Venture Capital and Private Equity Funds: Significant Influence or Control?

Venture capital and private equity funds (‘VC/PE’) are investment vehicles aimed at acquiring securities that are representative, convertible, or exchangeable for equity or equity-linked interests, primarily in privately held companies. These funds actively participate in the management and governance of the invested companies, with the objective of eventually divesting their holdings after a more or less determined period of time. This divestment involves selling the acquired equity stake and returning the invested capital, along with a profit, to the fund's investors (limited partners or LPs).

The historical evolution of the VC/PE market itself has been based on the development of an active investment model, whereby funds provide more than just financial resources. They actively participate in the managerial and strategic aspects of the business, offering additional support that may not be solely reflected in financial figures. Hence, it is often said in common parlance that VC/PE funds bring in what is referred to as ‘smart money.’

In my latest book, ‘Venture Capital and Private Equity Funds in Brazil,’ I set out to examine the following hypothesis: is it possible that VC/PE funds, by exerting significant influence on the decision-making process of the invested companies, actually exercise control over them, and hence should be deemed ‘controlling shareholders’?

While the question may appear trivial at first glance, considering the distinctive characteristics of VC/PE investments and the situational context in which they occur reveals its complexity.

From a quantitative perspective, these investments are predominantly minority stakes. However, VC/PE funds typically have certain economic or political rights attributed to them, which are the result of negotiation processes. These rights reflect the associated risks, potential conflicts of interest, existing informational asymmetry, and the investor's perception of the need for involvement in the social affairs of the invested company.

It is important to remember that the relationship established between VC/PE funds, their investors, and the invested companies is long-term and characterized by significant informational asymmetry and uncertainty. This condition contributes to the emergence of various conflicts of interest among the parties involved. These relationships, originally designated as agency relationships in finance literature, provide a fertile ground for opportunistic behaviors aimed at extracting private benefits at the expense of the interests of other stakeholders.

The primary way in which VC/PE funds address these issues is through the use of contracts in their operations. By distributing economic and political (or ‘control’) rights, an incentive structure is established to encourage the parties to behave in the expected and intended manner. This arrangement varies depending on the perceived risk associated with the invested company and its entrepreneurs, as well as the projected internal rate of return by the fund. Importantly, VC/PE funds are typically granted disproportionate economic and control rights, regardless of the specific contractual arrangement, relative to their equity participation in the company.

It is undeniable, therefore, that specific allocations can represent a clear shift in intra-corporate control, enabling the fund to direct the company's activities without the entrepreneurs having any real possibility of resisting the imposition of the fund's will.

In such settings, although entrepreneurs may be identified, either individually or collectively, as the formal center of control according to normative parameters, in practical terms, they have little to no ability to command the company. They become subordinate to the stable dominance of the VC/PE fund.

In such cases, there will be a transition from effective influence to control. This transition occurs whenever the circumstances—such as the specific allocation of economic and political rights and the influence of reputational capital—reveal the existence of a lasting state of subordination that permeates all activities carried out by the company. The company is effectively commanded by the VC/PE fund, depriving other shareholders, even if they hold a majority stake, of the ability to escape its influence due to the undeniable harm that would result from doing so.

By observing the specific characteristics of VC/PE investments and combining it with a systematic understanding of control, it becomes possible to ensure the prevalence of the principle of unity: where there is power, there must inevitably be responsibility.

We are confident that the relationship between VC/PE funds and invested companies, as well as the role played by such investments in a broader economic and social context, can and should be the subject of many more research studies. Despite the growing significance of this investment modality worldwide, there has been relatively little interest in this topic until now. Therefore, there is ample room for further exploration and understanding of the subject.

Recent cases, such as the emblematic examples of WeWork, Theranos, and Toys R Us, confirm that the increasing prominence of VC/PE funds will undoubtedly face greater scrutiny from society. These high-profile cases have highlighted the potential risks and challenges associated with VC/PE investments, leading to a heightened awareness and demand for greater transparency and accountability in this sector. It is likely that the role and impact of VC/PE funds will continue to be subject to increased public inspection in the future.

Raphael Andrade is a PhD in Corporate Law from the University of São Paulo (USP), and a Partner at Andrade Chamas Advogados.