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77 Chi.-Kent L. Rev. 211 (2001-2002)
The Venture Capital Investment Bust: Did Agency Costs Play a Role - Was It Something Lawyers Helped Structure

handle is hein.journals/chknt77 and id is 227 raw text is: THE VENTURE CAPITAL INVESTMENT BUST: DID AGENCY COSTS PLAY A ROLE? WAS IT SOMETHING LAWYERS HELPED STRUCTURE? JOSEPH BANKMAN* AND MARCUS COLE** INTRODUCTION The rise of the venture capital industry has attracted the at- tention of a wide array of scholars. Scholars in the Law and Economics tradition have focused on the legal structure of start-up corporations backed by venture capital funds and explained that the corporations' structure is a response to the problem of agency costs.' Venture capitalists possess expertise and information that their individual and institutional investors lack. These investors hire the venture capitalists to select investments and monitor the behavior of the managers/entrepreneurs of the start-ups. Venture capitalists possess the power, through the corporate charter, to remove managers at will. The carrot of stock options motivates the managers, but they are worried about the stick that the venture capitalists wield as monitors. Perhaps more significantly, managers must repeatedly return to the venture capitalists for funding. Venture capitalists are restrained from abusing their power over entrepreneurs because they must relinquish their monitoring role after an initial public offering.2 Additionally, venture capitalists are restrained from abusing their power in two ways: by the requirement that the venture * Ralph M. Parsons Professor of Law and Business, Stanford Law School. ** Associate Professor of Law, Stanford Law School. We thank Richard Brooks, Richard Craswell, Mariano-Florentino Cuellar, Ron Gilson, Joseph Grundfest, Michael Klausner, Robert Sitkoff, Richard Steinberg, Jeff Strand, and participants in the Northwestern University School of Law Faculty Workshop, and the Stanford Law School Faculty Workshop for their thoughtful comments and suggestions. 1. There is a substantial body of literature on this subject, dating back as least as far as William A. Sahiman, The Structure and Governance of Venture-Capital Organizations, 27 J. FIN. ECON. 473 (1990); see also PAUL A. GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE (1999); Anat R. Admati and Paul Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. FIN. 371 (1994); Paul A. Gompers, Optimal Investment, Monitoring and the Staging of Venture Capital, 50 J. FIN. 146 (1995); Josh Lerner, Venture Capitalists and the Oversight of Public Firms, 50 J. FIN. 301 (1995). 2. See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. FIN. ECON. 243 (1998).

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