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					                THE PREFERENCE FOR PREFERENCES:
             LIQUIDATION AND DIVIDEND PREFERENCES IN
                  VENTURE CAPITAL CONTRACTING


                                    Marcus Cole*


                                Abstract
        Economists and industry lawyers have long pondered the
question as to why venture capitalists insist upon convertible
preferred stock, with its dividend and liquidation preferences,
when making investments in fledgling enterprises. Economists,
recognizing the awkwardness of efficiency justifications, have
posited non-price justifications for the existence of these
instruments. Recent legal scholarship, confronted with the same
difficulties, has advanced a tax-based explanation for this structure.
        This article assembles the explanations offered by venture
capitalists themselves for the widespread use of preferred stock.
These findings demonstrate that while tax advantages are an
ancillary benefit of convertible preferred stock, they are not the
central reasons for its widespread use. Instead, venture capitalists
assert that control of assets in the wide array of outcomes and exit
possibilities serves as the primary function of liquidation
preferences. Similarly, dividend preferences serve as an
obstruction to looting behavior by managers and insiders.
Together, liquidation and dividend preferences operate to reduce
the transactions costs associated with the large percentage of
investments that are neither complete failures nor glorious
successes.


*
  Professor of Law, Stanford Law School. The author thanks Steven Anderson, Todd
Bauman, Bernard S. Black, William Bratton, William Campbell, David Chen, Vincent
Chiapetta, Lisa Cook, John Danner, Victor Fleischer, Brad Handler, Peter Henry, Kirk
Holland, Kenneth Judd, Donald Krahmer, Peter Letsou, Kate Litvak, Jeffery MacIntosh,
Erich Merrill, Jay R. Pritzker, Gordon Smith, Jeff Strnad, Peter Thiel, Susan Woodward,
participants at the Hoover Institution Economics Workshop, and at the Willamette Law
Review Symposium on Venture Capital for helpful comments on earlier drafts. I am
deeply indebted to the venture capital industry insiders whose comments, insights, and
impressions form the substance of this project. Because many venture capitalists and
other industry actors are often reluctant to speak frankly about industry and firm specific
practices, interviewees were promised confidentiality, and that any quotes used would be
without attribution.
Page 2                                                           Marcus Cole




                                    INTRODUCTION

    There is an old “saw” that makes the rounds among Silicon
Valley lawyers and law firms. While it takes many forms, they all
express the following sentiment: “liquidation and dividend
preferences are meaningless in a venture capital deal, because if
the firm succeeds, then the venture capitalist will convert to
common stock to participate in the upside. If the firm fails, the
technology and all of the other assets are going to be worthless,
and so a preference on nothing means nothing.”
    This seemingly simple saying is rooted in a complex and
curious truth: Venture capitalists in the United States
overwhelmingly employ convertible preferred stock as the means
by which they make investments.1 It has also given rise to a
cottage industry in academic circles, namely, attempts to explain
the existence and prevalence of preferred stock in venture capital
investment. Financial economists have attempted to explain it by
advancing efficiency models regarding the allocation of control
between investor and entrepreneur, signaling with regard to an
entrepreneur’s talents, and alignment of investor and entrepreneur
incentives.2
    The tenaciousness of this puzzle has only magnified regard for
the old saw, but has also fueled new attempts at an explanation.
Dissatisfied with the efficiency explanations advanced by
economists, legal scholars Ronald Gilson and David Schizer have
advanced a law-based explanation. Gilson and Schizer assert that
the ubiquity of preferred stock in venture capital investment in the
United States, when combined with the recognition of its virtual
absence outside of the United States, suggests a tax explanation
that is understandably beyond the ken of financial economists.
These legal scholars demonstrate that preferred stock, when
combined with the use of common share incentive stock options,
and the spread potential permitted by U.S. tax law, creates a
mechanism by which venture capitalists can offer portfolio
company founders intense incentive compensation that is actually
subsidized by the government.

1
    See PAUL GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE (1999).
2
    Richard C. Green, Investment Incentives,
The Preference for Preferences                                Page 3


     This Article advances another law-based explanation for the
existence of preferred stock in venture capital investment, namely,
a transactions cost justification. Reporting the results of interviews
with venture capitalists, entrepreneurs, and industry lawyers, this
Article demonstrates that the central features of convertible
preferred stock in the venture capital setting, liquidation and
dividend preferences, actually reduce the transactions costs
associated with the most common outcome of venture capital
investment: failure.
     Contrary to the old saw, and despite its surprising staying
power, the reasons advanced by venture capital industry insiders
for the existence of convertible preferred stock is the fact that a
great percentage of portfolio firms neither completely fail nor exit
with the fanfare and success of an IPO. Instead, many companies
enjoy a prolonged, lukewarm existence. In the circumstances
where such existence exceeds the investment horizon of the
venture investor, these companies are either sold, restructured, or
dismantled in a manner that recoups some portion or even all of the
initial capital investment. It is under these circumstances that the
liquidation preference becomes most meaningful.
     Similarly, if the old saw is to be believed, dividend preferences
are meaningless. The venture capitalists contributing to this
Article insist that nothing could be further from the truth.
According to industry insiders, the real function of dividend
preferences is another legal one, namely, to prevent interim
“looting” of invested capital by entrepreneurs. While every
entrepreneur contributing to this Article insisted that such looting
safeguards were unnecessary, they all acknowledged this function
of dividend preferences.
     These transactions cost explanations for the existence of the
liquidation and dividend preferences at the heart of convertible
preferred stock challenge the tax justification advanced by Gilson
and Schizer. Importantly, it does not suggest that Gilson and
Schizer are wrong. Instead, it suggests that they are correct to
suspect a legal justification, one that would not be obvious to
financial economists. They are also correct when they identify the
tax benefits associated with convertible preferred stock. But the
Gilson and Schizer tax explanation rests heavily upon the truth of
the old saw. In short, for the Gilson and Schizer tax justification
for the existence of preferred stock to have substantial explanatory
force, dividend and liquidation preferences must be, as they and
Page 4                                                  Marcus Cole


the old saw assert, meaningless. Industry insiders, including
venture capitalists, venture capital lawyers, entrepreneurs, and
investors, all insist that this is patently untrue.
     This Article proceeds in five parts. Part I reviews the pervasive
use of convertible preferred stock, and the two key components at
its core, namely, liquidation and dividend preferences. Part II
surveys the current pantheon of explanations for the existence and
ubiquity of convertible preferred stock, with special attention to the
first and only legal explanation advanced thus far. That
explanation, the Gilson and Schizer hypothesis, is explicated here.
     Part III presents the results of interviews with industry
participants, and their explanations for the existence of convertible
preferred stock with dividend and liquidation preferences. These
explanations demonstrate that while the tax advantages outlined by
Gilson and Schizer are important ancillary benefits, they are not
the principal driving force behind the preference for preferences.
Instead, it is the control of assets at reduced cost that explains why
venture capitalists insist upon convertible preferred positions.
According to industry insiders, dividend preferences reduce agency
and monitoring costs by preventing looting of invested capital by
entrepreneurs, while liquidation preferences permit control of
assets in the large percentage of cases where portfolio firms under
perform without failing completely.
     Part IV concludes with an observation about the relationship
between the operation of dividend and liquidation preferences in
equity-backed firms, and that of instruments proposed by legal
scholars for debt financed firms. Specifically, the literature of the
early 1990’s proposing more efficient, privately crafted
mechanisms for restructuring debt-financed corporations envisions
a world strikingly similar to the actual use and function of
convertible preferred stock in the world of equity-financed firms.
This Part concludes by posing, without answering, a question for
further exploration: “If convertible preferred stock performs so
many functions so efficiently in firms backed by venture capital,
then why don’t we see these instruments more widely employed in
larger, publicly traded firms?”
     An introductory note about methodology and exposition is in
order. The explanations presented in this Article were compiled
through a series of interviews and informal conversations with
over a dozen venture capitalists, lawyers specializing in venture
capital transactions, entrepreneurs who have secured venture
The Preference for Preferences                                        Page 5


capital funding, and limited partner investors in venture capital
funds. For competitive and reputational reasons, most of the
participants in this study insisted upon strict confidentiality and
anonymity. For this reason, quotes are presented without
attribution.



    I. THE UBIQUITY OF CONVERTIBLE PREFERRED STOCK IN VENTURE
                        CAPITAL INVESTMENT


    One of the most distinctive features of venture capital
contractive is the pervasive use of convertible preferred stock.3 In
an empirical study of venture capital contracts involving over 200
investment rounds for 118 portfolio firms, Steven Kaplan and Per
Stromberg demonstrate that 189 of these rounds, or 94.5 percent,
involved convertible preferred stock as the vehicle for investment.4
Convertible preferred is an instrument that gives the holder rights
that are senior to those of common shareholders, but a right to
“convert” these preferred shares into common shares at some
future point in time.5 Like creditors of the firm, preferred
shareholders enjoy a position senior in the capital structure to that
of common shareholders. But like common shareholders and
unlike creditors, preferred stock grants its holders an interest in the
upside potential of the firm.
    The seniority of preferred stock confers on its holders a priority
right with respect to the distribution of assets upon a firm’s
liquidation. This “liquidation preference,” is a typical and defining
feature of preferred stock in virtually any setting, but in venture
capital, it frequently enjoys two particular features. First, it can
involve “multiples.” A liquidation preference multiple requires
payment to the holder of the preferred stock an amount equal to the
investor’s paid in capital, multiplied by some factor. It is not
uncommon, for example, to see venture capital investments
involving a “4X multiple,” meaning that the holder of the preferred

3
 Steven Kaplan & Per Stromberg, Financial Contracting Meets the Real World: An
Empirical Analysis of Venture Capital Contracts,
4
    Id.
5
    Gompers & Lerner, *
Page 6                                                  Marcus Cole


shares is entitled to four times its capital investment upon
liquidation of the issuing company. Liquidation preference
multiples vary from investment to investment, but empirical
studies have shown that virtually all preferred stock positions in
venture investments enjoy some form of liquidation preference.6
     Second, preferred stock can be either “participating” or “non-
participating.” Participating preferred stock entitles its holders to
“participate in,” or share, alongside common shareholders
whenever common shareholders are paid upon a liquidation event.
Technically, participation is not a liquidation “preference,” since it
merely entitles preferred and common shareholders alike to enjoy
liquidation distributions pari pasu.
     Another distinctive feature of the liquidation preference in
venture capital settings is the automatic conversion trigger. These
clauses provide for automatic conversion of the preferred shares
into common shares upon the occurrence of an IPO. While these
terms differ with respect to the particulars of each placement, they
commonly “require the IPO to exceed a designated common stock
price, dollar amount of proceeds, and/or market capitalization for
the company.”7
     A second provision at the heart of convertible preferred stock is
the dividend preference. Dividend preferences require that in the
event that distributions of firm assets are made to firm equity-
holders, the holders of preferred stock must receive the distribution
first before common shareholders are entitled to anything.
     This dividend preference can be structured in one of two
different ways. Preferred shares can be either cumulative or non-
cumulative. Cumulative preferred shares are entitled to expect
periodic dividend distributions that might be declared but not paid.
If and when a dividend is eventually paid, preferred shareholders
are entitled to all dividends that were withheld, or accumulated,
over time, before common shareholders can receive any
distribution at all. In the context of venture capital, most preferred
positions bear a non-cumulative dividend preference. This means
that while the preferred shareholder is entitled to dividend
distributions before common shareholders can receive anything,
these dividends do not accumulate over time.


6
    Kaplan & Stromberg
7
    Kaplan & Stromberg, p. 21.
The Preference for Preferences                                                   Page 7


    A third characteristic typically associated with preferred stock
is with respect to control rights within the corporate governance
structure of the underlying firm. Multiple classes of stock enable
firms to separate control rights from cash flow rights. A preferred
class enables venture capital investors to insist upon board seats,
while preserving cash flows for the firm, its managers, or its
employees. This set-up enables investors to reduce the monitoring
costs associated with firm decision-making to prevent managerial
opportunism, while preserving the profit incentive for managers to
perform.8
    These three features, the liquidation preference, the dividend
preference, and the allocation of control rights, are standard
features of convertible preferred stock in venture capital
placements. Current explanations for the existence and prevalence
of convertible preferred stock have focused on one or more all
three. Yet most of these explanations acquiesce to the wisdom of
the old saw that the first two, liquidation and dividend preferences,
are generally meaningless terms. This Article now turns to a more
detailed exploration of these explanations.




    II. THE CURRENT EXPLANATIONS FOR THE USE OF CONVERTIBLE
                        PREFERRED STOCK


    The extensive literature attempting to explain the prevalence of
convertible preferred stock is itself a testament to the intractability
of the puzzle.9 These explanations can be grouped into two types:
efficiency justifications advanced by financial economists, and a
tax-law-practice justification advanced in a collaboration of two
eminent legal scholars. Each type of explanation focuses on the
ability of one or more of the characteristics of convertible preferred

8
  Several studies have shown that while venture capitalists often bargain for a capital
structure that would entitle them to board seats, and frequently control of the board, many
actually refrain from exercising board control. Several explanations, ranging from the
market value of board independence, to dilution of general partner (VC) time and
oversight, have been postulated, but no study has definitively determined why this
phenomenon is so common in pre-IPO firms.
9
 Steven Kaplan & Per Stromberg, Financial Contracting Meets the Real World: An
Empirical Analysis of Venture Capital Contracts,
Page 8                                                       Marcus Cole


stock to solve one or more contracting problem presented by the
venture capital environment. Yet, because these explanations are
so very different, each type of explanation will be treated in turn.


         A. Financial Economists’ Explanations for the Existence of
             Convertible Preferred Stock in Venture Capital

     Financial economists advance three explanations for the
prevalence of convertible preferred stock in venture capital
placements, namely (1) incentive and signaling models; (2) control
rights models; and (3) models involving the allocation of control at
exit points. All of these models attempt to find an efficiency
explanation for the widespread use of convertible preferred stock.
     Incentive and signaling models assert that the true explanation
for the existence of convertible preferred stock lies in its ability to
prevent signal manipulation by firm managers.10 These theories
start with the assertion that the issuance of debt typically signals
management belief in the upside potential of the firm, while the
issuance of equity typically signals management uneasiness with
future prospects. From this it follows that managers seeking to
manipulate investors, and recognizing the signals that particular
instrument import, may issue a particular instrument for the
purpose of sending the wrong signal. Issuance of debt, or any type
of instrument with priority over the residual claim of common
stock, for that matter, also bears the the agency costs associated
with leverage. Managers representing or holding the residual
claims on the firm will have an incentive to engage in risk-
preferring activity, since the residual claimants will enjoy all of the
upside of a risky investment decision, but will only bear part of the
shared downside of such decisions. It is for this reason that equity
is frequently characterized as a “call option on the value of the
firm.”11
     A firm issuing a convertible instrument deprives its
management of the opportunity to manipulate the signals typically
associated with instrument issuance. Convertible shares
effectively postpone an investor’s key decision, the form of

10
  See, e.g., Francesca Cornelli & Oved Yosha, Stage Financing and the Role of
Convertible Debt,
11
     Brealey & Meyers,
The Preference for Preferences                                          Page 9


investment, until a later date, when more or better information may
be available. This delayed decision-making authority reduces
management’s ability to conceal private information from potential
investors, since once the truth is revealed, investors can act.
Similarly, convertible instruments align management incentives
with those of investors. Even the most opportunistic managers
cannot know ex ante the position of investors after the firm
chooses among its investment possibilities. The possibility that the
investor will ultimately share pari pasu in the fruits of winning
investments, but will enjoy priority in the event of losing ones,
aligns the incentives of managers with the investors holding the
convertible instruments.12
    Financial economists have also developed what we can call
“control rights” models to explain the use of convertible preferred
stock in venture capital investment. These explanations rest upon
the separation of control rights from cash flow rights made
possible by the issuance of more than one class of equity.13
Convertible preferred, in the venture capital context, can enjoy
disproportionate voting power, and with it, board control. This in
turn permits venture investors to prevent dilution of their position
in subsequent financing rounds, and to wield authority over
important investment decisions.14
    One other type of model advanced by financial economists
takes the control rights theory to its ultimate conclusion,
attempting to explain the existence of convertible preferred stock
by focusing its ability to allocate control over exit decisions
between the entrepreneur and the investor.15 This model,
developed by Thomas Hellmann, suggests that the role of
convertible preferred stock is to permit the investor greater
leverage in the final stages of the investment with regard to exit
alternatives. Convertible preferred with enhanced voting power
gives the venture capitalist substantial board presence to affect
disposition determinations. Similarly, the automatic conversion
trigger at the IPO stage grants the investor participation with the
common, while the acquisition alternative and the liquidation
12
  See James F. Strnad, ______. See also Leslie M. Marx, Contract Renegotiation in
Venture Capital Projects,
13
  Thomas Hellmann, IPO’s, Acquisitions, and the use of Convertible Securities in
Venture Capital, ___ . See also Kaplan & Stromberg, supra note ___, at 3.
14

15
Page 10                                                 Marcus Cole


preference, with its multiples, give the investor an enhanced return.
Either event places the venture capital investor in an enhanced
bargaining position vis a vis the entrepreneur, who may now be
enticed to stay on in a transition in exchange for a reduced
multiplier or an affirmative IPO vote.16
    These three types of explanatory models suffer from three
significant weaknesses. First, and most importantly, they presume
that multiple classes of stock are necessary to accomplish the
division between control rights and cash flow rights that serve as
the core of their explanations. But as many commentators have
noted, the allocation of control rights could as effectively be
accomplished through other devises, including an “all-common”
capital structure, providing for uniform cash flow rights, but
coupled with a shareholders agreement governing the allocation of
control rights.17 In short, the first weakness of the financial
economists models is that they prove too little with respect to
investors’ choice of instruments.
    The second difficulty for the economists’ models is that they
assume too much control with respect to exit alternatives,
regardless of the method ultimately preferred by the parties. The
choice between an acquisition and an IPO is not merely a function
of the bargaining zone between investor and entrepreneur. An
acquisition requires a willing third party acquirer, who is unlikely
to invest in a firm in which valuable human capital is unwilling to
cooperate with the sale. Likewise, an IPO requires a willing
underwriter, which might be difficult to find in the event that the
venture capitalist opposes the offering. Even Hellmann
acknowledges that there are alternative methods of accomplishing
the same exit control allocation without using preferred equity.
Again, the second problem with the economists’ models is that
they fail to prove the need for convertible preferred stock to
perform the desired function.
    A third shortcoming of the economists’ models is that they fail
the test of universality. While convertible preferred stock is
ubiquitous in venture capital transactions within the United States,
it has only recently begun to become a part of the venture capital
landscape in Canada, and is virtually non-existent in venture
capital transactions elsewhere. It is this absence of universality

16
     Hellmann, supra note ___, at
17
The Preference for Preferences                                               Page 11


that begins to cast doubt on the enterprise of finding an efficiency
explanation for the existence of convertible preferred stock. It is
this same shortcoming that might suggest to other scholars that a
legal factor, and not an economic one, is where the solution to this
puzzle is to be found.


            B. “A Tax Explanation for Convertible Preferred Stock”

     Legal scholars Ronald Gilson and David Schizer question the
explanatory power of the models advanced thus far by financial
economists. The note the weaknesses of the models already
outlined above, but add one more. Gilson and Schizer fault the
financial economists for conferring far too much significance on
the liquidation and dividend preferences that lie at the heart of
convertible preferred stock. If the liquidation and dividend
preference have no value in most venture capital placements, as the
old saw asserts, then, Gilson and Schizer argue, “incentives and
signaling should be similar to those in an all-common capital
structure.”18 In other words, if the firm has no value when it fails,
then the venture capitalist is not protected by a preferred position,
and may just as well have held common stock. On the other hand,
if the true protection on the upside lies in the ability to convert to
common stock, then the venture capitalist may as just as well have
held the common shares all along in that scenario too.
     Given the absence of a practical, efficiency-based justification
for the use of convertible preferred stock, and recognizing the
absence of universality, Gilson and Schizer posit that the true
justification must be legal rather than economic. Contract
standardization may explain the momentum of the choice, but
cannot explain the initial choice of convertible preferred stock as
an investment vehicle.19 And even “boilerplate momentum” cannot
explain the persistence of a choice if a more profitable alternative
can be found.20 To Gilson and Schizer, the choice of convertible

18
     Gilson & Schizer, supra note ___, at 887.
19
  See Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate
Contracting (or “The Economics of Boilerplate”), 83 Va. L. Rev. 713, 718-740
(suggesting that path dependence explains the choice of contract terms).
20
  See Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency,
70 Va. L. Rev. 549, 592-609 (1984) (detailing the cost barriers to introduction of new
capital market instruments).
Page 12                                                  Marcus Cole


preferred stock, to have staying power in a competitive market,
must have a cost-benefit advantage rooted in law. The obvious
culprit is one that escaped the notice of financial economists: U.S.
tax law.
    Gilson and Schizer posit that U.S. tax law creates
circumstances that make convertible preferred stock more
profitable than other, functionally equivalent, instruments.
Specifically, the issuance of convertible preferred stock to venture
capital investors lowers the tax burden on management’s incentive
compensation. Furthermore, because incentive compensation is
key to reducing the agency and monitoring costs associated with
any human capital dependent undertaking, including venture
capital contracting, this tax reduction must be central to the
pervasiveness of convertible preferred stock.
    The tax benefit of convertible preferred stock arises as follows.
When venture capital is invested in a portfolio firm, the investor
and the entrepreneur managers recognize the need for incentive
compensation. This compensation, under U.S. tax law, can take
one of two forms: (1) “compensatory return,” or (2) “investment
return.” U.S. tax law also provides dramtically disparate treatment
for these two types of return. First, compensatory return is
typically taxed much earlier than investment return. Second,
compensatory return is taxed as ordinary income, while a much
lower rate applies to investment return, particularly if the
manager’s stock qualifies as a “small business stock.” These
differences, with all else being equal, lead managers to prefer
investment return treatment over compensatory return treatment.
    To gain investment return treatment, managers must make a
tradeoff. They must pay taxes due on current profits in order to
receive deferred, investment-rate taxation on the appreciation. If
the current profits of the firm are low or zero, as is often the case
for early to mid stage startups, then this trade off is worth it. The
trade off is even more valuable the lower the initial valuation of the
portfolio firm’s common stock at the time that the manager
receives it. The real difficulty is that the more capital the venture
capitalist invest in a round, the more valuable is the underlying
equity as represented by the firm’s common stock.
    To get around this difficulty, the portfolio firm must issue two
classes of stock; a class of common shares, that are artificially
assigned a low value, and a preferred class, artificially assigned a
high value. These valuations are artificial in the sense that they
The Preference for Preferences                                Page 13


bear little relationship to cash flow rights. Instead, the parties
would have the IRS believe that the control rights associated with
the preferred class justifies its relative value. Gilson and Schizer
recognize that such a strategy is aggressive and risky, but that
regulators have yet to attack this widespread practice.
    This separation of valuation plays a role when the manager’s
compensation is in the form of stock options too. Although there
are generally two varieties of option compensation, “incentive
stock options” (“ISO’s”) and “nonqualified stock options”
(“NQO’s”), both benefit from a low grant-date valuation. First, a
low valuation enables options to qualify for the favorable tax
treatment afforded ISO’s. Second, even if options do not qualify
as ISO’s, a low valuation can allow managers holding tax
disfavored NQO’s to minimize their tax disadvantages, as long as
they can claim low valuation at the time of exercise. This can
occur, for example, if the NQO’s are exercised on their grant date.
    Gilson and Schizer argue that the tax savings afforded
management incentive compensation amounts to a tax subsidy to
venture capital backed firms. This subsidy, in turn, represents a
bargaining range, which is divided between managers and
investors. This value is large enough to obviate any incentive to
develop instruments other than convertible preferred stock to
accomplish their ends. Furthermore, as Gilson and Schizer
effectively demonstrate, other devices are much less effective at
accomplishing the convenient mix of investment potential and tax
advantages that convertible preferred stock affords.
    The Gilson and Schizer tax explanation for the pervasiveness
of convertible preferred stock is attractive for several reasons. It
combines counterintuitive nuances of tax law with “real world”
sophistication to solve a puzzle seemingly beyond the reach of the
finest financial economists models. Nevertheless, it leaves one
nagging question unanswered. If Gilson, Schizer, and the old saw
are to be believed, then liquidation and dividend preferences are
largely superfluous. But if they are superfluous, then what
explains their persistence, and why haven’t the competitive
pressures of the industry developed adequate substitutes for the
insignificant functions they perform?
    Gilson and Schizer acknowledge only one scenario in which
the contents of convertible preferred stock can have any
significance whatsoever. That scenario, which they dub the
“zombie cases,” involve portfolio firms that have not succeeded,
Page 14                                                      Marcus Cole


but have not failed so miserably as to be utterly worthless. The
define the zombie firm as “a venture whose business essentially
breaks even.”21 In these scenarios, Gilson and Schizer confess
some role for convertible preferred stock. As they put it:

        Admittedly, the [liquidation and dividend] preference
        would have a real effect in . . . protecting the venture
        capitalists’ investment in zombie cases. Even if this
        scenario constitutes only a subset of cases, lawyers
        presumably would still want to provide for it, since
        lawyers are supposed to worry about even remote risks.
        Yet while the zombie scenario certainly helps to explain
        the preference, we wonder whether it looms so large in
        the parties’ minds as to be the sole, or even the main,
        determinant of capital structure; after all, the stereotypical
        risky venture-backed firm is either a “home run” or a total
        failure.22

    This assertion by Gilson and Schizer summarizes the necessary
condition for their tax explanation. In order for the tax justification
to carry principal explanatory force, dividend and liquidation
preferences must be relatively meaningless. Venture capitalists,
their lawyers, entrepreneurs, and other industry insiders could not
disagree with this supposition more.



       III. VENTURE CAPITALISTS’ EXPLANATIONS FOR THE USE OF
                   CONVERTIBLE PREFERRED STOCK


    As has been demonstrated above, the question as to why
venture capitalists in the United States typically employ
convertible preferred stock as their medium of investment has
proven to be a surprisingly difficult one to answer. One approach
to the question that has yet to be tried by financial economists or
legal scholars, is to put the question to the industry actors


21
     Gilson & Schizer, supra note ___, at 884.
22
     Gilson & Schizer, supra note ___, at 884.
The Preference for Preferences                                                Page 15


themselves.23 Assembled below are responses by venture
capitalists, venture capital lawyers, entrepreneurs, and other
industry insiders, to questions posed in a series of interviews and
informal conversations, from October 2003 to March, 2004.24
While the emphasis and complexity of their answers varied
dramatically from one person to the next, two characteristics of
their answers were quite uniform. The first was the quickness with
which they responded, and the second was the substance of the
answer. All of the parties questioned indicated that both
liquidation and dividend preferences were very important terms.


           A. Venture Capitalists’ Explanations for their Use of
                    Convertible Preferred Stock

     First, it should be acknowledged that there are various manners
by which the question at issue might be put, and it should also
come as no surprise that the answer one receives is highly
dependent upon the form of the question. When venture capitalists
are asked “why do you use convertible preferred stock as the
means by which you make investments?,” most venture capitalists
ran through a list of benefits, most of which focused on the option
value of convertible preferred stock. As one venture capitalist put
it, “one of the hardest things in the world to do is put a value on a
product that has yet to be sold, and that’s essentially what you are
doing when you do a valuation of the company that makes the
product.” According to this partner, the use of convertible
preferred stock is driven by the its ability to afford the investor
more information before making key investment decisions.
     When the question is narrowed to “why do you use liquidation
preferences?” or “why do you use dividend preferences?”, the
answers became more focused and, in some cases, curt. For
example, when one venture capitalist was asked why he might
insist upon a liquidation preference, his immediate response was
“you’re kidding me, right?” Another venture capital partner at a
large, prestigious firm responded with even less generosity. “Why
do we use liquidation preferences? Let me explain it this way. We
23
  Steven Kaplan & Per Stromberg, Financial Contracting Meets the Real World: An
Empirical Analysis of Venture Capital Contracts,
24
  As noted earlier, many interviewers insisted upon anonymity before agreeing to answer
questions. Accordingly, all quotations used are without attribution.
Page 16                                                   Marcus Cole


use liquidation preferences in case we have to face the possibility
of LI - QUI - DAY - SHUN.”
    According to these two venture capitalists, liquidation
preferences are a very real and important part of any deal.
Liquidation events are typically defined in every deal as ones
involving the dismantling of the firm, but also, and more
importantly, a sale or acquisition of the firm or its assets. Since the
latter is a fairly common event, liquidation preferences appear to
loom much larger in the minds of venture capitalists than
academics assume. When asked what percentage of portfolio firms
are likely to trigger a liquidation preference, a third venture
capitalist put it this way: “if I have ten companies, I expect that
only one is likely to be a home run, one or two are likely to be
complete busts, but the other seven or eight may have some value
that I can do something with.” “Liquidation preferences come into
play,” according to another venture capital partner, “in this in
between cases.”
    One venture capitalist explained the operation and rationale
behind multiples used in conjunction with liquidation preferences.
“When I insist on a ‘four-X’ multiple, I’m telling [the
entrepreneur] what I expect my return to be.” He added that the
function of the multiple was to provide a real return in an event,
typically an acquisition of the company or its technology, that did
not take the form of an IPO. He also noted that after the “bubble,”
“VC’s were more likely to moderate their multiples, some as low
as one-x.” He said the reason for this was to align the incentives of
the entrepreneur with those of the investor. “If I tell a guy that he
owes me four times my investment, I’m essentially calling him my
employee rather than my partner. I want him to know that we are
in this together.”
    Another venture capitalist explained that liquidation preference
multiples were a good bargaining chip where firm specific human
capital is involved. “If I want to sell the company, and the
manager is out of the money because of my liquidation preference,
I can get him to buy in to the deal if I agree to scale back on my
multiples in a way that puts him into the money.” Another venture
capitalist referred to this practice as a “cash out,” characterized by
a payment to the entrepreneur to keep his firm specific talents or
expertise in place, thereby giving the firm a going concern value to
an acquirer. He explained “this is easier to do if I am owed four-X
rather than three.”
The Preference for Preferences                                                Page 17


     Another important feature of convertible preferred stock to
venture capitalists are their dividend preferences. As noted earlier,
dividend preferences give the holder of preferred shares the right to
receive a dividend before common shareholders. All of the
venture capitalists who were asked about the reasons underlying
the need for dividend preferences acknowledged that the reasons
for this term were less obvious than those for liquidation
preferences. “When I insist on a dividend preference,” one partner
explained, “I’m not looking for dividends. What I’m looking for is
protection against this guy walking off with my money.” In other
words, the dividend preference protects the venture capital investor
from looting on the part of the manager/entrepreneur.
     All of the venture capitalists with whom I spoke were in
agreement on this point. According to one of them, “dividend
preferences eliminate the possibility that the management is going
to use my investment in a way that is not in the interests of all of
us.” To him, dividend preferences were a way of reducing the
risks associated with placing funds under the control of someone
else.
     When asked why venture capital placements typically involve a
non-cumulative, rather than a cumulative dividend preference, the
answers were more varied. One suggested that a cumulative
dividend preference and liquidation preferences were fungible
terms. “I can get my money either way, so it doesn’t matter
how.”25 Another venture capitalist expressed the view that actual
payout was not the purpose of the dividend preference. “Whether
it is cumulative or not doesn’t really matter to me. I just need to
know that the common [shareholders] can’t get paid before I do.”
Yet another venture capitalist believed that a cumulative dividend
preference was, in his terms, “nonsensical.” “If you have a
cumulative dividend, all that means is that you’ll never have a
dividend, since the company won’t make any money to begin with,
and by the time its making money, you’ll get yours some other
way.” One venture capital lawyer noted that while he almost never
sees cumulative dividends in venture capital placements, he said he
sees them a lot in other private equity deals. He did not have an
explanation for why this might be the case.
     When the Gilson and Schizer thesis is explained to venture
capitalists, the response was strikingly uniform. “The problem is
25
  Recent research by Kate Litvak regarding the terms of venture capital contracts shows
that this is a widely shared view. See Kate Litvak, [Willamette L. Rev.]
Page 18                                               Marcus Cole


that they are taking a binary approach to this,” was the way one
venture capitalist put it. Another venture capitalist was much more
generous. “They are right about the tax advantages, everybody
knows about those.” This venture capitalist went on to add “but
the real reasons why we use convertible preferred stock is because
it allows us to do a whole range of things that nothing else can do
for us.”


      B. Lawyers’ Explanations for the Existence of Convertible
               Preferred Stock in Venture Capital

    When venture capital lawyers are asked the question as to why
convertible preferred stock is used in venture capital deals, their
answers were much closer to the explanations of both the financial
economists, and Gilson and Schizer. The first answer offered by
one lawyer was “when you’re dealing with people who have a lot
of money at risk, they don’t want to take any more chances than
necessary. You go with what’s tried and true.” Another lawyer
expressed the sentiment that “I get paid to cover all the bases.”
Still another noted that “what do I say if something happens, and I
didn’t use a term that everyone else uses?”
    One lawyer with a venture capital practice outside of Silicon
Valley noted that transactional law is slow to change. “When I
started writing these things, I had to come up with a lot of the
terms on my own. Years later, I see contracts coming to me using
the language that I originally drafted.”
    When the question of liquidation and dividend preferences are
put to them more explicitly, the lawyers’ answers mirrored those of
venture capitalists. Most of them agreed that liquidation
preferences are among the most important terms in a venture
capital deal. “You have to understand that the liquidation
preference gets triggered by a whole range of events, including an
acquisition.” That, according to another, makes these clauses one
upon which venture capitalist clients pay particular attention. One
lawyer reported that “when it comes to most of the terms, there are
lots that they rely upon me to handle, but when it comes to
something like liquidation preferences, that’s one they will
negotiate themselves.”
The Preference for Preferences                                Page 19


     Another lawyer expressed the same idea differently. “I usually
take the term sheet and draft from that, but liquidation preferences
are almost always part of the negotiation before I write it up.”
     Many of the lawyers had a different posture with respect to
dividend preferences. These, many of them insisted, were lawyer
driven terms. As one noted, “dividend preferences are things that
we often have to put into a deal to protect our clients.” Another
said “everyone assumes that ‘preferred stock’ means ‘dividend
preference.’” All of the lawyers interviewed said that there is
typically much less discussion of dividend preferences than
liquidation preferences when consummating a venture capital deal.
One lawyer explained the difference as a product of the nature of
the two types of terms. “A dividend preference can only take one
of two forms, cumulative or non-cumulative, but liquidation
preferences can vary all over the place.” He went on to explain
that because liquidation multiples can be different from deal to
deal, the parties will naturally give them more attention.
     When the Gilson and Schizer thesis was put to the lawyers
questioned, their responses varied. One lawyer said, “whenever I
do a deal, I always have one of my tax partners review it and sign
off on it, but we never get into the relative tax advantages of other
ways of doing things.” Another lawyer was already familiar with
the Gilson and Schizer argument, and was in full agreement that
the tax treatment of ISO’s was one of the reasons for using
convertible preferred stock. “But,” he added, “they are wrong to
say that liquidation and dividend preferences don’t matter. They
only don’t matter in a small number of cases, and you can’t know
at the outset which ones those are going to be.” Yet another
lawyer was less generous to the tax explanation. “The reason why
these deals are done is to make money, not save taxes. If we can
save our clients taxes, that’s great, but that’s gravy.”


           C. Entrepreneurs’ Explanations for the Existence of
           Convertible Preferred Stock in Venture Capital

    It should not come as a surprise to anyone familiar with
relationships within the industry that entrepreneurs take a very
cynical view of venture capital deals and venture capitalists. As
one, very successful entrepreneur put it, “whenever you want to
understand why a venture capitalist does anything, you can start
Page 20                                                  Marcus Cole


with one word: ‘greed.’” All of the entrepreneurs interviewed,
including one who has now become a venture capital investor
himself, expressed the similar sentiments. One entrepreneur,
insisting upon strict anonymity, put it this way: “Some of them
[meaning, venture capitalists] have become some of my closest
friends, but as a group, those are the greediest, most selfish,
heartless bastards you’ll ever meet.” Yet another successful
entrepreneur suggested that “no one in this relationship is fooled;
they know what its about, and we know what its about: money.”
    Despite this cynicism, all of the entrepreneurs agreed that the
quality of the start-up experience is a product of the “quality” of
the venture capital firm involved. While all of the entrepreneurs
with whom I spoke had started at least one very successful
company, they all credited a “good” venture capitalist with much
of their success. Each one had counterexamples of horror stories,
however, involving friends or even themselves.
    When asked about the reasons for the use of convertible
preferred stock, all of the entrepreneurs understood the alignment
of incentives that is involved with convertibility. One entrepreneur
acknowledged that “it gets everyone working on the same page.”
They all also expressed the understanding that most venture
capitalist expect a preferred position. One said “I can’t imagine a
deal where the VC doesn’t take preferred.”
    When asked specifically about liquidation preferences, the
entrepreneurs were unanimous. “Liquidation preferences matter to
them [meaning, venture capitalists] more than anything else.”
Another said, “it really the one thing I’ve seen VC’s walk away
from a deal for.” Yet a third, very successful entrepreneur said,
“I’ve seen deals where negotiations over liquidation preferences
hold up the deal for weeks.”
    When asked why they thought VC’s were so focused on
liquidation preferences, all of the entrepreneurs made similar
comments. One said, “absent an IPO, that’s how they make their
money.” Another said that when the IPO market dries up, VC’s
can’t adjust their investment horizon to wait for it to pick up again.
“Sometimes a sale is the only exit option available.”
    When entrepreneurs were asked about the significance of
dividend preferences, all of the entrepreneurs understood the anti-
looting purpose. One said, “they do it because they don’t trust
anybody.” Another said that “its made very clear at the outset that
The Preference for Preferences                                 Page 21


dividend preferences prevent the management from taking money
out.”
    When presented with the Gilson and Schizer thesis, all of the
entrepreneurs showed some familiarity with the tax advantages of
the two tiers of stock. One entrepreneur said that the venture
capitalist in his first deal explained this to him as though it were a
selling point. “He explained to me everything that he was getting,
and everything that I was getting, and the tax advantages that went
with my options was one of them.” None of the entrepreneurs,
however, recalls ever explicitly bargaining over tax savings, or
even discussing alternative capital structures. One noted that this
did not preclude the possibility that the tax savings were implicitly
“on the table.”


              D. Summary of Industry Insider Explanations

    This Part has presented the comments and views of venture
capital industry insiders with respect to the role of convertible
preferred stock in venture capital placements generally, and of the
significance of dividend and liquidation preferences in particular.
Contrary to the key assumption underlying the tax explanation
offered by Gilson and Schizer, all of the interviewees asserted that
dividend and liquidation preferences are important parts of a
venture capital contract. Dividend preferences perform an “anti-
looting” function, serving to reduce the monitoring costs
associated with venture capital investment. Likewise, liquidation
preferences perform a very different, but very important function.
These preferences provide venture capital investors some upside
potential in the absence of a “home run” IPO. Instead, investors
can recoup anywhere from a portion to multiples of their paid in
capital upon a recognized liquidation event. The most common of
these, a sale of the company or its principal assets, is not,
according to industry insiders, as rare as Gilson and Schizer assert.
    In short, convertible preferred stock performs a host of
functions in venture capital investment. All of the explanations
offered by financial economists, as well as Gilson and Schizer, are
acknowledged by industry insiders to play some part in the choice
of convertible preferred stock as the medium of investment. All of
the terms of the venture capital contract appear to have
significance to the actors involved. Taken together, liquidation
Page 22                                                   Marcus Cole


and dividend preferences afford venture capital investors
protections that are difficult or expensive to replicate through other
means. These protections in each case represent a form of asset
control. The next Part of this Article considers the similarities of
these control rights over assets to those found in structures used in
debt finance.



IV. WHY ISN’T CONVERTIBLE PREFERRED STOCK MORE COMMON?


    Given the multiple talents of convertible preferred stock, the
next question is an obvious one. “If convertible preferred stock is
so effective at performing so many functions, why don’t we see it
more often in publicly traded or debt financed companies?”
    The truth is that we do see some use of convertible preferred
stock in publicly traded companies. According to Standard &
Poor’s Compustat database, some ten percent of publicly traded
companies have an outstanding class of convertible preferred
stock.26 Yet, in the world of publicly traded and debt financed
companies, convertible preferred stock is more of an exception
than the rule. Since convertible preferred is not completely foreign
to the world of publicly traded companies, some functional or
regulatory difference may explain the gap. Also, since many
publicly traded companies are partially financed with debt, it may
be the case that convertible preferred stock is less valuable in debt
financed firms than in equity backed ones. It is also possible that
debt financing is so different from equity financing that the
functions performed by dividend and liquidation preferences are
either superfluous or irrelevant.


         A. Are there Parallel Structures to liquidation and dividend
                      preferences in Debt Finance?

    While the answers to questions differed from person to person,
interviewees in this study used several words in common to
describe the function of dividend and liquidation preferences.

26
     [Confirm COMPUSTAT calculations].
The Preference for Preferences                                                Page 23


Many of the interviewees used the term “control” to describe the
central purpose of both liquidation and dividend preferences. They
also frequently used the phrase “control of the assets” to explain
the importance of each. This usage both reaffirms the intuitions of
the financial economists modeling these transactions, and calls to
mind parallels in the world of debt finance.
    One legal scholar, George Triantis, has called into question
whether any of the structures we witness in the world of venture
capital are truly unique to it.27 He notes that virtually every
function performed by structures in equity finance have an
equivalent in debt financed firms. Although he does not directly
analyze them, the Triantis thesis implies that dividend and
liquidation preferences will be absent in the environment of debt
finance where their functions are duplicated by other structures. In
order to understand what structures or institutions might replicate
the function of dividend and liquidation preferences, we first need
to gain an abstracted view of what those functions might be.
    From the explanations given by venture capitalists, their
lawyers, and the entrepreneurs who have done business with them,
some of the functions of preferences are clear. Liquidation
preferences allow venture capital investors to control all of the
assets of the firm at a point at which conversion to common is
either unprofitable or undesirable. For example, in the event of a
possible acquisition, a liquidation preference, with multiples
exceeding firm value, allow the venture capitalist to negotiate a
sale without having to convert to common, and the concomitant
dilution accompanying conversion. In other words, a venture
capitalist with a liquidation preference exceeding firm value is not
unlike a secured creditor with a blanket lien on all of the firm’s
assets. In the event of a sale, in either case, the investor owns the
whole firm. In the case of a blanket lien, the senior creditor can
“bid its debt.” Since no one will exceed this bid where the firm is
worth less than what the senior creditor is owed, the senior creditor
can do what it wills with the firm and all of its assets.
    The scenario is quite similar where a venture capitalist holds a
liquidation preference with, say, “three X” or “four X” paid in
capital. If the firm is worth less than the investor’s liquidation


27
  See George Triantis, Financial Contract Design in the World of Venture Capital, 68 U.
Chi. L. Rev. 305, 322 (2001)(reviewing PAUL GOMPERS & JOSH LERNER, THE VENTURE
CAPITAL CYCLE (1999)).
Page 24                                                  Marcus Cole


preference, then the venture capital investor, in essence, owns the
whole firm.
    It is probably to the advantage of both the senior creditor, or
the lead venture capitalist, to strike some bargain with management
to preserve the going concern value of the firm, particularly if firm
specific human capital is involved. In either event, however, the
end result is the same: the investor owns the entire company, and
may do with it whatever it wants.
    The dividend preference of convertible preferred stock has
slightly different parallels in the world of debt finance. If venture
capitalists, their lawyers, and entrepreneurs are all to be believed,
then the dividend preference serves as a mechanism to reduce
monitoring costs, reducing the opportunities for looting. Direct
parallels to this function are more difficult to find. It could be, as
Triantis suggests in other work, that secured credit performs this
function.28 By requiring regular payments and routine inspections
of collateral, security interests in capital equipment perform a
monitoring function that actually reduces the necessity of creditors
to step in and survey the portfolio firm from top to bottom.29
    The dividend preference may perform a function similar to that
of security interests in capital equipment. By imposing a legal
barrier on distributions from the operational capital of the firm,
dividend preferences obviate the need for constant inspection of
capital levels. Managers, subject to regular reporting
requirements, cannot make distributions of invested capital without
going so far as to commit a crime.30
    Critics of this analogy may note that secured credit requires
regular payments that have no parallel in the world of equity-
backed start-up firms. Indeed, Triantis himself points to regularity
of payments as a monitoring device.31 Since start-up firms are
unlikely to be able to make any dividend distributions, let alone
regular ones, in early periods, then the cash stream cannot, as this
argument runs, serve the same function performed by a security
interest.
    The response to the cash flow argument is that it elevates form
over function. If the true function of the cash stream, in the

28
     See George Triantis, [the secured credit article]
29
     Id. at ___.
30

31
     Triantis, supra note ___, at ___.
The Preference for Preferences                                               Page 25


secured credit context, is to relax the need for monitoring, then the
parallel stands if some other device similarly reduces monitoring
costs. In the environment of the venture capital-backed firm,
regular reporting requirements and benchmarks, when combined
with the dividend preference, appears to provide similar
monitoring benefits as those provided by cash payments in the case
of secured credit.
     Despite these similarities, there is one difference between debt-
financed firms and equity-financed firms that looms large. In the
world of debt finance, the common pool problem of too many
claims on too few assets is solved by bankruptcy. In the world of
equity finance, the problem of too many claims on too few assets is
solved by a venture capitalist.32
     The common thread between these two solutions to a common
pool problem rests in the fact that in each, a single decision-maker
governs disposition of the assets. In bankruptcy, a trustee or
debtor-in-possession makes asset deployment decisions. In the
case of a less than successful equity-financed firm, a venture
capitalist makes the call. In either event, the tragedy of the
commons is solved with all of the assets under the control of one
decision-maker, both of whom have an incentive to make the most
of them.
     Failed debt-financed firms have an additional distinction from
failed equity financed firms. In the debt finance setting, the single
decision-maker is presumed to be available only through public
provision. A failed firm files for bankruptcy in publicly subsidized
courts, and eventually emerges with a publicly enforced court
order. In the venture capital setting, liquidation and dividend
preferences circumvent a resort to publicly provided institutions. It
is true that violations of contractual terms or property rights will
result in public enforcement, but such an event would be a
departure from the norm of private resolution.
     With such striking similarities between debt finance and equity
finance, another question presents itself. Why can’t debt financed
firms resolve asset control and insolvency issues the way venture
capital contracting has so successfully done?
     One proposal in the debt finance literature appears to have
attempted such an approach. In his article, Financial and Political

32
  For an analysis of venture capital structures in bankruptcy, see William W. Bratton,
Venture Capital on the Downside: Preferred Stock and Corporate Control, 100 Mich. L.
Rev. 891 (2002).
Page 26                                                             Marcus Cole


Theories of American Corporate Bankruptcy, Barry Adler has
advanced a financial instrument that would resolve corporate
insolvency without resort to publicly subsidized bankruptcy.33
     Adler’s private bankruptcy scheme is amazingly simple. When
a corporation is chartered, it establishes two classes of equity. The
first class is identical to what we typically call “common stock.”
The second class, however, is a class that the firm refers to as
“chameleon equity.”34 The distinguishing characteristic of
chameleon equity is that its holders are entitled to a fixed payment,
and only a fixed payment, so long as the firm is solvent enough to
pay them. Chameleon equity, in turn, will be issued to investors
willing to extend what is typically thought of as “credit” to the
firm. As long as the firm is able to “service” this “debt,”
chameleon equity holders have the same rights as traditional
creditors. When he firm is unable, however, to service this fixed
obligation over a prolonged period of time, however, then the
common equity holders are forced to relinquish their interest in the
firm. They are “out of the money.” Simultaneously, the
chameleon equity holders become the residual claimants on the
firm, their chameleon equity having “changed its color” from
looking like debt to looking like equity.35 In short, without
petitions, or trustees, or expensive valuation proceedings, the firm
with a chameleon equity capital structure has seamlessly
performed the function of a bankruptcy proceeding. Chameleon
equity has transferred control of the firm from the hands of the
shareholders and its management to the senior “creditors.”
     This description of Adler’s chameleon equity should call to
mind the operation of convertible preferred stock with liquidation
and dividend preferences. When the firm does well, the common
shareholders and their management team reap the rewards of good
performance. When the firm underperforms, however, the firm
and all of its assets revert to the senior investors who have
bankrolled the firm’s efforts. In both cases, the firm and all of its
assets change hands seamlessly.
     It may be the case that in both environments, the new residual
owners of the firm want the human capital with firm-specific

33
  Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy,
45 Stan. L. Rev. 311 (1993).
34
     Id.
35
The Preference for Preferences                                 Page 27


talents to stay in place. This negotiation does not, in either event,
change the underlying dynamics of the capital structure. In both
cases, convertible preferred stock and chameleon equity solve the
problem of firm underperformance without expensive lawyers or
legal proceedings. In other words, convertible preferred stock,
with its liquidation and dividend preferences, reduce the
transactions costs associated with failure. When Adler confronts
the “Chicago question,” namely, “if this is so efficient, why don’t
we see it in the real world?,” he can now answer, “we do, in the
real world of venture capital.”
    The analogy between convertible preferred stock and
chameleon equity brings us full circle to the question with which
this Part began, namely, “if convertible preferred stock (or
chameleon equity) performs so many valuable functions so
uniquely, then why don’t we see it in publicly traded companies?”
One remaining explanation is that a possible regulatory barrier
prevents the development of these efficient instruments in public
markets.


     B. Do Regulatory Differences Explain the Difference Between
    the Use of Convertible Preferred Stock in Public and Private
                              Equity?

    [This section summarizes the regulatory environment for
convertible preferred stock in publicly traded companies. It
concludes by noting that while this regulatory environment
circumscribes the use of convertible preferred stock, it does not
necessarily inhibit it. Some other factors must contribute to the
limited use of convertible preferred in public companies.]


                             V. CONCLUSION


    It is widely recognized that one of the most distinctive features
of venture capital contracting is the pervasive use of convertible
preferred stock. There is also equally wide recognition that its
ubiquity is difficult to explain. Financial economists have
attempted efficiency justifications, all of which have had
irredeemable shortcomings. Legal scholars have advanced a tax
Page 28                                                 Marcus Cole


explanation for the pervasiveness of convertible preferred stock,
but this explanation depends heavily upon the irrelevance of
dividend and liquidation preferences.
    By presenting the explanations of venture capitalists, their
lawyers, and several successful entrepreneurs, this Article has
demonstrated that the assumption underlying the tax explanation
for liquidation and dividend preferences is false. Instead, it shows
that liquidation and dividend preferences are important and
meaningful terms in venture capital contracts, performing valuable
functions. Dividend preferences prevent management from looting
invested capital, while liquidation preferences provide asset control
and reduced transactions costs in the event of firm under
performance. Since liquidation events, like the sale of the portfolio
firm or its assets, are a common rather than rare occurrence,
liquidations preferences loom large in the minds of the parties to
the transaction, and are a frequent point of contention in the
negotiations leading up to investment.

				
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