Document Type

Article

Publication Date

1-2024

DOI

https://doi.org/10.1086/724389

Abstract

We develop a model of venture capital contracting and use it to evaluate an emergent set of judicial precedents in corporate law, which we label the Trados doctrine. In our model, founders hold common stock, while venture capital investors hold convertible preferred stock. We show that preferred shareholders have inefficient incentives to liquidate low-valued firms and to continue high-valued firms, while common shareholders inefficiently favor the opposite. The extent of incentive misalignment depends on the firm’s intrinsic and outside valuations, and it is most severe around preferred shareholders’ liquidation preference and conversion point. Although legal liability rules can rectify these misalignments, they can only do so categorically when management prioritizes preferred shareholders’ interests. The Trados doctrine, however, generally obligates management to prioritize common shareholders’ interests. Our model offers a precise mechanism for how capital structure, corporate governance, and legal doctrine jointly determine firms’ value.

Disciplines

Banking and Finance Law | Business Organizations Law | Law | Securities Law

Creative Commons License

Creative Commons Attribution-NonCommercial 4.0 International License
This work is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License

Comments

© 2024 by The University of Chicago.

Center/Program

Ira M. Millstein Center for Global Markets and Corporate Ownership

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