Two Recent Items About Preferred Stockholder/VC Liability

A couple of items came across my desk that may be apropos of the lawsuit over the Epinions/DealTime merger.

First item:

Jesse M. Fried and Mira Ganor, Common Shareholder Vulnerability in Venture-Backed Startups, UC Berkeley Public Law Research Paper No. 784610.

The abstract (the bolding is mine):

“The capital structure and governance of venture-backed startups have received significant attention from economists and legal academics. Much of this literature has focused on venture capitalists’ use of preferred stock and control rights – including board control – to reduce agency costs. Recently, it has also been suggested that VCs’ use of preferred stock is tax-driven. However, scholars have failed to notice that these arrangements, whatever their explanation, lead to a highly unusual and perhaps unique corporate governance structure: one in which preferred shareholders, not common shareholders, control the board and the corporation. The purpose of this paper is threefold: (1) to highlight the unusual governance structure of venture-backed startups; (2) to show that this structure leaves common shareholders vulnerable to opportunistic behavior by preferred-holding VCs, especially under current corporate law doctrines; and (3) to consider changes in these doctrines and the tax laws that would reduce common shareholder vulnerability and enlarge the startup pie for all its investors.”

Another interesting item:

Montgomery Cellular Holding Co. Inc. v. Dobler (Delaware Supreme Court 8/1/05). Though the Supreme Court decision turned on a denial of attorneys’ fees, the underlying litigation turned on the failure of the majority shareholder to get a valuation when doing a merger to squeeze out the minority shareholder.

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