Venture Capital Limited Partnerships: A Study in Freedom of Contract

Tuesday, January 1st, 2002 at 12:00 am by David Rosenberg
David Rosenberg, Venture Capital Limited Partnerships: A Study in Freedom of Contract, 2002 Colum. Bus. L. Rev. 363

Foremost among the institutions contributing to the dramatic growth of the high technology (‘high-tech‘) sector in the 1980s and 1990s is the venture capital fund. The crucial role of venture capitalists in sparking the creation of new firms and developing new technologies in Silicon Valley and elsewhere is by now well-accepted. Venture capital funds introduced two mechanisms crucial to the kind of successful entrepreneurship that has characterized the last twenty years of high-tech development: (1) they created an investment vehicle through which institutional investors were willing to inject large sums of capital into highly speculative, but potentially hugely remunerative, new businesses; and (2) they created a structure which allowed seasoned managers to draw on their experience to nurture young entrepreneurial companies into profitability.

Entrepreneurs solicit the participation of venture capitalists because young companies, particularly those experimenting with high-tech, require a great deal of capital in the months and years before they reach profitability. Banks, the traditional institutions from which businesses receive needed funding, are, comparatively speaking, reluctant to take big risks; they tend to avoid extending loans to companies whose ability to stay solvent and thus pay back their loans remains unproven. Venture capitalists, on the other hand, are drawn to risky propositions; they gravitate toward start-up firms whose success depends on the development of new technologies and new products. Unlike bank officers, venture capitalists take an equity stake in their portfolio companies, and the payback to venture capitalists is directly proportionate to the profits enjoyed by the start-ups they fund. Further, and perhaps most crucially, venture capitalists provide advice, guidance and even supervision to the firms in their portfolios. Since many venture capitalists are already experienced entrepreneurs and managers themselves, they can give less-experienced firms a competitive edge over companies whose outside investors take a less active role.

In the early 1960s, the first venture capital fund organized as a limited partnership was formed. Since then, the vast majority of funding for venture capital in the United States has derived from funds organized as limited partnerships. Many non-legal studies of the venture capital industry have acknowledged the crucial role that limited partnerships play in the success of venture capital funds, describing them, for example, as ‘the single most important organizational innovation of the modern venture capital system.‘ Yet little work has been done in the legal literature that explains why this particular form of business organization (a legal form whose death has been announced on many occasions) is so dominant in this particular industry.

The venture capitalists’ incentive to work effectively on behalf of their investors arises from two sources: (1) the desire to maximize their own equity stake in the firms currently in their portfolio; and (2) the desire to establish and maintain a reputation for success with current and future investors who will agree to provide funds in the next round of venture capital investment. This article discusses how the limited partnership under Delaware law is uniquely suited to create such incentives and to satisfy the needs of all parties (including passive investors and venture capitalists) involved with venture capital funds. The article will demonstrate how prevailing practices in the industry bear out the theory that when parties have the ability to contract freely, the marketplace will produce contracts that satisfactorily align the parties’ interests through devices other than the threat of legal action. It examines the relationship between venture capitalists and the passive (usually institutional) investors who fund them. It will highlight the striking degree to which investors are willing to enter into limited partnership contracts that offer them little legal protection against the opportunism or incompetence of the venture capitalist general partners who manage their money.

The article concludes that the importance of reputation in the venture capital industry, made possible by the cyclical nature of investment in venture capital limited partnerships, provides sufficient safeguards to ensure that managers act in the best interests of their investors. Since litigation is rarely used to protect investors, non-legal mechanisms, particularly reputation, play a dominant role in influencing the behavior of venture capitalists. The ability of the industry to rely on reputation as its primary enforcement mechanism depends largely on the unique nature of the limited partnership form and on the flexibility made available to the parties by Delaware’s Revised Uniform Limited Partnership Act (‘DRULPA‘).

In most venture capital funds organized as limited partnerships, the investors, in the role of limited partners, provide 99 percent of the capital; the venture capitalists, in the role of general partners, provide the remaining 1 percent. As in all limited partnerships, the venture capitalist general partners have nearly complete control over the way the fund is operated on a daily basis. To a large extent, this distribution of power makes perfect sense given the skills and expertise that the parties bring to the relationship. The limited partners who invest in venture capital are often huge pension funds, university endowments and other entities that are in no position to oversee and monitor their investments. Indeed, they choose to put their money into such funds because they want to take advantage of the experience, skill and contacts of the venture capitalists themselves. Investors choose those venture capitalists who have either brought them good returns in the past or who have developed reputations for success with other investors. Given the vagaries of creating new businesses and technologies, the venture capitalists must be in a position of relative freedom to be creative and use their managerial skills to help nurture the development of young companies in their portfolios, without being burdened by oversight from the bureaucratic priorities of the professionals who manage large investment funds.

Given the amount of money at stake and the uncertainty involved in the investments, one would assume that limited partners in venture capital funds would avail themselves of substantial legal protections to ensure that those managing their investments act in the investors’ best interests. Yet a close examination of the nature of venture capital limited partnerships reveals that few such protections exist: the managers of venture capital funds have virtually no general legal obligation to behave in the best interest of their investors.

Given the liveliness of the industry in recent years, it might also be assumed that venture capital investors have used litigation to enforce their rights under venture capital limited partnership agreements. Surprisingly, little litigation has taken place in this area. Rather, investors in venture capital funds rely on market forces, reputational constraints in particular, to ensure that the venture capitalists make decisions that will maximize the return on their investment. With investors still pouring billions of dollars into venture capital even after the recent economic downturn, these forces are plainly sufficient to attract further investment, even in the absence of significant legal protections.

Proponents of the contractarian view of law argue that, in a free market, contracting parties ought to be able to dictate the nature of their relationship by bargaining away certain rights while assuming others. The parties ought not, the contractarians argue, be forced to accept standard provisions found in state law if they are willing to waive those provisions in exchange for something else of value. They further argue that state law should be modified as much as possible to recognize such waivers in most commercial agreements and to allow market forces to determine the nature of either party’s obligation to the other.

Until recently, the law of limited partnerships did not explicitly guarantee enforcement of the waiver of certain duties. In 1992, however, Delaware passed its then-controversial provision allowing parties to limited partnership agreements to waive the duties imposed on the general partners under state law. These obligations, which originated in common law and were then codified in the Uniform Limited Partnership Act and its subsequent revisions, became merely default obligations rather than mandatory duties. Passage of the law made Delaware a virtual laboratory for the contractarian view; parties were now able to enter into limited partnership agreements, the terms of which were crafted and agreed to solely by the parties themselves, without significant reference to the default rules under state law. Contractarians believed that market forces would likely lead business people to form limited partnerships governed by Delaware law in order to take advantage of the comparative freedom of contract made available by DRULPA.

Although systematic data are not yet available, evidence suggests that venture capital contracts are routinely organized under Delaware law, and that such contracts make use of the law’s flexibility to waive many of the default duties that otherwise would apply. The limited partnership agreement thus dictates on its own, the terms of the relationship between the investors and managers of venture capital funds, with very few duties assumed that are not explicitly outlined in the contract itself. The default duties provided by Delaware law are waived and replaced by duties crafted by the parties to the limited partnership agreements themselves. Under these agreements, venture capitalists are allowed, to a large degree, to make decisions that have far-reaching consequences to their investors, without allowing such investors to influence or second-guess the decisions made during the life of the venture capital fund.

An explanation for an investors’ willingness to enter into such a seemingly one-sided relationship lies in the uniquely cyclical nature of the venture capital industry. Parties to a venture capital limited partnership enter into a relationship that will last a comparatively brief amount of time and that will only be renewed if the providers of capital are satisfied with the venture capitalists’ performance. In their recent study, The Venture Capital Cycle, Paul Gompers and Joshua Lerner describe the ‘interrelatedness‘ of the various segments of the cycle:

Venture capital can be viewed as a cycle that starts with the raising of a venture fund; proceeds through the investing in, monitoring of, and adding value to firms; continues as the venture capitalist exits successful deals and returns capital to their investors; and renews itself with the venture capitalist raising additional funds.

As Gompers and Lerner recognize, the final step of renewal will only take place if the investors have been satisfied with the services provided by the venture capitalists; continuation of the cycle depends on the successful completion of the previous round. Such success depends on the ability of the venture capitalist managers to use their skills and experience to choose viable start-ups in which to invest and to add value to those companies through their close supervision and advice.

Limited partnerships under Delaware law are ideal structures for such a cycle because they permit the parties to create relationships in which reputation, rather than the threat of enforcement of burdensome legal obligations, is the most powerful constraint on venture capitalists’ behavior. The role of a venture capitalist is, after all, very different from that of a professional investor in equities. Not only do venture capitalists choose which start-up firms to invest in, but they also act as managers and consultants to those firms. Success or failure depends on their ability to navigate the subtleties of managing the creation of new technologies and introducing them into the marketplace. Ultimately, this is measured only by the willingness of investors to put more money into a future venture capital fund managed by the same general partners.

Gompers and Lerner and other commentators have pointed out that, in the course of this cycle, opportunities for self-interested behavior arise at every turn. The goal in drafting agreements on behalf of investors in venture capital funds is to minimize the scope of such behavior, without unduly constraining the freedom of the venture capitalist to do her job. The terms of most venture capital limited partnership contracts do much to align the interests of investors and venture capitalists by requiring that the venture capitalists’ compensation be closely linked to the actual performance of the firms they manage. Despite this apparent alignment of incentives regarding the success of the current venture, the relationship leaves a good deal of opportunity for exploitation by the venture capitalists who control the conduct of the fund’s investments. The fact that such exploitation seems not to take place is a powerful testament to the contractarian view. Investors in venture capital funds are willing to expose themselves to the risk of exploitation and are thus happy with the terms of the contractual agreement into which they have entered. Here, the potential for solid monetary gain, coupled with assurances provided by reputational constraints, are enough to counterbalance the chance that they will be mistreated by those in control of their investment.

A number of commentators have pointed to parallels between the ways in which investors in a venture capital fund attempt to curtail opportunistic behavior on the part of venture capitalists and the way in which venture capitalists attempt to discourage such behavior on the part of start-up firms in which they are investing. In both relationships, the commitment of capital is staged, and the party holding the purse strings retains the option of discontinuing funding. However, as the authors of the Federal Reserve report indicated, venture capitalists manage to hold disproportionate power in both instances. As general partners in the venture capital fund, venture capitalists have almost complete control over the operation of the fund; as shareholders in the companies in their portfolios, venture capitalists are able to keep the entrepreneurs on the proverbial short leash.

In the article The Venture Capital Company: A Contractarian Rebuttal to the Political Theory of American Corporate Finance, Douglas G. Smith argues that the relationship between venture capital firms and the start-up firms they invest in and nurture, exemplifies the ‘contractarian rebuttal in action.‘ Smith notes that, ‘venture capital investors are relatively unrestricted in their exercise of influence over management of the companies in which they invest.‘ As Smith describes it, venture capitalists gain much control over the management of their portfolio companies (usually organized as corporations) by ‘taking advantage of holes in the regulatory framework and by entering into creative agreements with management of the companies in which they invest.‘ Although some corporate regulations are designed to prevent the concentration of power in a few individuals, Smith argues that venture capitalists succeed in crafting relationships in which they possess the type of singular influence that is atypical of shareholders in a corporation.

The limited partnership structure of most venture capital funds (as opposed to the more complex corporate structure of the firms they nurture and manage) makes things much simpler. A fundamental difference between corporations and partnerships is that the ‘basic elements of the corporate structure, including fiduciary duties, traditionally have been mandatory. ‘ By giving ‘maximum effect‘ to the terms of the limited partnership agreement, Delaware law allows venture capitalists essentially to craft the terms of their relationship with investors, subject only to the give and take of negotiation and not to the default provisions of Delaware law. Even more than in the relationship between venture capitalists and portfolio companies described by Smith, here, venture capitalists exercise almost complete control over the conduct of the venture capital funds they run, subject to scant legal restraints.

Author Information

Assistant Professor of Law, Zicklin School of Business, Baruch College, The City University of New York