongs: care and loyalty. The Delaware Revised Uniform Partnership Act does not define these duties. Rather, they have been defined in the state’s case law addressing the same duties in the corporate context,50 and then applied directly to cases involving limited partnerships.
Delaware courts cast a skeptical eye on allegations of breach of the duty of care by corporate directors as well as by general partners in limited partnerships.51 In order to prevail in a lawsuit alleging breach of the default duty of care by a general partner, the plaintiff must rebut the “business judgment” rule’s presumption that the general partners “acted on an informed basis and in the honest belief they acted in the best interest of the partnership and the limited partners.”52 The standard for rebutting this presumption in the corporate context was set out in the well-known Smith v. Van Gorkom.53 The Delaware Supreme Court held that for a plaintiff to prevail in a lawsuit alleging failure to exercise fair or reasonable business judgment, the defendant must have acted with “gross negligence” and without “informed reasonable deliberation.”54 In deferring to the right of managers to work with the freedom and flexibility required to run a business, the Court said that it “will not substitute its own notions of what is or is not sound business judgment.”55 Although no reported cases exist applying the Van Gorkom standard directly to disputes involving limited partnerships, there is no reason to think that courts would not apply that standard should such a conflict arise.
The overwhelming body of case law involving the duty of loyalty concerns conflicts in which corporate directors had interests on both sides of a transaction.56 Unlike the issue of the duty of care, there is a much more substantial body of cases in which Delaware courts applied corporate fiduciary duty principles to limited partnerships regarding the duty of loyalty.57 The courts adapted these standards to limited partnership disputes and inquired, among other things, whether the general partner acted independently and not self-interestedly, and whether the general partner failed to act in good faith.58 Absent modification in the limited partnership agreement, the duty requires that any action taken by the general partners be “entirely fair” to the interests of the limited partners.59
As in lawsuits against corporate directors, the plaintiff has the burden of providing evidence that rebuts the presumption of the business judgment rule.60 For example, the plaintiff “can rebut the [business judgment] presumption by sufficiently pleading that the general partner appeared on both sides of a transaction or derived a personal benefit from a transaction in the sense of self- dealing.”61 If a plaintiff pleads such specific acts of misconduct by the general partners, the burden then shifts to those partners to demonstrate the “entire fairness” of the transaction by, for example, establishing “to the court’s satisfaction that the transaction was the product of both fair dealing and fair price.”62 Courts have emphasized the need to look at all the actions taken by defendants: not simply the price received in an exchange, but also the procedural fairness leading up to the decision in question.63
Thus far, Delaware case law reveals no important cases where investors successfully sued venture capitalists for breach of duty of care or loyalty under the default standards discussed here. Further, it is extremely unlikely that a body of law will develop in this area since parties to Delaware limited partnerships-in all areas of business including venture capital-overwhelmingly choose to modify the default duties under Delaware law, and to negotiate specific fiduciary duties suitable to their specific relationship.
As Delaware courts themselves have stated, one explanation for the attractiveness of Delaware limited partnerships as the choice of form for a variety of businesses is the contractual flexibility allowed by Section 17-1101 of the DRULPA.64 Not surprisingly, most of the body of recent Delaware case law regarding breach of fiduciary duties by general partners involves interpretation of the limited partnership agreement itself, rather than the default duties under Delaware law. Any effort by limited partners in a venture capital fund to recover damages for breach of fiduciary duty by the general partners would inevitably require a court to interpret the terms of the limited partnership agreement, and to decide whether or not the defendant attempted to adhere to those terms in good faith.65
Where the parties to a limited partnership agreement clearly intended to displace the default fiduciary duties with ones of their own creation, courts will always defer to the duties embodied in the contract itself.66 The provision allowing for modification or restriction of the default duties of parties to a limited partnership agreement states that partners will not be liable for actions taken in “good faith reliance on the provisions of . . . [the] partnership agreement . . . .”67 Therefore, for a general partner to be liable for conduct taken on behalf of the limited partnership, he must have acted knowing that such conduct was not consistent with the partnership agreement itself.68 A good faith belief that the prohibited conduct is permitted will prevent recovery from the general partner, even if the conduct in fact violates the plain meaning of the agreement.69
Depending on the specific provisions of the limited partnership agreement at issue, the contractual standard will likely be more difficult to satisfy than the one required for violation of the default duties of care and loyalty. Indeed, once a limited partnership agreement specifies duties other than those provided by the default rules of fiduciary d\uty, courts will apply the good faith standard. For example, in a cause of action alleging breach of fiduciary duty through self-dealing, a court held that the “entire fairness” standard was not appropriate because the parties had formulated their own duties through the limited partnership agreement.70 The court dismissed a duty of loyalty claim since the plaintiff merely alleged that a transaction was not “entirely fair,” but failed to claim that the defendant intended to violate the limited partnership agreement.71
The Delaware case law states that in the case of ambiguous terms in a limited partnership agreement, courts will defer to the good faith of the defendant. Such an ambiguous term might be part of a provision restricting the default fiduciary duties of the general partners72 and expanding the breadth of activity in which a general partner may engage. For a general partner to be held liable for breach of that provision, the limited partners would have to show not only that the general partner’s conduct was prohibited by the agreement, but that the general partner knew that she was violating the agreement when engaging in the conduct in question.73
The terms of the limited partnership agreements that govern most venture capital funds are, of course, negotiable. In order for the investors to agree to abandon their default rights under Delaware law, they must receive something of value from the venture capitalists.74 In the strong market for venture capital that characterized the late 1990s, the value the investors received was the right to benefit from their general partners’ experience of success and their reputation for fair dealing, as well as the right to participate in a market with seemingly guaranteed high returns. In that market, just as the terms of remuneration became more and more favorable to the venture capitalists, the constraints imposed upon them by the contract itself became less strict.75
Of course, the terms of the limited partnership agreements that govern venture capital funds define the duties of the general partners in varying ways. It can safely be assumed that the definition of fiduciary duty varies among these agreements on a continuum, from the use of the default duty under Delaware law to nearly complete waiver.76 Evidence from practitioners in the industry suggests that investors in venture capital funds are willing to permit the venture capitalists to be free from liability for actions made in good faith in the best interests of the fund, up to the point at which the general partners are liable only for “gross negligence, fraud and willful misconduct.”77 This standard sounds very much like the default duty of care standard described above.78 Indeed it appears that, with regard to certain actions, venture capital agreements often spell out a standard which is not that different from the duty of care standard provided under Delaware law.
However, with regard to the duty of loyalty, venture capital limited partnership agreements plainly give venture capitalists broader discretion than the default rule provides. For example, the agreement might specifically state the general partners may invest funds in portfolio companies in which they invested in the past, as long as the general partner determines in his discretion that such investment would be in the best interests of the current partnership. Such a contractual provision (which would trump the default fiduciary duty standard) might be required by the venture capitalists, because investing current limited partnership funds in a company in which they already have an interest through an earlier fund could easily be construed as a conflict of interest. Under the contractual standard, plaintiffs would have to show that the venture capitalist made an investment decision knowing that it violated a specific term of the limited partnership agreement (which typically includes the requirement that the general partner act in the best interests of the fund).79 This contrasts with the default standard which requires the defendant to show the “entire fairness” of the transaction regardless of whether or not he knew the transaction was unfair or self-dealing.80 The contractual standard, therefore, allows the venture capitalist the freedom to distribute his investments in a way that he believes to be fair regardless of whether or not they actually are fair. A good faith belief in the fairness of the general partner’s actions should be sufficient to prevent recovery.
With the recent abysmal performance of venture capital funds, it is no surprise that groups of investors are unhappy. But their apparent desire to stem their losses through litigation suggests that they are attempting to disregard the enforceability of contracts into which they have willingly entered. Apparently, contracts that seemed fair and even sensible at the height of the venture capital boom now seem “unreasonable” and “egregious” to the investors who entered into them.
V. VENTURE CAPITAL’S Two CYCLES
Plainly, these investors-or perhaps more importantly, their lawyers-failed to fully understand the cyclical (in two senses of the word)81 nature of the industry. When venture capitalists raise funds from limited partners and then invest them, both parties expect to renew the relationship again and again in the future. Until 2000, this cycle of investment rarely encountered significant changes in the market for venture capital. As a result, experienced venture capitalists were able to attract funding from their past investors at terms increasingly favorable to the venture capitalists regarding compensation, as well as to the degree of discretion the venture capitalist had in operating the fund. By alleging misconduct by the general partners in the wake of a weak market, the limited partner investors seem to be acting as though the “venture capital cycle” were not subject to the inevitable changes in the economic cycle.
Recent experience has shown that many top venture capital firms are willing to sacrifice the favorable terms to which they have been contractually entitled to ensure that the venture capital cycle will continue in subsequent funds with the same investors despite the downturn in the market.82 Willingness to do this demonstrates the importance these firms place on maintaining a healthy relationship with these investors. It appears that to these venture capitalists- and it should be emphasized that they include some of the most successful firms83-the goal of being a long-term regular, active participant in venture capital is more important than the short- term desire to enforce the terms of a binding agreement.
However, other firms are unwilling to modify the terms of their agreements with investors. These venture capitalists appear to be adopting the view that the implicit contract between them and their investors assumes not only that the investors will return for more following a successful round, but that they will also return following an unsuccessful round, even one in which the investors themselves bore the bulk of the financial losses. Doubtless, in some instances, these venture capitalists will lose investors who refuse to take part in the next round of investment because the venture capitalists failed to voluntarily share their losses. Some venture capitalists, because their reputation for success has been sufficiently unscathed by their recent failures, will manage to raise new funds with past investors simply on the strength of their good-though now slightly tainted-reputations. Finally, some firms will face lawsuits from investors who must plainly understand that their reputations among venture capitalists will now plummet.
Deciding to sue to recover money lost in disastrous investments is a time-honored response during downturns of the market in any area of investment. The difficult task for lawyers representing such plaintiffs is to find causes of action for which the likelihood of recovery justifies the cost of the litigation, and, more importantly in this context, justifies the cost of the resulting harm to the plaintiff’s reputation in the world of venture capital.84 A lawsuit by limited partners alleging breach of contract against general i partners in a venture capital fund might allege breach of a specific covenant in the limited partnership agreement. This has rarely happened in the past and does not appear to be a strategy being pursued now. Rather, aggrieved groups of limited partners have been threatening to bring suits for breach of fiduciary duty, mismanagement, and, in extreme cases, gross negligence and fraud.85 Most implausibly, some potential plaintiffs seem to be asserting that the venture capitalists actually have an obligation to reduce fees or refund committed capital because the terms of the existing agreements are now unfair to the limited partners in a market in which investors are regretting decisions they made while the market was still high.86
If the venture capitalists could somehow demonstrate that the terms of the contracts binding on them are unconscionable, then they could seek rescission. But courts, especially those in Delaware, reserve such a defense for instances which “include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.”87 Courts also take into account the level of sophistication of the aggrieved party and are reluctant to apply the doctrine of unconscionability to sophisticated parties.88 Surely, investors in venture capital funds have well-informed legal advisors explain the implications of agreeing to certain terms and modifying certain obligations on the parts of those with whom they have entrusted their money. Further, such investors are also sophisticated enough to know that during the 1990s, venture capitalists were in a position to demand more favorable terms even \from their long-time investors. The situation that prevailed in the venture capital industry required investors to understand that in order to avail themselves of certain opportunities, they were required to agree to certain terms that in retrospect they regretted accepting.
Courts are not designed to judge the wisdom of agreements already formed. Delaware courts have directly addressed attempts by limited partners to resist enforcement of limited partnership agreements when such agreements have not benefited the limited partners as anticipated. Courts will not engage in “some court-approved, after- the-fact, moralistic ‘entirely fair’ standard, when the parties defined the desired process in the Partnership Agreement.”89
The kind of retrospective regret on the part of investors that we are seeing now is precisely what venture capitalists attempted to protect themselves from in drafting limited partnership agreements that contained terms increasingly favorable to themselves, and which imposed on them less and less restrictive obligations. Investors commit funds to venture capitalists because the investors themselves do not have the necessary knowledge or skills to do what the venture capitalists do: to choose the most promising start-ups and, most importantly, to nurture them to profitability. The modification of fiduciary duty allows the venture capitalists to exercise the kind of discretion they need to provide the service for which they are being paid. Arguing that losses arising from a bad round of investments constitute a breach of a fiduciary duty, whether or not such a duty exists in any kind of meaningful way, denies the proper role of the venture capitalist in the relationship.90
Ribstein describes the paradigmatic relationship that calls for fiduciary duties as one “where one who owns property in the sense of controlling and deriving the residual benefit from that property (i.e. the owner) delegates open-ended management power to another person (i.e. the controller).”91 This fits the typical limited partnership arrangement. Ribstein goes on to say that strong fiduciary duties are most appropriate where “one party has a significant discretionary power that is subject to abuse and where that discretion cannot readily be constrained by devices other than fiduciary duties without undermining the parties’ objectives.”92 This formulation plainly does not fit the arrangement in a typical venture capital fund where the general partners’ “carried interest” goes a long way in providing them with the motivation to pursue the limited partners’ objectives.93 The reduction of the importance of fiduciary duty in venture capital limited partnership agreements makes sense given the other incentives for good performance motivating the general partners.
Courts might be tempted to impose fiduciary duties based not on an agreement between the parties, but on a sense of injustice arising from a disparity in knowledge or sophistication in one party.94 However, where the parties to a limited partnership create a relationship that relies jointly on monetary incentives, contractually imposed duties, and strong reputational considerations, it would be inappropriate for a court to impose a standard of fiduciary duty that plainly does not exist in the agreement even where, in retrospect, the bargain seems “unfair” or “unreasonable.” Anything else would be a clear contradiction of the spirit and letter of Delaware law which demands that courts enforce the terms of bargains. While it would be impossible to quantify the value of retention of fiduciary duties in a contractual relationship, the reduction or modification of those duties must necessarily be made in exchange for something else of value.95 It may be that that something else is the willingness of venture capitalists to enter into a relationship with investors at all.96 Whatever the rationale for entering into such an agreement, Delaware courts will enforce it, unless the investor can show the absence of any “meaningful choice.”97
Ribstein emphasized that “fiduciary duties arise from the structure of the parties’ relationship rather than the nature or identity of the parties.”98 The evolution of the contracts between investors and venture capitalists bears out this proposition. Indeed, the venture capital cycle requires that its participants, as well as the courts, understand this. Investors in venture capital funds agree to allow venture capitalists to reduce broad fiduciary obligations, while still insisting that the venture capitalists explicitly agree to refrain from certain specific activities. Further, both parties agree to the implicit contract promising that the venture capitalists will allow the investor to participate in a subsequent fund, an implicit agreement relying heavily on the desire by both parties to protect their own reputations. This arrangement of duties and obligations, both explicit and implicit, arises from the unique nature of the venture capital cycle, and the unique role of venture capitalists as both professional arbitrageurs99 and professional managers, and advisors with knowledge, experience, and connections,100 who take key roles in the development and growth of young companies.
VI. CONCLUSION
The modification of broad fiduciary duties allows the venture capitalist the necessary freedom to make decisions on behalf of possibly dozens of businesses in related areas without having to fear the possibility of breaching his fiduciary duties to the investors of any single fund. Under Delaware law, the explicit duties imposed through covenants in the limited partnership agreement require the venture capitalist to avoid certain activities that he knows to be prohibited. Finally, the implicit contract ensures that the venture capitalists behave in a way that will increase the likelihood their investors will be willing to provide capital to future funds. All of these forces combine to form the core of the relationship between investors and venture capitalists. To describe them merely as limited partners whose investments are controlled by general partners is inadequate.
As in other areas of human interaction, business relationships are easy to govern when things are going well. When investors were earning twenty to thirty percent per year, they were wisely reluctant to sue the venture capitalists for any apparent breach of contract or duty. But the converse of this is not necessarily also true: when things go badly, the best solution is not always litigation, especially in an industry in which reputation plays such a crucial role.101 The fact that so many venture capital firms have been willing to modify contracts by lowering management fees, and by returning funds already collected,102 demonstrates the importance of reputation in protecting the long-term interests of the investors. Such actions suggest that in many investor-venture capitalist relationships, a further implicit contract exists where the venture capitalists agree to modify the terms of limited partnership agreements when market conditions would result in heavy losses for the investors. They do this although they have no legal obligation to do so and although they do not face any real threat of legal action arising from their conduct that brought about the losses in the first place. Certainly, disgruntled investors have no legal obligation to re-invest with venture capitalists who have brought disappointing returns. But at the same time, they have no legal right to bring causes of action that have no basis in their contractual relationship or under law.
The current threat of litigation by investors against venture capitalists represents a bump in the road of the venture capital cycle. Like professionals in other industries, venture capitalists have an incentive to perform their jobs in good faith because they are contractually required to do so, because they have a strong financial incentive to achieve strong results, and because they wish to protect their reputations as fair dealers. They require a system that will allow them the freedom and discretion to perform their jobs without fear of legal action being taken against them for their good faith business decisions. The nature of the venture capital cycle provides a balance of incentives to the venture capitalists through remuneration, legal constraints found in the limited partnership agreement, and an emphasis on reputation based on an unenforceable implicit contract. Unless discontented investors can allege specific actions by venture capitalists that violated actual contractual duties imposed upon them by the limited partnership agreements with investors, their threats of legal action in the wake of poor earnings are simply bad faith attempts to cut their losses after many years of substantial earnings. Such threats fly in the face of the good faith actions of venture capitalists who for years have honored obligations under limited partnership agreements and their implicit promises to give previous investors the opportunity to share in their future earnings. The venture capital cycle requires an adherence to this implicit promise by both sides. When the market for venture capital returns, investors who violated the promise will doubtless face the consequences through irreparably damaged reputations.
1. Paul Abrahams, Nothing Ventured, FlN. TIMES, july 2, 2002, at 30 (discussing the response of institutional investors to the slump in the venture capital market).
2. AP Wire, May 13, 2002, available at 2002 WL 2123904 .
3. The active role of the venture capitalist in the life of her portfolio companies has been widely acknowledged: The first feature distinguishing venture capital/private equity investing is the VC professional’s active involvement in identifying the investment, negotiating and structuring the transaction, and monitoring the portfolio company after the investment has been made. O\ften the VC professional will serve as a board member and/or financial adviser to the portfolio company. Hence, venture capital/private equity investing is significantly different from passive selection and retention of stock and debt investments by a money manager.
JACK S. LEVIN, STRUCTURING VENTURE CAPITAL, PRIVATE EQUITY AND ENTREPRENEURIAL TRANSACTIONS [sec] 103 (2001). The National Venture Capital Association seems eager to distinguish its membership from the less active type of investor: “Far from being simply passive financiers, venture capitalists foster growth in companies through their involvement in the management, strategic marketing and planning of their investee companies. They are entrepreneurs first and financiers second.” Available at http://www.nvca.org/def.html (last visited Mar. 27, 2003).
4. For a discussion of the nature of the limited partnership relationship between investors and venture capitalists, see David Rosenberg, Venture Capital Limited Partnerships: A Study In Freedom of Contract, 2002 COLUM. Bus. L. REV. 363. The limited partnership agreements entered into by venture capitalists and their investors are typically governed, pursuant to agreement, by Delaware law. Id. While scholars are still puzzled about the continuing preference for Delaware law by those forming corporations, see, e.g., Robert Daines, The Incorporation Choices of IPO Firms, 77 N.Y.U. L. Rev 1559 (2002), there is little debate regarding Delaware’s dominance as the choice of law among those forming limited partnerships. It seems clear that the parties to limited partnership agreements and their lawyers prefer Delaware because of the flexibility offered by [sec] 171101 (c) of the Delaware Revised Uniform Limited Partnership Act. see infra text accompanying note 64.
5. Ryan Cornell, Battered Venture Cap Due for Rebound, GRAIN’S CLEV. Bus., Feb. 11, 2002, at 1.
6. Lisa Bransten, Venture Firms Face Backlash From Investors, WALL ST. J., Apr. 29, 2002, at Cl.
7. For example, the “carry,” or percentage of equity granted to the venture capitalists rose from 20% to 30% during the peak of the internet bubble. Abrahams, supra note 1. In addition, the management fee charged by the venture capitalists also increased, sometimes rising from 2% to 3.5% of committed capital. The management fee is rarely reduced in response to the increase in size of a fund, thus essentially allowing the venture capitalists to earn more without providing proportionately greater services. The management fee is, however, sometimes reduced in response to market demands. see infra text accompanying note 14.
8. Paul A. Gompers & Josh Lerner, The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements, 39 J.L. & ECON. 463, 475-76 (1996) (suggesting that such restrictions usually take the form of covenants specifically prohibiting certain kinds of activity on the part of the venture capitalists). Another expert on venture capital contracting has made a similar observation. In his treatise on venture capital, Michael Halloran notes that restrictions on the general partner’s activities that might constitute conflicts of interest are weaker when the general partner can demonstrate a good track record on behalf of past limited partners. MICHAEL HALLORAN ET AL., 1 VENTURE CAPITAL & PUBLIC OFFERING NEGOTIATION 1-84 (3d ed. 2002).
9. This Article assumes that the parties to venture capital limited partnership agreements are knowledgeable and rational actors who enter into such contracts willingly, with full understanding of the nature of their own legal obligations and those of the other parties. As sophisticated investors, they surely understand that any commitment of funds to venture capital is a highly risky proposition that could result in substantial gains-or substantial losses. The standard under Delaware law is clear: “given no defect in process (e.g., fraud, non-disclosure, or manipulation) explicitly negotiated and validly adopted provisions of a constitutional document will be enforced.” U.S. West, Inc. et al. v. Timer Warner Inc., 1996 WL 307445, at *22 (Del. Ch. June 6, 1996).
10. Beth Healy, The Boston Globe Venture Capital Column, BOSTON GLOBE, Aug. 26, 2002, available at 2002 WL 26062044 (discussing the relatively new risk of litigation for venture capitalists).
11. Id. (explaining “[b]esides, they’ve made a ton of money over the years; only recently have some become disenchanted with their VCs”).
12. Rosenberg, supra note 4, at 394. see also Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, WASH. & LEE L. REV. 537, 548-49 (1997) (analyzing the contractual nature of fiduciary duties).
13. Bransten, supra note 6.
14. Sharing the Pain, ECONOMIST, Apr. 13, 2002, at 63 (reporting that seven leading venture capital firms, in response to pressure from their funds’ limited partners, have announced changes amounting to a pay cut). Among the venture capital firms who reduced fees are Kleiner Perkins Caufield & Byers and Mohr, Davidow Ventures. Id. see also Bransten, supra note 6. It is important to note here the distinction between unilateral modification of a contract and bilateral renegotiation of a contract. In the instances described in the above reports, venture capital firms voluntarily agreed to modify the terms of already binding contracts although they plainly had no legal obligation to do so. Often, though not here, two parties will agree to bilaterally modify the terms of a contract in response to developments taking place after the contract has been formed. It appears that the venture capitalists who agreed to modify their rights under binding contracts are not asking for anything in return other than the goodwill of the investors.
15. Robert Clow, Private Equity Gets a Low Grade from Yale, FlN. TIMES, May 21, 2002, at 30 (discussing the frustrations of private equity investors in mid-2002).
16. The press quotes several investors who accepted their losses as simply one possible outcome of what they bargained for when investing in venture capital: “Those of us in the limited-partner community need to own up to the responsibility that we signed these documents because we were all looking for these triple-digit [returns]. We lost sight of what was reasonable as did everyone in technology investing.” Bransten, supra note 6, at C5; “I sat down and negotiated a deal. A deal’s a deal.” Norm Alster, What’s that Rumble in Venture Capital Funds, N. Y. TIMES, Mar. 3, 2002, [sec] 3, at 4.
17. Alster, supra note 16, at 4 (describing “an outbreak of litigation in this relatively closed world”); Bransten, supra note 6 (quoting a prominent attorney: “We will likely see a significant increase in litigation involving VC players”); Sharing the Pain, ECONOMIST, April 13, 2002, at 63; Robert Clow, Holy Grail Proves Elusive for VCs, FlN. TIMES, Mar. 26, 2002 (stating “[ajnecdotal evidence suggests that disgruntled investors have started to revolt against the general partners of buy-out and venture capital firms . . . [t]he buzz around the private equity world is that investor spats with general partners are becoming far more common”). Another indication of the likelihood of some disputes ending up in court is an increasing demand by venture capitalists for liability insurance against negligence lawsuits. Erika Brown, Capital Punishment: The Boom Birthed Hundreds of Venture Capital Firms. Now Investors Want Them Dead, FORBES (Nov. 25, 2002), available at http:// www.forbes.com/premium/archives/purchase.jhtml?storyURL=/forbes/ 2002/1125/052.html&_requestid= 11999 (subscription required); Healy, supra note 10.
18. Doubtless, investors will point to past performance when negotiating the next round of limited partnership agreements. Indeed, press reports indicate that this is already happening, and at least one study notes that it has happened before. Fenn et al. note that after a run of bad years in the late 1980s, venture capitalists began to offer lower management fees and began to agree to a lower percentage of equity for themselves. George W. Fenn et al., The Economics of the Private Equity Market (Fed. Reserve Bd. Staff Study No. 168) Nov. 1995, at 39.
19. PAUL A. GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE 29- 55 (2000). 20. Id.
21. Sonet v. Timber Co., L.P., 722 A.2d 319, 323 (Del. Ch. 1998). However, when the meaning of a covenant is ambiguous, courts will find breach of contract only where a plaintiff can show that the defendant knew his actions contradicted any reasonable interpretation of the terms of the contract. see infra notes 72-73 and accompanying text.
22. It does not go without saying that courts will almost always enforce the explicit terms of limited partnership agreements. Indeed, the legislature of Delaware has distinguished the law of that state from most others by specifically enacting into law the rule that Delaware courts will give “maximum effect to the principle of freedom of contract and to the enforceability of partnership agreement[s].” DEL. CODE ANN. tit. 6, [sec] 17-1101 (c)(1999).
23. Fenn et al., supra note 18, at 36; William Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J. FlN. ECON. 473, 494 (1990); Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. FlN. ECON. 243, 256 (1998); Joseph Bankman & Marcus Cole, The Venture Capital Investment Bust: Did Agency Costs Play a Role? Was it Something Lawyers Helped Structure?, 77 CHI.- KENT L. REV. 211,217 (2001).
24. Sahlman, supra note 23, at 494.
25. See GOMPERS & LERNER, supra note 8. The details of the venture capital cycle are, of course, best described in the book named The Venture Capital Cycle.
26. Shannon Henry, The Download, WASH. POST, Mar. 7, 2002, at El. Press reports confirm that venture capitalists are keenly aware of the right of investors not to invest in future funds if they are dissatisfied wi\th a fund’s performance or with the conduct of the general partners: So far, it seems, limited partners may have a limited voice when it comes to money they have already invested, particularly if they are in the minority. But they do hold the purse strings for the future. “This is the ultimate policing of venture returns, says [a venture capitalist] – the threat of refusing to invest again.” Id. (emphasis added).
27. Rosenberg, supra note 4, at 393. As one attorney who drafted such documents, and wishes to remain anonymous, told the author, “once the parties sign the limited partnership agreement, it stays on the shelf.”
28. Black & Gilson, supra note 23, at 256. The authors describe in much greater detail a second “implicit contract” between venture capitalists and entrepreneurs. Pursuant to that understanding, venture capitalists implicitly promise to cede control of companies in their portfolios to the entrepreneurs themselves following successful initial public offerings. Id. at 257-64. As in their implicit contract with investors, venture capitalists have a strong incentive to honor this non-legally-binding promise in order to protect their reputations for loyalty and fair dealing. Id. at 263. Black and Gilson note that, in a world as unpredictable as the venture capital market, implicit contracts are superior to explicit obligations set out in contracts:
An explicit contract that specifies the operating performance necessary to entitle the entrepreneur to reacquire control is a difficult undertaking. Creating a state-contingent contract that specifies the control consequences of the full range of possible states of the world over the four-to-ten-year average term of a venture investment, without creating perverse incentives, is a severe challenge both to the parties’ predictive powers and their drafting capabilities. It is in precisely these circumstances that an implicit contract is likely to have a comparative advantage over an explicit contract.
Id. at 263. The same reasoning applies to the implicit contract between the venture capitalists and the limited partner investors.
29. Black and Gilson do not provide empirical evidence for the proposition that venture capitalists almost invariably turn to previous investors when raising new funds. Nonetheless, that this in fact happens is widely accepted in studies of the industry. For example, “partnership managers generally turn first to those that invested in their previous partnerships-assuming of course, that their previous relationships were satisfactory.” Fenn et al., supra note 18, at 36. Bankman and Cole also note that “[preference is given to investors in the firm’s previous offerings. For example, an investor can realistically hope to participate in next year’s Mayfield fund only if she subscribed to this year’s fund.” Bankman & Cole, supra note 23, at 217.
30. Black & Gilson, supra note 23. In a penetrating study of the relationship between venture capitalists and the firms in which they invest, Terence Woolf describes a similar implicit contract at work with a virtually identical reputational dynamic:
[M]anagers adhere to implicit contracts because their adherence enables them to develop a reputation for trustworthiness, and thus to benefit from implicit contracts. If violating an implicit contract today would make the managers untrustworthy in the future, they will uphold the contract as long as the option of entering into future contracts is valuable enough . . . (quoting Andrei Shlefer & Lawrence Summers, Breach of Trust in Hostile Takeovers, in RONALD J. GlLSON & BERNARD S. BLACK, THE LAW AND FINANCE OF CORPORATE ACQUISITIONS 615 (2d ed. 1995)). VCs are repeat players in the finance industry and when faced with competition, should rationally not be willing to risk their goodwill and financial investments if usurped opportunities will cause net financial losses.
Terence Woolf, The Venture Capitalist’s Corporate Opportunity Problem, 2001 COLUM. Bus. L. REV. 473, 505.
31. Bankman & Cole, supra note 23, at 221-23.
32. Id. at 221-22.
33. In contrast, a shareholder in a corporation has the legal right to benefit from the profit-earning potential of that corporation. That future expected earning potential is, by definition, accounted for in the current value of its stock price. In a corporation, reputation-building activity plainly contributes to the future potential profits of the corporation and should therefore translate into a higher share value. Therefore, there can be little doubt that reputation-building activity is and ought to be an acceptable mission of a corporation.
34. Otherwise, Bankman and Cole point out, there would not be “an excess of demand over supply for slots in first-tier venture capitalist investment partnerships.” Bankman & Cole, supra note 23, at 222.
35. Id. at 221.
36. Id, Bankman and Cole use as an example the decision to provide follow-up funding to a portfolio company on the decline. A decision to withdraw funding from such a company could result in the venture capitalist acquiring a reputation for insufficient lo
