Abstract
This paper evaluates the primary legal and financial mechanisms that help support the development of a venture capital market. Specifically, we argue that emulating the organization and contractual pattern of the US venture capital market could enhance the development of the European venture capital market. We first show that the modernization of the ‘venerable’ limited partnership form, based on US experiences, offers substantial contracting benefits for investors and is crucial to the operation of a mature venture capital market. We then argue that the emergence of more efficient limited partnership structures can emerge from jurisdictional competition between European states. We argue that the United Kingdom, which has recently embarked on general and limited partnership law reform, could, in light of the competitive lawmaking environment that the ECJ has opened up, be in the best position to enter the competition within the EU. It then explores the prominent features of the UK special Limited Partnership statute, which makes it possible for venture capitalists to organize their contractual relations that are best suited to the characteristics of the venture capital market. Finally, our analysis provides an understanding of the competitive forces that shape legal change, which has implications for the ongoing debate in Europe over the reform of limited partnership law and related business forms.
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Cf. J. Bankman and R.J. Gilson, ‘Why Start-ups?’, 51 Stanford Law Review (1999) p. 51.
See B. Black and R.J. Gilson, ‘Venture Capital and the Structure of Capital Markets: Banks versus Stock Markets’, 47 Journal of Financial Economics (1997) pp. 243–277; R.J. Gilson, ‘Globalizing Corporate Governance: Convergence of Form or Function’, 49 American Journal of Comparative Law (2001)pp. 329–358; C. Keuschnigg and S.B. Nielsen, Start-ups, Venture Capitalists, and the Capital gains Tax, Center for Economic Studies & Ifo Institute for Economic Research (CESifo) Working Paper No. 742 (2002); E.B. Rock, ‘Greenhorns, Yankees and Cosmopolitans: Venture Capital, IPOs, Foreign Firm & U.S. Markets’, 2 Theoretical Inquiries in Law (2001) pp 711–744.
Cf. W.W. Bratton, ‘Venture Capital on the Downside: Preferred Stock and Corporate Control’, 100 Michigan Law Review (2002) pp. 891–945.
American executives and research personnel often resign to join new ventures. Americans have an inborn tolerance of risk, whereas Europeans are generally more risk-averse. In addition, failure is not something to be ashamed of in the United States; on the contrary, failure is appreciated nearly as much as success. See C.J. Milhaupt, ‘The Market for Innovation in the United States and Japan: Venture Capital and the Comparative Corporate Governance Debate’, 91 Northwestern University Law Review (1997) pp. 865–898.
See Black and Gilson, supra footnote 2. They argue that a well-developed stock market that allows venture capitalists to exit through an initial public offering (IPO) is critical to the existence of a vibrant venture capital market.
See Milhaupt, supra footnote 4. Empirical research shows that independent venture capital firms are willing to make early-stage investments. In the United States, most venture capital firms are independent private partnerships, whereas in Europe most tend to be affiliated to banks, pension funds, corporations and insurance firms.
See, e.g., Keuschnigg and Nielsen, supra footnote 2.
See D.J. Cumming and J.G. Macintosh, Crowding Out Private Equity: Canadian Evidence, Working Paper (2002).
See Keuschnigg and Nielsen supra footnote 2.
Cf. B. Cassiman and M. Ueda, Optimal Project Rejection and New Firm Start- Ups, Centre for Economic Policy Research (CEPR) Discussion Paper No. 3429 (2002) (arguing that reducing the cost of entry does not always increase the start-up rate when it leads incumbent and established firms to reduce their research and development expenditures): ‘Contrary to common belief, we find that the development of venture capital markets and stock markets, or subsidies towards new firms do not always increase the start-up rate. This happens when the cannibalization effect is strong. When a start-up becomes less costly, the established firm expects that rejecting projects is more likely to lead to the start-up of competing firms. Because of this negative externality, the established firm reduces the R&D expenditures and consequently less ideas will be generated.’
See A. Admati and P. Pfeiderer, ‘Robust Financial Contracting and the Role of Venture Capitalists’, 49 Journal of Finance (1994) pp. 371–402; M. Baker and PA. Gompers, The Determinants of Board Structure and Function in Entrepreneurial Firms, Working Paper (2000); J. Bankman, ‘The Structure of Silicon Valley Start-ups’, 41 UCLA Law Review 41 (1994) pp. 1737–1768; Barry, et al., ‘The Role of Venture Capital in the Creation of Public Companies’, 27 Journal of Financial Economics (1990) pp. 447–471; P.A. Gompers, ‘Optimal Investment, Monitoring, and the Staging of Venture Capital’, 50 Journal of Finance (1995) pp. 1461–1489; M. Gorman and WA. Sahlman, ‘What Do Venture Capitalists Do?’, 4 Journal of Business Venturing (1989) pp. 231–248; Th. Hellmann, ‘The allocation of control rights in venture capital contracts’, 29 RAND Journal of Economics (1998) pp. 57–76; LA. Jeng and P.A. Wells, ‘The Determinants of Venture Capital Funding: Evidence Across Countries’, 6 Journal of Corporate Finance (2000) pp. 241–289; S.N. Kaplan and P. Stromberg, Financial Contracting Theory Meets The Real World: An Empirical Analysis of Venture Capital Contracts, National Bureau of Economic Research (NBER) Working Paper 7660 (2000); J. Lerner, ‘Venture Capitalists and the Oversight of Private Firms’, 50 Journal of Finance (1995) pp. 301–318; W.A. Sahlman (1990), ‘The Structure and Governance of Venture-capital Organizations’, 27 Journal of Financial Economics (1990) pp. 473–521.
Case C-212/97, Centros Ltd. v. Erthvers-og Selskabbsstyrelsen, [1999] ECR 1–1459, [1999] 2 CMLR 551 (Centros); Case C-208/00, Überseering BV v. Noradic Construction Company Baumanagement GmbH (NCC), [2002] ECR I-9919 (Überseering); and Case C-167/01, Kamer van Koophandel en Fabrieken voor Amsterdam v. Inspire Art Ltd (NL), [2003] ECR 1 (Inspire Art). These decisions are available at <http://europa.eu.int/cj/en/content/juris/index.htm> (last visited 24 February 2004).
See A. McCallum, ‘Key Developments at the Heart of the European Union’, 14 EuroWatch (2002) p. 5 (arguing that despite sustaining an even steeper decline, the United States still raised three times more venture capital than the European Union in 2001).
See Rock, supra footnote 2. But see E.B. Rock, Coming to America? Venture Capital, Corporate Identity and U. S. Securities Law, University of Pennsylvania Law School, Institute for Law and Economics Research Paper No. 02–07 (2001) (arguing that despite the fact that Delaware markets Delaware incorporation all over the world, US securities law allows and invites foreign firms to present themselves as Americans without incorporating in the United States).
See Black and Gilson, supra footnote 2.
Venture capitalists consider trade sales as the most important exit vehicle for venture capital finance. In fact, for many markets, IPOs are the least probable exit strategy for venture capitalists. Cf. Cumming and Macintosh, supra footnote 8.
See Rock, supra footnote 2.
See European Commission, Risk Capital: A Key to Job Creation in the European Union (1998), p. 7 (‘[m]any good European ideas — themselves the result of expensive public investments in education and research — end up being developed in the United States where capital, know-how and the business environment are more conducive to their development and success. It means the migration and loss of some of Europe’s best talent and best ideas.’).
Although Gilson suggests piggybacking, he is aware that entrepreneurs are the most important factor. See Gilson, supra footnote 2.
Different Rock, supra footnote 2: ‘The decision to incorporate in the U.S., or to set up a corporate headquarters in the Valley, or to seek investments from prominent Silicon Valley venture capitalists, may be important not so much in and of themselves, but because they teach the entrepreneurs what it takes to succeed and they signal to investors that this is a company that understands what it takes to succeed today.’
See Jeng and Wells, supra footnote 11. See also the European Commission, supra footnote 18 (‘there is also evidence of strong regional fragmentation in the EU as well, with an overemphasis on ‘domestic’ equity placements.’). To be sure, data shows that European firms have listed on the NASDAQ as means of exit.
See J.C. Coffee jr., ‘The Future as History: The Prospects for Global Convergence in Corporate Governance and Its Implications’, 93 Northwestern University Law Review (1999) pp. 673–674 (‘[t]he accelerating pace of this migration may seem surprising when one realizes that foreign issuers incur extensive regulatory costs when they enter the U.S. markets and that most have never thereafter made securities offerings in the United States. Why then do they list? Arguably, companies in smaller markets gain liquidity and possibly also some international recognition and prestige from a U.S. listing. But greater motivation probably lies in the finding, repeatedly observed by financial economists, that the announcement of a dual listing on a US exchange by a foreign firm typically increases the firm’s share value.’).
See J.A. Adler and F. Monod, ‘American Investors Participating in European Venture Capital Funds’, 14 EuroWatch (2002) (noting that US investors are increasingly being invited to participate in European Venture Capital Funds).
Cf. G. Hertig, ‘Western Europe’s Corporate Governance Dilemma’, in T. Baums, K.J. Hopt, and N. Horn, Corporations, Capital Markets and Business in the Law, Liber Amicorum Richard M. Buxbaum (London, Kluwer Law International 2000) pp. 265–282.
Three groups of players can be distinguished in the venture capital industry: outside investors, venture capital funds and entrepreneurs. Traditionally, the relationship between the first two players is managed and organized in a limited partnership. The venture capitalist is the general partner who will invest the limited partners’ money in several rapidly growing and highly innovative businesses.
See J. Lerner and A. Schoar, The Illiquidity Puzzle: Theory and Evidence from Private Equity, National Bureau of Economic Research (NBER) Working Paper 9146 (2002). In Europe, however, venture capital funds are often an affiliation to a corporate group. See A. Schwienbacher, An Empirical Analysis of Venture Capital Exits in Europe and the United States, Working Paper (2002) pp. 30–31.
See P.A. Gompers and J. Lerner, The Venture Capital Cycle (Cambridge, The MIT Press 1999).
See A. Wong, Angel Finance: the other venture Capitalist, working paper (2002) (explaining that angel investors, which occupy a different segment of the market, employ a different level of institutional and control mechanisms than VCs).
See Sahlman, supra footnote 11.
See Gompers and Lerner, supra footnote 27.
See Sahlman, supra footnote 11.
See P.A. Gompers and J. Lerner, ‘Money Chasing Deals? The Impact of Fund Inflows on Private Equity Valuations’, 55 Journal of Financial Economics (2000).
See Gompers and Lerner, supra footnote 27.
See R.J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience, John M. Olin Program in Law and Economics Working Paper 248 (2002).
See P. Myners, Institutional Investment in the UK: A Review (2001). p. 155 (arguing that English limited partnership law is particularly cumbersome because of strict constraints on the number of partners and on limited partners’ involvement in investment advisory work).
See section 5.
See supra footnote 12.
W.J. Carney, ‘The Political Economy of Competition for Corporate Charters’, 26 Journal of Legal Studies (1997) p. 327; Code of Conduct Group, Report form the Code of Conduct Group on Business Taxation to Ecofin Council, 29 November 1999.
See, e.g., W.F. Ebke, ‘Centres — Some Realities and Some Mysteries’, 48 American Journal of Comparative Law (2000). pp. 625–628 (explaining that competitive lawmaking has become a dominant theme in European company law); B.R. Cheffins, Company Law: Theory, Structure, and Operation (Oxford, Clarendon Press 1997) pp. 421–451 (explaining the potential role of the market for incorporations in deepening European economic integration).
See F. Scharpf, Governing in Europe, Effective and Democratic? 9 (Oxford, Oxford University Press 1999) pp. 101–103.
See E. Wymeersch, ‘Centros: A Landmark Decision in European Company Law’, in Th. Baums, K.J. Hopt, and N. Horn, Corporations, Capital Markets and Business in the Law, Liber Amicorum Richard M. Buxbaum (London, Kluwer Law International 2000) (arguing that competition is taking place on the basis of differences in tax laws, labour laws and environmental laws in Europe; business forms are not an essential component of regulatory competition). Cf. E. Ferran, Company Law Reform in the UK, Working Paper (2001) (noting that limited evidence considered in the context of the UK’s company law review supports the view that fiscal, operational and macro-economic considerations rather than business organization law are the major considerations in the decision whether or not to locate a business in a given country).
See W.W. Bratton and J.A. McCahery, ‘Tax Coordination and Tax Competition in the European Union: Evaluating the Code of Conduct on Business Taxation’, 38 Common Market Law Review (2001) p. 701.
The spatial concentration is at the heart of the economic geography worldview (economic geography is the study of where economic activity takes place and why), which is underpinned by the ‘new economic geography’ synthesized by M. Fujita, P. Krugman and A.J. Venables, The Spatial Economy, Cities, Regions, and International Trade (Cambridge, The MIT Press 1999). See also N. Crafts and A.J. Venables, Globalization in History: A Geographical Perspective, Centre for Economic Policy Research (CEPR) Discussion Paper No. 3079 (2001) (arguing that the economic geography worldview is fundamental to understanding comparative economic development in the context of globalization). Examples abound of industrial clusters: Silicon Valley (a cluster of high-tech firms), German printing equipment, Italian ceramic tiles, Japanese robotics and American health care equipment.
According to the 2001 Global Competitiveness Report from the World Economic Forum, Finland is the most competitive economy in the world, despite its rigid labour markets, powerful unions and high tax rates. See M.E. Porter, J.D. Sachs. and J.W. McArthur, ‘Executive Summary: Competitiveness and Stages of Economic Development’, in The Global Competitiveness Report 2001–2002, World Economic Forum.
Cf. R. Baldwin and P. Krugman, Agglomeration, Integration and Tax Harmonization, Centre for Economic Policy Research (CEPR) Discussion Paper No. 2630 (2000) (arguing that levying a extremely high tax rate could have catastrophic results for competitive countries; not only because capital will move abroad, but also because that movement will undermine the attractiveness of the particular jurisdiction in a massive and irreversible way).
Cf. A. Breton and H. Ursprung, Globalisation, Competitive Governments, and Constitutional Choice in Europe, Center for Economic Studies & Ifo Institute for Economic Research (CESifo) Working Paper no. 657(2), (2002) p. 4. Thus seen, large firms that made irreversible investments and therefore cannot threaten to move their seat to another jurisdiction could conceivably join other interests in a lobbying process. See also W.W. Bratton and JA. McCahery, ‘The New Economics of Jurisdictional Competition: Devolutionary Federalism in a Second-Best World’, 86 Georgetown Law Journal (1997) pp. 256–259 (discussing ‘yardstick competition models’ that attempt to ameliorate the Tiebout model’s shortcomings by substituting the vote for mobility as the competitive mechanism).
See, e.g., R.J. Gilson, ‘Globalizing Corporate Governance: Convergence of Form or function’, 49 American Journal of Comparative Law (2001) p. 352 (arguing that Centros signals that venture capitalists and entrepreneurs will shop around for the most favourable jurisdiction that offers board control for the venture capitalists and exemption from employee participation rules).
See Cheffins, supra footnote 39, pp. 435–440 (noting that from a tax perspective — the UK does not have franchise tax and charter fees — regulatory competition is largely irrelevant for the United Kingdom).
See, e.g., B. Black, ‘Is Corporate Law Trivial?: A Political and Economic Analysis’, 84 Northwestern University Law Review (1990) (explaining that Delaware’s competitive success is due to its specialized judiciary); R. Romano, ‘Law as a Product: Some Pieces of the Incorporation Puzzle’, 1 Journal of Law, Economics and Organization (1985) (explaining that businesses benefit from Delaware’s well-developed precedent); Cheffins, supra footnote 39, p. 443 (suggesting that the UK’s Chancery Division and a large stock of legal precedent could provide benefits for non-UK firms incorporating in Britain).
Cf. L.A. Bebchuk and A. Cohen, Firms’ Decisions Where to Incorporate, Working Paper (2002).
See J.A. McCahery and E.P.M. Vermeiden, ‘The Evolution of Closely Held Business Forms in Europe’, 26 Journal of Corporation Law (2001).
The double taxation treaties most European countries have entered into act as a disincentive for jurisdictions to engage in regulatory competition. Cf. Cheffins (1997: 435). In addition, incorporation fees and franchise taxes are not easily obtainable in Europe after the ECJ case of Ponente (case 71/91 and 178/91 Ponente Carni Spa [1993] ECR 1947): ‘duties paid by way of fees or dues (…) may be payment collected by way of consideration for transactions required by law in the public interest such as, for example, the registration of capital companies. The amount of such duties, which may vary according to the legal form taken by the company, must be calculated on the basis of the cost of the transaction, which may be assessed on a flat-rate basis.’ See S.F.G. Rammeloo, Corporations in Private International Law, A European Perspective (Oxford, Oxford University Press 2001) pp. 18 and 271.
Jurisdictions which already have a policy and reputation with respect to tax competition, may well have an incentive, supported by a number of organized interest groups, to take up regulatory competition in the context of business forms.
See Schedule 6 of the UK Partnership Bill (The Law Commission and the Scottish Law Commission, Partnership Law, Report on a Reference under Section 3(1)(e) of the Law Commissions Act 1965, 2003).
H. Hansmann and R. Kraakman, ‘The Essential Role of Organizational Law’, 110 Yale Law Journal (2000).
The Law Commission and the Scottish Law Commission, Partnership Law, Report on a Reference under Section 3(1)(e) of the Law Commissions Act 1965, 2003, p. 27: ‘Serious concerns have been expressed to us, particularly by the APP (Association of Partnership Practitioners), that giving legal personality to limited partnerships may affect their tax treatment overseas, and that uncertainty over that issue would affect their usefulness as a vehicle for investment and, therefore, be damaging to the economy.’
Cf. Gilson, supra footnote 34.
See Schedule 10 of the UK Partnership Bill (The Law Commission and the Scottish Law Commission, Partnership Law, Report on a Reference under Section 3(1)(e) of the Law Commissions Act 1965, 2003).
For an overview of the different forms of linkage between statutory forms, see L.E. Ribstein, ‘Linking Statutory Forms’, 58 Law and Contemporary Problems (1995). Besides the situation in which business form statutes are linked in the sense that rules from one statute are applied to a business form created under another statute, Ribstein distinguishes three other variations on linkage: (1) explicit linkage (one statute governs two business forms); (2) implicit linkage (a business form statute imports language from other business form statutes); (3) implicit delinkage (firms may waive certain provisions of a particular business form statute and so create a different business form).
See The Law Commission and the Scottish Law Commission, Partnership Law, Report on a Reference under Section 3(1)(e) of the Law Commissions Act 1965, 2003, p. 300: ‘At the same time, our recommended reforms in relation to the overriding duty of good faith and the statutory statement of duties of disclosure on joining a partnership are as applicable to the special limited partnership as to any other partnership as are many default rules, for example, in relation to the sharing of profits and losses and the management of the business.
See Ribstein, supra footnote 59, pp. 203–206.
See L.E. Ribstein, Confining Fiduciary Duties, Working Paper (2002); D. Rosenberg, ‘Venture Capital Limited Partnerships: A Study in Freedom of Contract’, Columbia Business Law Review (2002).
Commentators note that explicit legal remedies crowd out the positive effect of extra-legal mechanisms. When parties have the explicit opportunity of bringing a remedial action against the opportunistic partner, they seem to rely more on the ‘stick’ and less on the ‘carrot’. See, e.g., E. Fehr and S. Gächter, Do Incentive Contracts Crowd Out Voluntary Cooperation?, USC Center for Law, Economics & Organizational Research Paper No. C01-3 (2001).
See ULPA 2001 §305.
In order to clarify the range of fiduciary duties in special limited partnerships, UK lawmakers could alternatively adopt a provision similar to section 17-1101 of the Delaware Limited Partnership Act, which states that ‘(c) It is the policy of this chapter to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements. (d) To the extent that, at law or in equity, a partner has duties (including fiduciary duties) and liabilities relating thereto to a limited partnership or another partner, (1) any such partner acting under a partnership agreement shall not be liable to the limited partnership or to any such other partner for the partner’s good faith reliance on the provisions of such partnership agreement, and (2) the partner’s duties and liabilities may be expanded or restricted by provisions in a partnership agreement.’ It appears that the popularity of Delaware’s limited partnership is largely due to the flexibility given by this provision. See Kahn v. Icahn, No. CTV.A.15916, 1998 WL 832629 (Del. Ch. Sept. 10, 1998).
See Section 3.
Cf. Ch. J. Goetz and R.E. Scott, ‘The Limits of Expanded Choice: An Analysis of the Interactions between Express and Implied Contract Terms’, 73 California Law Review (1985) p. 296.
Cf. M.D. Goldman and E.M. Filliben, ‘Corporate Governance: Current Trends and Likely Developments for the Twenty-First Century’, 25 Delaware Journal of Corporate Law (2000).
In order to have some flexibility, the UK lawmakers propose that the Secretary of State may by order amend Schedule 6 (by adding, modifying or omitting an activity).
See section 17-303 of the Delaware Limited Partnership Act. ULPA 2001 provides that a limited partner is not personally liable, even if the limited partner participates in the management and control of the limited partnership (ULPA 2001 §303). This approach, however, is wrong headed since it disregards the importance of the governance structure of the limited partnership for venture capital funds.
See clause 66 and 68 in conjunction with Schedule 7 of the UK Partnership Bill. Form a historical point of view, the Law Commission’s recommendation to consider registration as a prerequisite for limited liability is misguided. The mediaeval limited partnership, the commenda, offered investors limited liability and anonymity. By doing so, this business form made it possible for special interest groups, such as the nobles and the clergy, to pour money into lucrative ventures without risking being condemned for usury or violating inhibitions against engaging in trade. See, e.g., J.W. Callison, Partnership Law and Practice, General and Limited Partnerships (St. Paul, West Group 2001).
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McCahery, J.A., Vermeulen, E.P.M. Limited Partnership Reform in the United Kingdom: A Competitive, Venture Capital Oriented Business Form. Eur Bus Org Law Rev 5, 61–85 (2004). https://doi.org/10.1017/S1566752904000618
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DOI: https://doi.org/10.1017/S1566752904000618