Venture Capital Limited Partnership in Financing Innovation A Comparative Study between the U.S. and China Inauguraldissertation zur Erlangung des Doktorgrades des Fachbereichs Rechtswissenschaft der Johann Wolfgang Goethe-Universität, Frankfurt am Main vorgelegt von XIAOXI ZHANG Erstgutachterin: Prof. Dr. Isabel Feichtner Zweitgutachter: Univ.-Prof. Dr. Moritz Bälz Datum der mündlichen Prüfung: 09.02.2017 2017 Table of Contents Table of Contents ........................................................................................................... 1 Abbreviations ................................................................................................................. 6 List of Figures .............................................................................................................. 12 List of Tables ............................................................................................................... 13 Introduction .................................................................................................................. 14 Chapter 1 Innovation and Venture Capital Investments .............................................. 20 1.1 The Worldwide Competition for Innovation .................................................. 21 1.1.1 The Importance of Innovation for the Global Economy ....................... 21 1.1.2 Global Innovation ................................................................................. 24 1.1.3 The U.S. Experience of Success ........................................................... 27 1.1.4 China’s Innovation Evolution ............................................................... 32 1.2 Venture Capital in Financing Innovation ........................................................ 37 1.2.1 Information Asymmetry as the Core Problem of Financing Innovation ........................................................................................................................ 37 1.2.1.1 The Problem of Funding with Debt ............................................ 38 1.2.1.2 The Problem of Funding with Equity ......................................... 40 1.2.2 Venture Capital as the Intermediary ..................................................... 41 1.2.2.1 Screening Investments ................................................................ 42 1.2.2.2 Value-adding Services ................................................................ 44 Chapter 2 Venture Capital Limited Partnership in Financing Innovation ................... 47 2.1 The Venture Capital Limited Partnership ....................................................... 47 1 2.1.1 The Limited Partnership Structure ........................................................ 47 2.1.2 The Venture Capital Cycle and the Reputation Mechanism ................. 50 2.2 The Benefit of Limited Partnership Structure in Financing Innovation ......... 53 2.2.1 The Direct Benefit and Cost of Personal Liability................................ 53 2.2.2 The Entrenchment of Management ....................................................... 55 2.2.3 The Net Benefit of Limited Partnership in Financing Innovation ........ 57 2.2.3.1 Risky Investments ....................................................................... 57 3.2.3.2 Hostile Takeover Defense ........................................................... 59 3.2.3.3 Firm-Specific Human Capital of Managers ................................ 60 2.3 The Cost of the Limited Partnership Structure ............................................... 61 2.3.1 Agency Conflicts between the Venture Capitalist and the Investors .... 61 2.3.2 The Market for Control ......................................................................... 62 2.3.3 Shielding from the Market for Control ................................................. 64 Chapter 3 Solutions to the Agency Problem in the US ................................................ 66 3.1 The Limited Partnership Agreement ............................................................... 66 3.1.1 Covenants in the Venture Capital Limited Partnership ........................ 66 3.1.1.1 Covenants Relating to the Overall Fund Operation .................... 67 3.1.1.2 Restrictions on the General Partner’s Activities ......................... 68 3.1.1.3 Covenants Regarding the Type of Investments .......................... 70 3.1.2 Compensation of the General Partner ................................................... 70 3.1.2.1 Compensation Structure .............................................................. 70 3.1.2.2 Compensation Variation ............................................................. 73 2 3.2 Fiduciary Duties in the United States ............................................................. 75 3.2.1 General Principles of Fiduciary Duties ................................................. 75 3.2.2 Fiduciary Duties in a General Partnership ............................................ 78 3.2.3 Fiduciary Duties in a Limited Partnership ............................................ 82 3.2.4 Fiduciary Duties in a Limited Partnership with a Corporate General Partner ............................................................................................................ 86 3.2.4.1 Limited Partnerships with a Corporate General Partner ............. 86 3.2.4.2 Fiduciary Duties of Directors of the Corporate General Partner 88 3.2.5 Fiduciary Duties in a Venture Capital Fund ......................................... 91 3.3 The Role of Reputation ................................................................................... 93 3.3.1 The Benefit of Control to the Reputation Mechanism .......................... 94 3.3.2 Loosening of Control ............................................................................ 96 3.3.3 The Reputation Constraint without Control ........................................ 101 3.3.3.1 Estoppel Liability ...................................................................... 101 3.3.3.2 Analysis of Reputation Mechanism without Control Rule ....... 103 Chapter 4 A Brief History of Venture Capital in China ............................................ 107 4.1 Stage 1: 1985-1998 The First Wave of Venture Capital Investments .......... 107 4.1.1 The First Encounter (1985-1993)........................................................ 107 4.1.2 Exploring the Path (1993-1998).......................................................... 109 4.2 Stage 2: 1998-2003 When the Bubble Bursts ............................................... 111 4.2.1 Building the Bubble (1998-2001) ....................................................... 111 4.2.2 Cowering Down (2001-2003) ............................................................. 113 3 4.3. Stage 3: 2003-Present Development under Regulation ............................... 115 4.3.1 Breaking the Ice (2003-2005) ............................................................. 115 4.3.2 The Second Wave (2005-2008) .......................................................... 117 4.3.3 A New Era (2008-Now) ...................................................................... 121 Chapter 5 Unique Features of Venture Capital Investments in China ....................... 125 5.1 Investor Activism in China ........................................................................... 125 5.1.1 The Choice of Business Form by Chinese Investors .......................... 125 5.1.2 Active Investors v. Passive Investors.................................................. 133 5.1.3 The Worries of Chinese Limited Partners .......................................... 136 5.2 Remedies for Chinese Limited Partners ....................................................... 140 5.2.1 Limited Partnership Contracting in China .......................................... 140 5.2.1.1 Covenants .................................................................................. 140 5.2.1.2 Compensation ........................................................................... 143 5.2.2 Fiduciary Duties in China ................................................................... 145 5.2.3 The Control Rule in China .................................................................. 151 5.3 The Chinese Culture and Venture Capital Investment ................................. 155 5.3.1 Less Sophisticated Contracting Culture .............................................. 155 5.3.2 The Reputation Mechanism in a Guanxi Society ............................... 158 5.3.2.1 A Guanxi Society ...................................................................... 158 5.3.2.2 The Circle in the Venture Capital World .................................. 161 Chapter 6 The Role of Government in Venture Capital Investment ......................... 164 6.1 The Government’s Involvement in Venture Capital Financing .................... 164 4 6.2 The Venture Capital Guiding Fund ............................................................... 167 6.2.1 The Development of the Venture Capital Guiding Fund .................... 167 6.2.2 Guidance on the Establishment and Operation of Venture Capital Guiding Funds .............................................................................................. 170 6.2.3 VCGF as a Solution to the Agency Problem ...................................... 175 6.2.4 The Challenges of the VCGF .............................................................. 180 6.3 Taxation ........................................................................................................ 182 7.3.1 Tax