Don't Go Chasing Waterfalls: Fiduciary Duties in Venture Capital Backed Startups

Abstract

Venture-capital-backed startups are often crucibles of conflict between common and preferred shareholders, particularly around exit decisions. Such conflicts are so common, in fact, that they have catalyzed an emergent judicial precedent -- the Trados doctrine -- that requires boards to prioritize common shareholders' interest and to treat preferred shareholders as contractual claimants. We evaluate the Trados doctrine using a model of startup governance that interacts capital structure, corporate governance, and liability rules. The nature and degree of inter-shareholder conflict turns not only on the relative rights and options of equity participants, but also on a firm's intrinsic value as well as its value to potential third-party bidders. Certain combinations of these factors can cause both common and preferred shareholders' incentives to stray from value maximization. We show that efficient decisions can be induced by an "anti-Trados" rule that emphasizes preferred shareholders' interests and treats common shareholders as contractual claimants. The Trados doctrine, by contrast, cannot categorically reconcile private interests with value maximization. More generally, our model offers a precise mechanism through which corporate governance and capital structure jointly determine firm value.