Governing by Exit: Default Penalties and Walkaway Options in Venture Capital Partnership Agreements

When investors sign venture capital partnership agreements, they do not immediately turn over the entire committed capital. Instead, they contribute capital in stages, as needed by the fund. Typically, investors have at least three years to decide whether to honor their commitment obligations fully. To discourage investor defaults, venture funds employ a complicated system of financial penalties. Since venture funds could eliminate default risk altogether by demanding that investors contribute the entire amount initially, the question * Assistant Professor, University of Texas Law School. I thank Bernie Black, Brian Cheffins, Victor Fleischer, Mark Gergen, Michael Klausner, Ronald Mann, Larry Sager, Charlie Silver, Jay Westbrook, and participants in the annual meeting of the Canadian Law and Economics Association for comments. I especially thank the venture capitalists, venture capital lawyers, and representatives of institutional investors who were willing to answer my questions and in some cases provide the limited partnership agreements that are the focus of this Article. Those who have given me permission to name them include: Alan Austin at Silverlake Partners; Micah Avni at Jerusalem Global Ventures; Johnatan Axelrad at Wilson, Sonsini, Goodrich & Rosati; Craig Dauchy at Cooley, Godward; Ken DeAngelis at Austin Ventures; Andrei Manoliu; Mark Tanoury at Cooley, Godward; Susan Woodward at Sand Hill Econometrics. Finally, my thanks to Daniel Hutzenbiler of Willamette Law Review for the excellent editing job. All errors are, of course, mine. 772 WILLAMETTE LAW REVIEW [40:771 arises: why do venture funds engage in this elaborate staging scheme? I suggest that staged contributions are a governance tool. The threat of investor walkaway creates incentives for venture capitalists to perform well. The walkaway right, however, can undermine a fund’s liquidity and threaten its ability to invest in a timely fashion. Thus, my governance hypothesis predicts that the strength of investor walkaway rights reflects a tradeoff between governance concerns and liquidity concerns. The higher are agency costs associated with the fund, the more liberal the walkaway regime. I test this hypothesis by studying a sample of 38 venture capital partnership agreements. I find that the strength of investor walkaway rights is related to several measures of expected agency costs. Venture funds run by more prominent VCs give investors weaker walkaway rights. Similarly, venture funds where VC compensation is more heavily performance-based make capital withdrawals more difficult. Competing explanations receive little or no support. Also, different fund families, represented by the same law firm, use different provisions, so these provisions are not mere “boilerplate,” copied by lawyers from one agreement to the next.

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