The Venture Capitalist’s Corporate Opportunity Problem

Monday, January 1st, 2001 at 12:00 am by Terence Woolf
Terence Woolf, The Venture Capitalist’s Corporate Opportunity Problem, 2001 Colum. Bus. L. Rev. 473

Much has been written about the duty of loyalty doctrine and the various tests developed and used by courts to determine whether a director or officer has usurped corporate opportunities. These tests are predicated on a notion that directors and officers owe their undivided loyalty to a single company and its shareholders, which consequently makes them anachronistic and ineffectual in the context of venture capital (“vc”) investing.

The judicially-created tests may make perfect sense when a director owes a duty of loyalty to a single company, because a court, faced with these facts, will not need to address the issue of competing fiduciary duties. However, when a venture capitalist (“VC”) serves on the boards of numerous companies that operate in similar fields of business, the application of these tests is impractical, and as I intend to demonstrate, has the potential to harm capital formation and business development.

Simply stated, a vc director cannot owe undivided loyalty when in reality loyalties are divided. The problem can be explored by considering the following illustration. Under a rigid application of the duty of loyalty doctrine, if a VC invests in companies X, Y and Z and serves on the boards of all three, the VC will owe a separate duty of loyalty to each corporation. However, despite the fiduciary requirements or prohibitions imposed on directors or officers, this expectation of unwavering loyalty is simply not realistic. This will be especially true in the context of vc investing where conflicts of interest, partially attributable to the inherent structure of the vc industry itself, inevitably arise.

This, then, is the VC’s corporate opportunity problem. When complex fact patterns, that arise specifically in the vc context, are coupled with the varying application of uncertain tests, courts may find it extremely difficult to determine whether a director has usurped a corporate opportunity. Granted, courts and juries are expected to make factual determinations of this nature, but when the facts are messy and do not fit neatly into the established tests, the courts either will have to deviate from what has previously been recognized as valid, thus creating additional uncertainty, or alternatively, they will have to defer to the legislature for more guidance.

I contend that neither courts nor legislatures are functionally equipped to address the corporate opportunity problem. Based on my research, there are no reported cases involving the usurpation of corporate opportunities by vc directors. It is theoretically possible that vc directors do not usurp opportunities from the businesses they invest in, and that this is really a non-issue. Yet, practically, based on the wide reach of the corporate opportunity doctrine and the very nature of vc investing, this possibility appears highly remote. Thus, even if courts did possess the capacity to address this issue effectively – which I do not believe they do – the dearth of cases suggests that they will not have the opportunity to affect a meaningful resolution. This lack of opportunity can be explained partially by the *475 constraints that are inherent in the structure of vc investments. As will be explained further, these restraints may effectively hinder entrepreneurs and other VCs from challenging alleged usurpations.

With respect to entrepreneurs, the staged financing structure, among other things, creates a dependency on the VC that makes it infeasible for the entrepreneur to bring a legal challenge. As for other VCs, tit-for-tat strategies may inhibit one vc firm from contesting a usurpation by another; this may be particularly true if the corporate opportunity problem is an industry-wide phenomenon and not simply firm-specific. If the problem is indeed that widespread, legislatures may decide that more regulations are needed to affect an adequate resolution. It is difficult to foresee, however, how legislatures can possibly impose effective new rules concerning the strategic management of privately-held companies without creating transaction costs that discourage capital formation and investment development.

If vc directors who assume competing fiduciary obligations are not subjected to the traditional corporate opportunity analysis, what alternatives, if any, should be considered? In addressing the VC’s corporate opportunity problem, I will analyze: (i) how the corporate opportunity doctrine has evolved, focusing primarily on the expectancy, line-of-business and A.L.I. tests; (ii) how the corporate opportunity problem is exacerbated in the vc context; and (iii) how a contractarian analysis, coupled with an argument in favor of private ordering, helps to address the venture capitalist’s corporate opportunity problem without discouraging investment and innovation.

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