Archives For

Anything by Henry Hansmann is worth reading and then revisiting from time to time. Recently, I revisited Hansmann’s article with Reinier Kraakman The Essential Role of Organizational Law, 110 Yale L.J. 387 (2000), which contends that organizational law has a more important function than offering owners limited liability against firm debts – it shields firm assets from the owners’ individual creditors. This “affirmative asset partitioning,” which is the reverse of limited liability, “reduces the cost of credit for legal entities by reducing monitoring costs, protecting against premature liquidation of assets, and permitting efficient allocation of risk.”

The article notes that this function of organizational law is underappreciated in comparison to limited liability. I think that’s right, at least in the classroom. My sense is that students leave a standard business associations course knowing something about limited liability (and veil piercing), but little about affirmative asset partitioning as its corollary. I am persuaded to teach these topics as sort of a one-two punch from now on. Another question to explore is whether affirmative asset partitioning would be attainable by contract in the absence of organizational law. The article argues no, and therefore organizational law is essentially property law rather than contract law. This could also lead to an interesting discussion…

On another note, I plan to spend the weekend working on my article on angel investing, so this will be my last post. Thanks to all of my wonderful hosts here at TOTM, as well as those who have commented on my posts – I’ve really enjoyed the past two weeks!

Rent a CFO?

Darian Ibrahim —  26 February 2007

This recent article in the NYT (log in required) caught my eye. It discusses the growing market for temporary financial services to companies. Since SOX this market has grown by 68% to $8.9 billion, and is expected to grow another 10% this year. The companies looking for temporary help include nonprofits, public corporations, and start-ups.

While the post-SOX boom suggests that public companies are the largest user of these services, the article also notes that start-ups have been renting CFOs for the past fifteen years. This practice makes a lot of sense from the entrepreneur’s perspective. Start-ups are short of cash and may be unable to keep a permanent finance person on staff. But when it comes time to solicit angel or venture capital funding, bringing in an expert can help entrepreneurs with financial projections in a business plan and during negotiations over valuation, all at an hourly rate. This hire-as-needed model works well for lawyers – why not for finance types? The article was quite rosy on the idea, but I wonder if there are any downsides? Perhaps liability concerns for the temp (the article mentions the possible need for a D&O policy)?

Structuring Start-ups

Darian Ibrahim —  23 February 2007

Choice of entity is a standard topic in courses on small or start-up businesses. The usual materials cover the basic tax, liability, and governance issues relevant to the choice. These materials are fine for pointing students toward the LLC or S corporation forms for the typical small business, or “lifestyle” firm, as both forms enjoy limited liability and flow-through taxation. (Although my one quibble here is that insufficient attention is devoted to the ultimate choice between LLCs and S corps, where items such as the LLC self-employment tax can be relevant.) The general advice doesn’t hold, however, for start-ups seeking or potentially seeking venture capital.

In this paper, Vic Fleischer explains why start-ups are a different animal, and why they actually prefer C corps despite double taxation and the inability of shareholders to use significant corporate losses during the early years (think R&D expenses). The most interesting reason, to me, requires looking to the ultimate investors in venture capital funds. The VC funds are limited partnerships, so any gains/losses that flow through the start-up to the VC fund also flow through the VC fund to the fund’s limited partners. The majority of limited partners are tax-exempt entities such as pension funds, endowments, and foundations. These investors don’t care about flow-through losses, because they have no tax liability to offset. Also, they try to avoid flow-through gains, which are unrelated business taxable income (UBTI) that, because these entities are tax-exempt, can trigger an audit. Therefore, these investors prefer start-ups to be C corps, venture capitalists will aim to please these favored investors, and start-ups will aim to please the venture capitalists.

On another note, I think Vic’s article is instructive on the craft of writing. It’s tempting to find irrational reasons for start-ups to form C corps (we’ll never have losses!), and as Joseph Bankman documented in The Structure of Silicon Valley Start-Ups, 41 UCLA L Rev 1737 (1994), a “gambler’s mentality” probably does have something to do with it. But when sophisticated players like venture capitalists are involved, I tend to favor rational over irrational explanations for behavior. In fact, I’m taking this approach in a new paper to explain the puzzling behavior of angel investors (no draft yet, although blogged about at Conglomerate).


Darian Ibrahim —  20 February 2007

I teach at a relatively small school, which has its great advantages. One of those is that faculty get to teach a range of courses in their respective fields – in my case business law. But this can also present challenges. Sometimes non-“core” courses, such as my law and entrepreneurship course (which focuses on venture capital but also covers other issues relevant to start-ups), are taught on a rotating basis. Because upper-level students have only one chance to take the course, I don’t require prerequisites, although I strongly suggest business associations and the basic tax course as co-requisites. Inevitably, students come in with wide variations in their knowledge of corporate and tax law, not to mention the economics/IO literature. To mitigate the differences, I grade on the basis of an in-class presentation and short paper on a particular topic (on the theory that everyone can get up to speed on one topic). But my lectures do have to be accessible to all without boring the students with advanced training (or me!).

I’m interested to hear how other profs handle this problem.  I think the approach may depend on whether the course is of the seminar variety, with no exam, or a standard exam course.  So next year when I add securities regulation to the mix, for example, I will probably require business associations as a prerequisite unless students have some sort of advanced training that’s an adequate substitute.

Venture Debt

Darian Ibrahim —  19 February 2007

Thanks to everyone at TOTM for having me.  I’m a big fan of this blog, and look forward to visiting here for a short time.

I was intrigued by a recent article in the Wall Street Journal on venture debt, or the practice of lending to start-ups as opposed to the standard practice of investing for equity.  According to the article, debt made up 7% (or nearly $2 billion) of the money invested in venture-backed companies last year, up from 2% the year before.  The article also shows that venture debt was nearly $4 billion at the height of the venture capital market in 2000.

Venture debt is interesting — and puzzling.  Investments in start-ups are risky, plagued by extreme levels of uncertainty, information asymmetries, and agency costs.  A VC fund invests in a number of start-ups in the hopes that its portfolio will contain the next Google or eBay, to offset the inevitable duds.  VC-fund investors expect a better-than-market rate of return, and most profits come from the IPOs of a small number of highly successful start-ups (like Google and eBay).  The VC model works because of the potential for a huge upside.  Can venture debt work, when by definition it does not offer this huge upside?

Perhaps.  While the start-up is solvent, venture debt commands a high interest rate (double digits, according to the WSJ article).  The article also mentions that lenders get warrants, convertible into equity, which allows them to share (to some extent) in a huge upside.  Also, if the start-up liquidates, debt has first priority over the preferred stock of VCs.  Therefore, venture debt makes sense by offering some upside, although of a different makeup, and by limiting the downside.  But venture debt also presents problems.  First, the typical high-tech start-up must spend available cash on R&D and other growth activities, not interest payments.  Venture debt is unlikely to be the “patient capital” that start-ups need for long-term success.  Second, and perhaps more importantly, venture debt is likely to complicate a start-up’s chances with VCs.  VCs fund relatively few companies.  If a start-up comes with venture debt, I can’t imagine it’s very attractive to the VCs, whose money would go to pay off the debt during solvency, and who would now be second in liquidation preference during insolvency.  Unless the amount of venture debt is sufficient to eliminate the need for venture capital – and by current levels it is nowhere close – do start-ups carrying venture debt really have a chance for long-term success?  Venture debt may make sense for some companies, but in general it seems like a bad idea.