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The Contracting Universe: Law Firms and the Evolution of ...

  1. 1. The Contracting Universe: Law Firms and the Evolution of Venture Capital Financing in Silicon Valley Mark C. Suchman Department of Sociology University of Wisconsin - Madison January 2006 [DRAFT: Please do not cite or circulate without permission] The research reported herein was supported in part by dissertation fellowships from the US National Science Foundation and the American Bar Foundation. The author wishes to thank W. Richard Scott, Robert Gordon, Nancy Tuma and Teresa Scheid for their numerous comments and suggestions on previous drafts.
  2. 2. 2 The Contracting Universe: Law Firms and the Evolution of Venture Capital Financing in Silicon Valley Mark C. Suchman Department of Sociology/School of Law University of Wisconsin - Madison ABSTRACT This project examines the contribution of local law firms to the development of California's Silicon Valley. By synthesizing prominent themes from organizational ecology, institutional theory, and the sociology of the legal profession, the analysis suggests that Silicon Valley law firms act as "interorganizational pollinators." In this capacity, lawyers exploit a distinctive structural position within the start-up process, in order to formulate and disseminate standardized blueprints for organizational structure. These activities exert both micro and macro effects, simultaneously promoting the founding of new firms and the structuration of the larger community. Support for this analysis comes from both qualitative and quantitative evidence. Interviews with lawyers, entrepreneurs and venture capitalists suggest that local attorneys act, in part, as business counselors, drawing on their experiences with recurrent start-up problems in order to develop and diffuse constitutive templates for common organizational activities. Statistical analyses of venture capital financing contracts (VCFCs) confirm this finding, revealing not only that these foundational contracts became increasingly standardized during the early years of Silicon Valley, but also that the level and form of standardization were significantly correlated with the involvement of particular law firms. These findings illustrate the complex co- evolution of resource and information flows in new organizational communities. In Silicon Valley, at least, the development of community-sustaining institutions results neither from the impact of a disembodied zeitgeist nor from the ministrations of an impervious external actor. Rather, the structuration of Silicon Valley reflects the mundane, day-to-day activities of specific intermediary organizations located within the community itself.
  3. 3. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Contracts are, first and foremost, social artifacts. Like most artifacts, they often emerge from the labors of specific artisans; but also like most artifacts, they necessarily bear the markings of broader social contexts. Some of these markings are technical, since contracts fall into the general category of ostensibly useful artifacts; but other markings are cultural, since the uses to which contracts are put involve substantial symbolic, narrative and even ceremonial components. Thus, contracts are at once both communicative gestures and marketable commodities, and to understand a contractual regime, one must understand both the cultural and the economic environment that gave it birth. At the same time, one must also recognize that contracts, like any artifacts, are themselves capable of transforming their environments, both culturally and materially. Thus, the sociological study of contracts must attend to several distinct but intertwined historical dynamics: It must study both the private parties who use contracts and the professionals who produce contracts; it must study both individual transactions and larger social systems; it must study both the influence of social environments on contractual practices and the reciprocal influence of contractual practices on social environments. This paper is not so bold as to attempt all of these tasks at once. For the most part, it offers a relatively modest preliminary study of the emergence of distinctive contractual practices in one particular locale. Informed by the foregoing sociological perspective, however, it strives to address the role of legal professionals, as well as contracting parties; to attend to systemic processes, as well as specific transactions; and to recognize that contractual regimes shape professions and business communities, as well as that professions and business communities shape contractual regimes. Empirically, this paper reports early results from an ongoing research project on the role of law firms (and, to a lesser extent venture capital funds) in the growth and development of California's "Silicon Valley." Lying along the San Francisco peninsula between Palo Alto and Los Gatos, Silicon Valley boasts one of the fastest growing industrial communities in the United States, and the region's distinctive indigenous business practices offer an excellent opportunity to 1
  4. 4. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN examine how contracts and organizational environments emerge in tandem. Social scientists have, of course, devoted a substantial amount of attention to Silicon Valley in recent years (see, e.g., Rogers & Larsen 1984; Saxenian 1994): Many researchers have studied the regions' core technologies -- semiconductors, computer equipment, software, telecommunications and biotechnology -- and the industries that have grown up around them. Others, especially within legal academia, have examined the public laws governing these new technologies, most notably those aspects of intellectual property law that deal with computer hardware and software or with genetic engineering. The project reported here, however, grows out of a somewhat different set of concerns. Rather than focussing on Silicon Valley's distinctive "high technology" innovations, the present investigation addresses Silicon Valley's more generic characteristics as an emerging business community. The question then becomes not "What can Silicon Valley teach us about the high-tech economy?" but rather, "What can Silicon Valley teach us about the emergence of governance structures in changing economic environments, regardless of those environments' underlying industrial technologies?" Drawing on theories from the sociology of organizations and the sociology of the legal profession, the following pages examine a significant but often overlooked aspect of industrial governance: the routinization of transactional practices within a developing organizational community. To this end, the paper offers a detailed empirical portrait of the emergence and institutionalization of one particular set of such practices, the standardized venture capital financing contracts (VCFCs) that structure new-company investments in Silicon Valley. The introductory section of this paper outlines the multiple theoretical concerns that motivate this research project, both from the sociology of organizations and from the sociology of law. Section two then presents some preliminary empirical results, illustrating the standardization of venture capital financing contracts, the emergence of distinct contractual archetypes, and the temporal and social dynamics driving choice among those archetypes. 2
  5. 5. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Finally, section three briefly returns to re-examine the implications of these findings for the theoretical traditions that motivated the investigation. Theoretical Framework Organizational Communities: Today's Silicon Valley exemplifies a phenomenon that organizational researchers have termed an "organizational field" (DiMaggio and Powell 1983) or an "organizational community" (Astley 1985): "organizations that, in the aggregate, constitute a recognized area of institutional life: key suppliers, resource and product consumers... and other organizations that produce similar services and products" (Dimaggio and Powell 1983:148). As a practical matter, organizational communities (and, particularly, new organizational communities) are often associated with specific geographic locales: The Pittsburgh steel industry, the Detroit automotive industry, the Hollywood film industry and, of course, the Silicon Valley computer industry. In theory, however, these units have no necessary geographic limits; they occupy fields in social, not physical, space. What defines an organizational community such as Silicon Valley is its high level of internal interaction and interdependence, its distinctive normative and behavioral style, its collective identity and, ultimately, its pervasive sense of "entity-ness." As one local chronicler observed, somewhat hyperbolically: [M]ore than any industry in history, [Silicon Valley] is a self-contained, living entity....It has defined boundaries, is self-perpetuating and reproducing and has predictable behavior -- including the instinct for self-preservation. Even in the electronics industry, there is a tendency to speak of "Silicon Valley" as though it were a sensate being. (Malone 1985:8) Although several of Santa Clara County's leading industrial firms date back to the 1930s or earlier, the region has only recently developed these crucial community attributes of structure, culture and identity. Until the advent of the microcomputer era, few local residents had much sense of participating in a distinctive industrial phenomenon. As recently as 1950, the area that 3
  6. 6. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN was to become "Silicon Valley" still touted itself more modestly as "the Prune Capital of America." Less than 0.25% of Santa Clara's population held manufacturing jobs (800 workers), and half of these were in canneries and food processing plants (Rogers & Larsen 1984:28). Although several electronics companies already operated in the area, neither their numbers nor their product lines distinguished them from electronics manufacturers in other parts of the country. In public discourse, the activities of the region were identified by their particular geographic locales -- Palo Alto, Sunnyvale, Santa Clara County -- rather than as part of a larger social system. By the 1970s, however, the population of interrelated spin-off firms had blossomed, and previously isolated start-ups were beginning to perceive themselves as participants in a common endeavor. In 1971, Microelectronics News coined the phrase "Silicon Valley" to describe this new regional entity. Use of this community label grew rapidly in the late 1970s and early 1980s, as local organizations developed a growing sense of collective identity, built around the region's emerging high-technology industries. This heightened commonality corresponded with a marked increase in intra-communal business relations and with a progressive standardization of local business practices. In the lexicon of organizational sociology, Silicon Valley's experience since the late 1960s falls under the ungainly rubric of "community structuration." Structuration refers to the development of coherent and consistent social relations -- shared meanings, stable interaction patterns, consensually defined roles -- within a group of previously isolated firms (DiMaggio & Powell 1983:148). Increasingly, organizations theorists identify this transition from quasi- randomness to systematicity as a crucial but only partially understood "phase change" in organizational life. Among other things, the trajectory that organizational communities follow in their early history often determines the fate of new technologies and "locks in" many environmental characteristics for years to come (Arthur 1989). Thus, the task of explaining how viable organizational communities coalesce over time poses an intriguing puzzle in the analysis 4
  7. 7. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN of organizational environments, and the solution of this "structuration puzzle" promises substantial theoretical and practical dividends. Clues to the resolution of this puzzle come from two distinct traditions in organizational sociology, one known as "institutional theory" and the other known as "organizational ecology." Institutional theorists, who focus primarily on the cultural features of organizational environments, argue that community structuration represents an important step in the institutionalization of a coherent industrial culture (see generally, Powell & DiMaggio 1991 [anthology of readings in institutional theory]). The concomitant standardization of local business practices is, thus, simply one element of the social construction of cultural norms, roles, definitions, and routines within the emerging industrial system. In contrast, organizational ecologists, who focus primarily on the material features of organizational environments, argue that community structuration reflects the consolidation of a coherent industrial ecosystem (see generally, Baum & Singh 1994 [anthology of readings in organizational ecology]). In this view, the standardization of business practices stems from the routinization of inter-organizational resource flows and the corresponding co-evolution of stable environmental niches and interconnected organizational populations. Together, these two apparently divergent models suggest that although standardized business practices may be socially-constructed cultural artifacts, the social construction process that produces them may nonetheless stem in large part from the activities and experiences of concrete organizational populations -- populations who are, themselves, subject to competitive pressures and material resource constraints. Among other things, this depiction raises the intriguing possibility that certain communities may include ecological niches for organizations that specialize in the transmission of basic constitutive information1 among the members of other local populations. In action, such "inter-organizational pollinators" would channel the 1 Suchman (forthcoming:18) defines "constitutive information" as "fundamental rules about how to produce an organizational structure, operational procedure or behavioral pattern." 5
  8. 8. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN development of business standards while, themselves, remaining profoundly enmeshed in (and vulnerable to) material and cultural forces within the larger community. Legal Practitioners: This, of course, is where the sociology of the legal profession comes in. In recent years, a substantial body of research has emerged around the question of what, exactly, corporate lawyers do. Despite persistent lay sentiment that attorneys amount to nothing more than a parasitic drain on the productive economy (Galanter 1994), socio-legal scholars have articulated a number of accounts in which corporate lawyers appear to be earning their fees in a somewhat more productive manner (see e.g., Suchman & Cahill 1996). In particular, several researchers have recently argued that lawyers may actually be creating value for their clients, by "engineering" complex transactions and by "inventing" useful legal "devices" (see, generally, Oregon Law Review 1995). In these accounts, standard-form contracts occupy a prominent position on the list of efficiency-enhancing inventions produced by the business lawyer qua transaction-cost engineer (Gilson 1983 [describing business lawyers as transaction-cost engineers]; Klausner 1995 [outlining benefits of standardized contracts]). Significantly, however, the existing literature offers remarkably few empirical studies of the actual emergence of specific legal devices over time (but see Powell 1993 [describing role of lawyers in the emergence of "poison pill" takeover defenses]). Rarer still are sustained efforts to situate the creative activities of corporate lawyers within a model of the larger inter- organizational environment. In reality, though, both history and context always matter. Marketable devices never spring fully-formed from the minds of their inventors, and new contractual governance structures are no exception. At the same time, law firms never invent on their own, in isolation from their social and economic context. Environmental dynamics necessarily structure and condition these organizations' every move, and the technologies that these firms produce often, in turn, reconfigure the organizational environment. Thus, if socio- legal scholars wish to reconceptualize corporate lawyers as entrepreneurial inventors who 6
  9. 9. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN construct and peddle novel legal devices, research must move beyond the economic exegesis of legal technology, to look empirically at the ways in which law firm activities mesh with the development of concrete organizational communities. What looks like technical transaction-cost engineering when viewed on a case-by-case basis may more closely resemble "paradigm pushing" when viewed across a longer time-span. And if law firms are, in fact, actively promulgating distinct, constitutive models of organizational structure, then it might make sense to view them as a species of inter-organizational pollinator, and to link socio-legal studies of corporate law with organizational studies of this particular pollinator niche. In applying this perspective to the case of Silicon Valley, one might hypothesize that during the early years of the community's development, law firms were among a small class of organizations whose activities provided regular contact with significant numbers of new high- technology enterprises. This network centrality created an opportunity for Silicon Valley lawyers to perceive, to foster and to promote hidden commonalities between otherwise isolated start-ups. In exploiting this privileged structural position, however, local law firms were not simply crafting technical devices that minimized transaction costs for individual clients in isolated instances. Rather, by assembling a standardized cultural tool-kit, the lawyers of Silicon Valley were playing an important role in developing the taken-for-granted business practices -- including the distinctive contractual artifacts -- of the community as a whole. Empirical Evidence on Venture Financing Read in conjunction, theories of organizational environments and accounts of corporate legal practice provide strong reason to believe that the structuration of new industrial communities may reflect the influence of law firms, as inter-organizational pollinators, on the construction and transmission of basic business routines -- and, in particular, on the institutionalization of standardized contractual practices. To explore these theoretical suspicions, the present study gathered a range of qualitative and quantitative evidence on the role 7
  10. 10. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN of law firms in the formation of new high-technology start-up companies in Silicon Valley. The goals of these investigations were to determine: (a) what, roles Silicon Valley's corporate lawyers were playing in the start-up process; (b) whether those roles involved the construction and transmission of constitutive information; and (c) what impact such activities had on the structuration of the organizational community as a whole. This section will first introduce the particular empirical focus of these investigations, the venture capital financing process. This brief introduction will be followed by a more extensive discussion of several qualitative and quantitative analyses bearing on the questions outlined above. Data sources and methodologies will be addressed (largely in footnotes) as they become relevant.2 Venture Capital Financing: Near the core of the start-up process in Silicon Valley lies the phenomenon of venture capital financing. In essence, venture capital is high-risk external funding, usually directed toward early-stage equity investments in "emerging growth" companies (Bartlett 1988 [treatise on venture capital financing]; Halloran et al. 1991 [venture capital financing contract formbook]).3 This, for example, is the kind of financing that Steven Jobs and Stephen Wozniak obtained in 1976, when they decided to move the Apple Computer Company out of Jobs' parents' garage. Entrepreneurs can, of course, raise start-up funds in many ways, including from traditional bank loans, corporate partnerships, wealthy "angels," and friends and family. Since 2 The empirical evidence presented below draws heavily on the author's prior studies of the role of law firms in the development of Silicon Valley. Readers who are interested in methodological and/or computational details beyond those reported here should refer to Suchman (1994). 3 Generically, the term "venture capital" refers to a wide range of high-risk investment activities, including -- but not limited to -- new company finance. Most Silicon Valley venture capitalists, however, specialize almost exclusively in emerging-growth start-ups, and consequently, within this particular community, the primary social significance of venture capital lies in its role in supporting such early-stage entrepreneurship. (See, generally, Bygrave & Timmons 1992). 8
  11. 11. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN the mid-1970s, however, the private venture-capital equity model has increasingly become the default route for financing new companies in Silicon Valley. Significantly, for most new Silicon Valley firms, venture capital financing represents more than simply a financial event (Timmons & Sapienza 1991). Venture capitalists tend to be extremely active, hands-on investors. Thus, as well as bringing an infusion of fiscal resources, the initial venture capital round often also represents the first juncture at which a start-up must integrate a substantial group of new stakeholders, whose interests and contributions differ significantly from those of the founding entrepreneurs. In short, not only do venture capital financings represent a central element of Silicon Valley's inter-organizational culture, but also they mark a crucial governance challenge in the "gestation" of local start-ups. Consequently, a new company's first funding round offers an ideal transactional event in which to discern the impact of Silicon Valley lawyers. An initial venture capital investment is precisely the sort of setting in which one might expect contractual structures to have an impact on organizational life -- and in which one might wonder whether and how standardized contracting practices emerge onto the scene. Qualitative Evidence: To begin tracing the role of law firms in the Silicon Valley start-up process, I conducted a number of exploratory interviews with local lawyers, entrepreneurs and venture capitalists.4 Although a detailed discussion of these interviews lies beyond the scope of the present essay, a 4 The following pages draw on quotations from a series of roughly 25 semi-structured interviews conducted during the summer of 1991 with various participants in the Silicon Valley organizational community. Interviews were divided approximately equally between lawyers, venture capitalists and entrepreneurs, as well as including several individuals who had played multiple roles over the course of their careers. The analysis was further enriched by informal conversations with a handful of journalists, academics and other informed community-watchers. The sampling frame for these interviews was a systematic, multiple-snowball sample of individuals who were active in Silicon Valley during the formative period from 1970 to 1990. In order to capture as full a range of accounts as possible, the sample was informally stratified along such dimensions as: industry, seniority, tenure in the community, geographic location, and the like. In two months of interviewing, the response rate (ratio of interviews to initial contacts) was over 85%. 9
  12. 12. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN few quotations should suffice to convey the general tenor of respondents' comments, regarding both what Silicon Valley lawyers do and how these activities effect the emerging community (for more extensive treatments, see Suchman 1994; Suchman & Cahill 1996). Most strikingly, interviewees frequently described local attorneys as playing what could be labelled a "counseling" role -- providing start-up clients not only with legal advice, but with basic business advice, as well. As one senior partner put it: Good lawyers are a wonderful resource for business advice, because the problems that growing companies encounter are similar. And even if a problem is new to an entrepreneur who has never been president of a company before, the outside counsel has seen various ways that people have dealt with it.5 The parallel between this account and the inter-organizational pollination model is readily apparent. As the previous quotation illustrates, Silicon Valley law firms have occupied a privileged position within the emerging organizational community: Long before the region had developed an over-arching normative structure, the routine activities of legal representation brought local attorneys into regular contact with large number of companies facing similar sets of operational challenges. This exposure, in turn, allowed law firms to monitor wide ranges of client strategies, to formulate coherent accounts of the determinants of success and failure, and to impart these accounts to new community entrants. Over time, it seems likely that these summaries of basic constitutive information could exert significant pressures on the structure of the developing business community: As clients come to embody the models compiled by their attorneys, one would predict that the diversity of organizational structures would fall, and that inter-organizational relations would become more consistent and more highly routinized. Two additional quotations, from lawyers with substantial 5 The quotations presented here have been edited for confidentiality, brevity and readability. In order to preserve the flow of the text, most of this material appears without ellipses, brackets or other diacritical marks. Care has been taken, however, to maintain the substance and tone of respondents' remarks, while eliminating some of the more awkward constructions of impromptu speech. 10
  13. 13. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN venture capital experience, nicely capture this structuration dynamic. The first describes the evolution or, more accurately the institutionalization, of venture capital financing agreements: If there is a transaction with one of the other Silicon Valley law firms, the transaction costs tend to be minimal. Very often they've adopted our contract forms or vice versa. I remember one attorney at another firm saying that, a couple years ago, he had this whole set of negotiating responses to my firm's forms. But in the last few deals I did with them, their forms were virtually identical to ours, and there wasn't anything to argue over. The second quotation goes a bit further in illustrating the role of law firms in this process of institutionalization: I think there are law firms out there that have three cookie cutters, and they just ask: "Is it A, B, or C?" They are going to force these things into one of those cookie cutters and just ignore the fact that you may not fit the profiles. They'll just pretend you do, and they'll just cram you into the structure. These quotations illustrate a number of significant features of the venture capital financing process: (a) Silicon Valley lawyers use their broad counseling role to transmit basic constitutive models between various clients; (b) this social influence is something that lawyers often consciously acknowledge as being an important part of Silicon Valley legal practice; and (c) in the aggregate, such pollination activity tends to narrow the range of behavioral variation within the larger community, and to produce relatively homogeneous sets of standardized and typified business routines. Quantitative Evidence: While generally supportive of the pollination model, the qualitative evidence described above leaves several questions about the venture capital financing process unresolved. Interview responses are themselves retrospective cultural narratives, and consequently they tend to be poorly suited to differentiating mythology from reality or to tracing the finer points of shifting practice over an extended period of time. To address such concerns, the second stage of the investigation sought to gather quantitative evidence on a typical Silicon Valley practice that 11
  14. 14. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN might plausibly have been affected by pollination processes, if these processes were indeed taking place. Data: This phase of the project employed statistical content analysis to examine the provisions of over 100 actual venture capital financings contracts (VCFCs), produced in transactions spanning a 15-year period of Silicon Valley's early history. Specifically, the following analyses employ content-analytic data on 100% of the first-round, high-technology VCFCs entered into by two of Silicon Valley's leading venture capital funds, between 1975 and 1990. The resulting data set contains a total of 108 contracts, spanning much of the organizational community's formative period. Each of these agreements was coded on over 400 elements of contractual structure. Measured items included: (a) formal issues, such as the length of the agreement and the number of separate contractual instruments involved; (b) substantive issues, such as stock redemption provisions, antidilution protections, dividend structures, etc.; and (c) "exogenous" information, such as the age, industry and valuation of the company, the structure of the investor syndicate, and the identity of the lead investor and of the drafting law firm. Background research (including field interviews, reviews of legal formbooks, and extensive pre-testing) suggests that these dimensions capture virtually the entire range of formal and substantive variation in venture capital financing agreements during the observation period.6 6 One caveat may be in order: Since VCFCs are formally confidential business documents, the data necessarily reflect access constraints, and the sample is in no sense a random one. Nonetheless, every effort has been made to construct as comprehensive a data set as possible: The two participating funds are widely recognized leaders in the industry, yet they do not maintain particularly close ties with one another; the coded agreements cover a wide range of industry segments (including semiconductors, computer systems, software, telecommunications and bio-technology); the time period extends throughout the early years of Silicon Valley; and the sampling frame does not exclude agreements on the basis of transaction size, geographic focus, legal representation, or contractual structure. While none of these precautions can entirely eliminate the possibility that the observed contracts are in some ways atypical, substantial exploratory analysis has failed to uncovered any evidence that the reported results constitute mere artifacts of the data collection procedures. Rather, the data seem to represent a reasonable cross-section of the "state of the art" in venture capital finance during the period under consideration. 12
  15. 15. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Using these data, one can examine three distinct, but interrelated aspects of the structuration process. First, one can measure the standardization and routinization of VCFCs over time. Second, one can investigate the possibility that these contracts may subdivide into several distinct "financing archetypes," rather than reflecting a single monolithic standard. And third, one can explore exogenous factors influencing choices among various contractual forms. The remainder of this essay presents a few results from each of these analyses. Although the findings are largely exploratory, they are also quite suggestive. Standardization: The VCFC data set provides two summary measures of contractual standardization/idiosyncracy: (1) an "uncodability" score, indicating the number of terms departing from the "preferred alternatives" identified in interviews, formbooks and pre-testing; and (2) a "rarity" score, indicating the number of terms shared with fewer than 5% of the other sampled agreements. From these indices, a combined "idiosyncracy" score was computed by: (1) logging the "uncodability" and "rarity" counts, (2) standardizing the logged scores, and (3) adding the standardized uncodability and rarity values together. This combined score provides a rough index of the degree to which a given contract contains "non-standard," "counter- normative" or "deviant" terms -- unusual provisions absent both from prescriptive models and from other observed financing agreements. In the current data set, these idiosyncracy scores are roughly normally-distributed, over a range from -3.621 to 3.703, with a mean of 0.02 and a standard deviation of 1.534.7 7 It is perhaps worth noting that this methodology defines "idiosyncracy" in fundamentally retrospective terms: A contractual provision is considered idiosyncratic if it fails to achieve either widespread usage or normative endorsement during the 1975-1990 observation period, taken as a whole. Consequently, a contractual form might conceivably be both standardized and normatively endorsed by a limited number of firms (or during a limited period of time) without ever achieving enough acceptance to avoid the "idiosyncratic" label. Thus, the idiosyncracy measure employed here reflects institutionalization or lack thereof, rather than "irrationality" or "quirkiness." From this perspective, overlooked innovations and careless mistakes look pretty much the same, and high idiosyncracy scores do not necessarily imply failures of draftership. 13
  16. 16. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN In theory, if venture capital financings are becoming more routinized and institutionalized over time, one would expect to see idiosyncracy scores declining over the course of the observation period. As Figure 1 illustrates, this is indeed the case: The average level of contractual idiosyncracy drops sharply from 1975 to 1980, and it continues to decline slightly from 1980 until about 1987. Significantly, in addition to showing this secular trend of standardization, the data also suggest that the eventually-dominant financing norms may have originated in Silicon Valley, and then gradually diffused outward (see also Suchman 1995). The upper and lower lines in Figure 1 indicate average idiosyncracy levels for two subsets of the VCFC sample: (a) those agreements involving either a lead investor or a drafting law firm from Silicon Valley, and (b) those involving neither a lead investor nor a drafting law firm from Silicon Valley. The results closely follow the classic pattern associated with socio-technical diffusion processes (Rogers 1983): At all points, the Silicon Valley contracts are more standardized than the non-Silicon Valley agreements, and over time, the Silicon Valley agreements become standardized relatively rapidly, while the non-Silicon Valley agreements retain substantial levels of idiosyncracy even into the late 1980s. In summary, this first set of analyses suggests that venture capital financings become increasingly routinized from 1975 to 1990, and that this routinization originates within Silicon Valley and then gradually diffuses outward. Not only do these findings provide concrete empirical evidence of contractual standardization, but also they demonstrate the importance of a "vanguard" local community in this developmental process. Of course, these results also leave several crucial questions unanswered. Taken alone, the observation that contracts have become increasingly standardized says little about the nature of the developing regime: A decline in idiosyncracy is equally compatible with (a) the ascendance of a single dominant design or (b) the emergence of a fixed "menu" of multiple acceptable alternatives. It is to this topic -- the nature of Silicon Valley's emergent contractual archetype(s) -- that the we turn next. 14
  17. 17. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Financing Archetypes: The second branch of the empirical investigation explores the substantive content of a "core subset" of the VCFC database. Specifically, it focusses in on the 78 transactions (out of the original 108) that involved at least one "local" party -- either (a) an attorney from Silicon Valley (including the two leading Silicon Valley-oriented San Francisco law firms), (b) a lead investor from the greater Bay Area, or (c) a company from the state of California. This restricted scope highlights the internal dynamics of the local business community, preserving fine-grained variations that might otherwise be overshadowed by more radically disparate contracts from other regions. The goal of the analysis is to create an empirical "map" of Silicon Valley financing contracts -- first tracing the dimensions that differentiate agreements one from another, and then examining the distribution of agreements across these dimensions -- in search of clusters and non-uniformities that might indicate the presence of discrete contractual models or archetypes. Although one could, perhaps, investigate the development of particular contractual terms by analyzing the VCFC data on an item-by-item basis, such an approach hardly represents a feasible methodology for investigating the development of overall contractual structure, as manifested in the combined patterning of all 400-plus variables in the data set. Rather, the task of mapping financing structures demands a multivariate technique that can summarize the contents of entire agreements along a limited number of analytically tractable dimensions. A number of such "data reduction" techniques are currently available; however, for the present analysis, Multi-Dimensional Scaling (Kruskal and Wish 1978) seems particularly promising. In essence, this technique starts with a matrix of "similarity coefficients," measuring the degree of resemblance between various data objects (VCFCs in the present context); from this similarity matrix, MDS produces an N-dimensional "map" of the data objects, such that the Euclidean distance between any two objects on the map corresponds to the dissimilarity of those same objects in the original input matrix.8 Thus, for example, an MDS analysis of the flight distances 8 For clarity's sake, the following discussion will refer to the input of an MDS analysis as a "similarity" (or "dissimilarity") matrix. As output, MDS yields a set of estimated "coordinates," 15
  18. 18. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN between American cities would reproduce the geographic configuration of the United States (Kruskal and Wish 1978:7-8). Applied to a matrix of coefficients indicating similarity among VCFCs, MDS ought to produce a scatter-plot of these contracts, in which similar agreements fall near one another, while dissimilar agreements fall farther apart.9 Figure 2 presents the two-dimensional map of VCFCs that results from such an analysis.10 Several intriguing features become immediately apparent. First, the observed contracts clearly do not fall randomly throughout the coordinate plane. Rather, the distribution is quite "lumpy," with three to five obvious clusters surrounding the origin, and a long trail of isolates extending from the far left to the lower right. Second, the denser portions of the plot seem to split into two bands, one lying well above the horizontal axis, and the other lying well below. Finally, at this level of generality at least, all contracts are definitely not unique: In several places, the observed financing agreements lie so close together that their marker symbols are almost perfectly superimposed. Financing agreements in Silicon Valley do, indeed, appear to follow structured patterns. from which one can calculated predicted "proximities" (or "distances") among the data objects (or "stimuli") of interest. In this terminology, the goal of the MDS algorithm is to estimate coordinates in such a way as to maximize the fit between observed similarities and predicted proximities. 9 The analyses reported below measured contractual similarity using Gower's "General Coefficient of Similarity," a covariation index designed for situations in which data objects are scored on a mixture of dichotomous, polytomous and continuous descriptor variables (Gower 1971). Separate similarity matrices were computed for five general categories of contractual provisions -- covering, respectively: routine operations, allocation of downside losses, allocation of upside rewards, safeguards against bad faith, and mandatory stock conversion. These five "views" of contractual similarity were then analyzed using the INDSCAL MDS algorithm, which uses information about differences in viewpoint to establish a substantively meaningful orientation for the axes of the resulting scatter plot. 10 The MDS algorithm can map objects in any number of dimensions. However, since high- dimension configurations are difficult to visualize, researchers must balance descriptive precision against interpretive clarity in each particular application. In the present analysis, statistical tests suggest that the most appropriate MDS solutions are those having either two dimensions or four. For ease of presentation, the discussion here focusses exclusively on the two-dimensional version. 16
  19. 19. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Identifying the substantive meaning of these patterns, however, requires further analysis. Perhaps the most common strategy for addressing this interpretive problem involves correlating selected variables with the MDS coordinates, in order to identify which items covary most closely with each dimension. Table 1 presents standardized regression coefficients obtained in this manner. Although hardly unequivocal, these coefficients do reveal several broad patterns. At the most general level, both dimensions of the scatter plot appear to reflect aspects of contractual elaboration, with each exhibiting strong negative associations with several indicators of missing or omitted contractual terms. This pattern emerges particularly clearly in the case of Dimension 1: The horizontal axis of the configuration displays coefficients of -.70 and beyond for variables that indicate the absence of dividend clauses, merger provisions and anti-dilution protections. Somewhat less dramatically, Dimension 2 shows at least a modest negative association (approximately -.20) with items indicating the absence of liquidation provisions and registration rights limitations. Further, as this "elaboration" interpretation would predict, both dimensions correlate positively with the length of the stock purchase agreement and with the number of covenants and representations and warranties that it contains. In short, contracts located toward the right and the top of Figure 2 tend to be both longer and more specific than those located toward the left and the bottom. While both dimensions of the map measure contractual elaboration, each axis seems to capture a somewhat distinct aspect of this phenomenon. With regard to Dimension 1, Table 1 suggests that location along this horizontal axis reflects the extent to which a financing agreement explicitly delineates the various rights and obligations of the contracting parties. Thus, financings that score highly on this dimension tend to involve preferred as opposed to common stock; they tend to include specific dividend, merger, mandatory conversion and anti- dilution provisions; they tend to establish formal mechanisms for stock redemption; and they tend to be heavily laden with protective covenants -- particularly covenants forestalling decisions which might weaken investors' preferential rights. The poles of this dimension contrast improvisational flexibility (toward the left) with pre-planned legalism (toward the right). 17
  20. 20. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Dimension 2, on the other hand, has less to do with the rights-based legalism of the financing agreement than with the anticipated duration and intensity of the resulting relationship between the start-up and its investors. Fairly consistently, the vertical axis in Figure 2 correlates positively with contractual provisions designed to foster a close, long-term partnership between venture capitalist and entrepreneur -- and negatively with provisions designed to facilitate an early disengagement of these parties. Thus, for example, contracts with high scores on this dimension are much more likely to contain "rights of first refusal" (which allow investors to preserve their involvement through multiple rounds of financing) and much less likely to provide for company-initiated stock redemptions (which allow successful companies to "buy out" their initial financial backers).11 At its poles, then, Dimension 2 contrasts short-term, arms-length financial relationships (toward the bottom of Figure 2) with long-term, hands-on partnerships (toward the top). While the foregoing paragraphs highlight important features of the configuration of financing agreements, an exclusive focus on dimension loadings also obscures certain parts of the story. Since the sampled contracts do not fall uniformly across the plane of Figure 2, a full interpretation requires discussion of clusters as well as of continua, of regions as well as of axes. In the language of multi-dimensional scaling, a "neighborhood" interpretation is required to complement the "dimensional" interpretation presented above. To provide such a neighborhood interpretation, one must first identify a limited number of fairly distinct clusters within the data. These clusters can then be described both in terms of their location in the plane and also in terms of their association with specific contractual attributes. 11 Interestingly, the pattern of loadings in Table 1 suggests that the inter-organizational linkages addressed by Dimension 2 are quite context-specific. While generally encouraging ongoing interaction between venture capitalists and entrepreneurs, high-scoring agreements also seem to acknowledge that certain developments can fundamentally alter the nature of the new company, making continuation of the investor-founder relationship problematic. These agreements tend to require companies to disclose prior obligations (such as commitments to pay finders' fees); they tend to provide investors with "vetoes" over changes in the organizational coalition (such as future stock issues or mergers); and they tend to facilitate the departure of investors when the corporation takes actions that might alter its fundamental character (such as a mergers, public offerings and even simple maturation). 18
  21. 21. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN As illustrated in Figure 3, statistical cluster analysis12 reveals five distinct groupings in the MDS map -- along with a sixth "pseudo-cluster" of isolates, lying at the fringes of the other clusters. In general terms, Cluster 1 occupies the lower left-hand quadrant of the figure, while Cluster 2 occupies the lower right. Clusters 3 and 4 lie in the upper right-hand quadrant, with Cluster 4 holding a position above Cluster 3 and slightly to its left. Cluster 5 stands alone in the upper left-hand quadrant. Finally, a trail of isolates (Cluster 0) extends from the far left of the horizontal axis down to the outskirts of Clusters 1 and 2, in the lower right. Table 2 explores the substantive content of these clusters, in a manner analogous to Table 1: Specifically, it presents the "cluster loadings" that arise when selected variables are standardized and regressed against cluster membership. These loadings indicate what sorts of contractual provisions are most likely to appear in each cluster. The overall pattern suggests that each group of VCFCs corresponds to a distinct, internally consistent, archetypal image of the venture capital relationship, as follows: Cluster 0: Idiosyncratic Contracts -- This pseudo-cluster of isolates contains a mixture of relatively non-standard contractual terms. On the whole, these agreements are united primarily by their minimalism. Cluster membership correlates highly with failure to specify a wide range of contractual features, including: dividend regimes (both nature and rate), merger treatments, mandatory conversion provisions, anti-dilution protections, and protective covenants. In addition to these omissions, agreements in this cluster display idiosyncracy in several other regards, as well -- such as a disproportionate tendency to involve common-stock- only financings and a significantly elevated likelihood of including restrictions on the private transfer of stock-ownership. Cluster 1: Weak Contracts -- This cluster represents weakly-specified, short-term agreements, with only limited protections for investors. These contracts contain fewer representations and warranties and fewer covenants than the average, and they rarely protect investors from stock dilution or from corporate mergers. As a general matter, contracts in this group resemble short-term loans more than long- term partnerships: Investors benefit from relatively stringent mandatory cumulative dividends, but they sacrifice items such as anti-dilution protections 12 Figure 3 displays the results of a "group average" hierarchical cluster analysis (Everitt 1980), which agglomerates contracts into a limited number of non-overlapping clusters, based on their spatial proximity within the MDS configuration. To enhance the robustness of this analysis, the 16 agreements (20%) having the fewest other contracts in their immediate vicinity have been "trimmed" and placed into a "pseudo-cluster" of isolates. Statistical tests indicate that the remaining 62 VCFCs compose five empirically distinguishable clusters, as described in the text. 19
  22. 22. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN and rights of first refusal, which would allow then to maintain their ownership stake through future financing rounds. In keeping with this "take the money and run" character, Cluster 1 also displays a much higher frequency of discretionary stock redemption provisions, which allow successful companies to "buy out" investors -- usually at a premium over the initial investment price, but at a discount from the stock's market value. Cluster 2: Pre-Programmed Contracts -- This cluster contains contracts that are in most regards relatively conventional, but that exhibit a marked preference for establishing a priori timetables, milestones and benchmarks for relations between the start-up and its investors. Thus, these agreements are substantially more likely than others to: (a) condition their merger provisions on the achievement of certain benchmarks, (b) structure their anti-dilution clauses so that harsh "ratchet" protections revert to more equitable regimes after a specified number of financing rounds, and (c) permit companies to redeem investors' stock upon the occurrence of particular triggering events. Coupled with an aversion to rights of first refusal, such timetables, milestones and benchmarks conjure an image of the venture capital relationship as an indentured servitude -- a limited period of reduced autonomy, during which the start-up faces various carefully-delineated opportunities to earn its freedom from initially-burdensome obligations. Cluster 3: Legalistic Contracts -- This cluster contains a bevy of highly-elaborated agreements that establish detailed legal rights for both the start-up and its investors, covering a wide range of eventualities. Thus, for example, financings in this group feature specific escape hatches for the start-up if performance is good and specific protections for the investors if performance is poor: These contracts guard the upside interests of the start-up through mandatory conversion provisions, discretionary stock redemption clauses and complexly contingent merger treatments; at the same time, these agreements address the downside concerns of investors through cumulative dividend provisions, abundant covenants, thorough representations and warranties, and nearly-universal anti- dilution protection. Between these performance extremes, Cluster 3 seems to embrace a relatively long-term view of the venture capital relationship, with virtually all agreements granting rights of first refusal to investors who wish to join in future financing rounds. In short, these agreements resemble classic long- term contingent claims contracts. Cluster 4: Close Contracts -- This cluster represents a collection of hands-on financings designed to foster lasting partnerships between start-ups and investors. Thus, contracts in this group tend to have few easy exits, eschewing discretionary stock redemption and placing stringent conditions on investors' powers to register their holdings for public sale. At the same time, these financings also enact extensive barriers against the intrusion of unwelcome interlopers into the venture capital relationship. In particular, this cluster features harsh anti-dilution protections, nearly-universal rights of first refusal, and numerous protective covenants (including investor vetoes over future stock sales, mergers and rights changes). Finally, in keeping with the partnership model, these agreements tend to be "enterprise-specific," treating mergers as dissolutions of the corporation, rather than obliging shareholders to continue on in a radically altered venture. The overall image here is of a "jealous marriage" -- a long-term, close and exclusive relationship, structured so as to forestall potential infidelities. 20
  23. 23. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Cluster 5: Flexible Contracts -- This final cluster embraces a relatively flexible, open- ended view of venture capital financing. On the one hand, agreements in this group resemble the minimalist agreements of Cluster 0 and the weak agreements of Cluster 1, in that they often fail to specify certain "key" terms, such as dividend rates and anti-dilution protections. On the other hand, the non-specificity of Cluster 5 appears to be a conscious strategy for building adaptive relationships, rather than an oversight or an effort to avoid lasting entanglements. Here, the omission of certain obligations goes hand in hand with the careful elaboration of others. Numerous representations, warranties and covenants protect investors against prior and future claims on the start-up's assets; financial reporting requirements and other covenants provide investors with relatively close supervision over corporate operations; rights of first refusal and stock registration rights allow investors to reevaluate their involvement as the company matures. In short, these agreements resemble relational contracts in laying a solid foundation for a long-term relationship, while leaving the specifics of that relationship open to future development. In summary, the six clusters portrayed in Figure 3 correspond, respectively, to: (0) idiosyncratic contracts, (1) weak contracts, (2) pre-programmed contracts, (3) legalistic contracts, (4) close contracts, and (5) flexible contracts. As a general matter, none of these cluster-descriptions invalidates the dimensional interpretation offered above: The pre- programmed and legalistic clusters located at the extreme right of Dimension 1 do, indeed, contain more extensively elaborated contractual obligations than do the idiosyncratic, weak and flexible clusters located at the left; similarly, the legalistic, close and flexible clusters located in the upper half-plane do, indeed, contemplate more lasting relationships than do the weak and pre-programmed clusters located below. At the same time, however, this neighborhood interpretation also suggests numerous characteristics of each cluster that are not easily deducible from its location with respect to the coordinate axes: Both short-term loans and indentured servitudes reflect obligations of limited duration, but they involve two radically divergent types of inter-organizational relationships. Similarly, close supervision and legalistic formalism address common underlying concerns in fundamentally different ways, and past research suggests that these differences may have profound effects on important maturational phenomena such as organizational growth and diversification (Scott 1992:261-262). By shedding light on such distinctions, a neighborhood interpretation adds important insights into the emerging map of Silicon Valley financings. 21
  24. 24. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Overall, the combined weight of the foregoing analyses suggests that Silicon Valley has produced several alternative financing archetypes, rather than a single unitary standard. Moreover, each of these archetypes corresponds to a distinct, internally-consistent model of the venture-capital relationship.13 From a theoretical perspective, one could argue that these results illustrate both the existence and the nature of the community's emerging cultural typologies. Determinants of Financing Structure: Finally, having identified distinct financing archetypes, one might wish to examine the exogenous factors that influence choices among these alternative contractual structures. Two key factors emerge: historical timing and inter-organizational pollination. Historical Timing: Looking at the data -- or, indeed, even looking at the contractual documents themselves -- one relationship that fairly leaps out is the pervasive importance of historical time. There are several ways to see this temporal pattern. First, one can examine the drafting date of the various contracts in the MDS mapping, as illustrated in Figure 4. Shading in this figure corresponds to date of financing, with darker symbols indicating more recent agreements. The superimposed arrow represents the predicted coordinates for an average contract in each year, based on a two-dimensional, curvilinear OLS regressions equation. Substantively, Figure 4 portrays a general increase in the expected duration of the financing relationship, coupled with a curvilinear trend in the level of legalism: While Relational Duration scores rise throughout the observation period, Rights Elaboration rises only until 1986 -- after which it experiences a notable decline. Figure 4 also reveals a dramatic concentration of the 13 Significantly, contrary to the tenor of much of the trade literature, none of these six archetypes seems unequivocally "pro-company" or "pro-investor." Although the burdens and rewards of individual models may fall unequally in specific transactions, each model represents a logically defensible vision of the venture capital relationship -- a coherent, facially-neutral image upon whose merits well-intentioned community members might honorably disagree. In short, these six contractual archetypes reflect different ways of reconciling competing interests, rather than total victories for one side or the other. 22
  25. 25. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN most recent contracts in the upper half-plane -- and, in particular, in Clusters 4 and 5 (Flexible contracts and Close contracts). Indeed, by the close of the observation period in 1990, the pluralism that characterized the community at mid-decade has given way to a situation in which roughly 75% of all venture capital transactions fall into these two clusters. These findings highlight the complex succession of organizational models that often characterizes the early years of an emerging community. At this level of detail, the term "structuration" seems a misnomer: The results appear to paint a picture of flux, not of structure. Before concluding the discussion of temporal dynamics, however, it may be worth pausing to reexamine this tumult from a slightly broader perspective -- looking not at the "typical" contract in each year, but at the shifting overall configuration. To this end, Figure 5 plots the historical trajectory of four summary statistics, each of which captures a distinct facet of the structuration process: Deviance: Since structuration involves the emergence of behavioral norms and cognitive schema, it presumably suppresses departures from conventional behavior. In Figure 5a, such departures are indicated simply by the percentage of contracts falling into the pseudo-cluster of outliers, Cluster 0. Density: In addition to eliminating idiosyncratic behaviors, structuration implies an increasing routinization and typification of more conventional behaviors, as well. In the present context, this suggests that contracts should coalesce into increasingly dense clusters. To measure this effect, Figure 5b employs the median "local density" of all non-idiosyncratic contracts within a five-year window.14 Diversity: According to most accounts, not only does the structuration process reduce idiosyncracy and standardize conventional behavior, but also it restricts the number of conventional alternatives "on the menu." In Figure 5c, the diversity of conventional alternatives is captured by a Herfindahl Index (Weinstock 1982), with a potential range from 0 to 0.8. 14 This analysis uses SAS's PROC CLUSTER (SAS Institute 1988) to determine the local density of all non-idiosyncratic contracts drafted within each five-year window. For a given contract, this score corresponds to the number of other contracts lying within a 0.5-unit radius in the MDS configuration, divided by the total N in the five-year subsample. 23
  26. 26. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Elaboration: A final aspect of structuration is the increasing elaboration of established institutions. Consequently, Figure 5d includes, as an index of contractual elaboration, an average of Rights Elaboration and Relational Elaboration15. Figure 5 offers strong confirmation for the proposition that Silicon Valley's venture capital financing practices do, indeed, undergo substantial structuration from 1979 to 1990. The first stage of this developmental process occurs prior to 1983, with the emergence of distinct contractual archetypes. Initially, most contracts are fairly simple and poorly elaborated. Many do not fall into any archetypal cluster, and the clusters that do exist are relatively diffuse, suggesting a great deal of variance in contractual terms. From 1978 to 1983, however, contracts become more elaborated, less idiosyncratic, and more tightly clustered into distinct archetypes. Interestingly, the level of diversity actually increases substantially during this early period, presumably reflecting the introduction of several previously non-existent contractual models. Between 1983 and 1987, the focus shifts from generating new alternatives to fleshing out existing approaches. Both density and diversity stabilize at fairly high levels, while elaboration rises steadily and deviance falls to virtually zero. Then, from 1987 onward, financing practices enter a consolidation phase: Elaboration reaches a plateau, and although density remains constant, diversity begins to decline, as some archetypes fall by the wayside. By the end of the observation period, the structuration process appears to be nearing completion. Most new contracts in these final years embrace one of two well-defined and highly-elaborated archetypes, and deviance/innovation remains rare. Thus, the community ultimately arrives at a fairly narrow range of highly-typified and widely-diffused models of "accepted" contractual structure. In a word, venture capital financing becomes institutionalized. 15 The elaboration of established institutions is not, of course, exactly equivalent to the elaboration of contractual provisions. Contracts could, for example, become simpler because alternative regulatory structures were becoming more complex (cf. Macaulay 1963 [reporting that business transactions are often governed by informal community norms]). Nonetheless, contractual elaboration and institutional elaboration are clearly related, since contractual practices are one of the various regulatory institutions that an emerging community might elaborate. 24
  27. 27. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Before moving on, it is perhaps worthwhile to speculate briefly on possible linkages between the overall process of structuration and the trends in Rights Elaboration and Relational Duration described above. With some simplification, one might characterize the institutional environments of organizations as being comprised of both normative institutions and cognitive institutions (Scott 1995 [distinguishing between regulative, normative, and cognitive institutions]). Normative frameworks impose moral rules of behavior and support both formal and informal sanctions for deviance; cognitive frameworks impose taken-for-granted definitions of reality and support both prospective and retrospective accounts for action. As the structuration of a new organizational community progresses, both sorts of cultural structure increase -- but at different paces and with different implications for contractual elaboration. In new communities, it seems likely that cognitive understandings will tend to become institutionalized before normative controls, since one must generally develop descriptive models for cognizing the world before one can develop evaluative criteria for judging it. This initial rise in cognitive structure presumably fosters both Rights Elaboration and Relational Duration, since the emergence of shared expectations allows contracting parties to identify (and contract for) "plausible" contingencies and to envision long-term relationships. As structuration proceeds, the attendant rise in interaction, hierarchy and social consciousness begins to generate normative order, as well. The emergence of behavioral norms tends to accelerate the rise in Relational Duration, because transacting parties can now rely on defectors being stigmatized and sanctioned. Under many conditions, however, the growth of normative structure may actually decrease Rights Elaboration, because generalized norms can often substitute for contractual terms, and because informal sanctions can often substitute for legal enforcement. Thus, early cognitive structuration fuels an increase in both Relational Duration and Rights Elaboration; but as normative structuration catches up, only Relational Duration continues to grow, with Rights Elaboration giving way to more informal standards and controls. While this explanation is 25
  28. 28. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN obviously speculative, it fits reasonably well both with the structuration statistics depicted in Figure 5 and with the curvilinear trajectory depicted in Figure 4.16 Inter-organizational Pollination: In addition to showing the effects of historical dynamics, the choice of contractual structure also shows the influence of sponsorship on the part of both law firms and venture capital funds. In other words, some law firms and some venture capital funds act as "paradigm pushers," employing contracts that disproportionately reflect a limited subset of the available archetypes. Perhaps the most straightforward way to see this is simply to compare the output of the three law firms that are most heavily represented in the VCFC sample. Figure 6 offers such a comparison. The first panel depicts the output of LawFirm1, one of Silicon Valley's largest law offices. While LawFirm1 is clearly a "generalist," the firm displays a noticeable preference for contracts in Quadrant 1 and Quadrant 3 -- and a clear aversion to the Pre-programmed contracts of Quadrant 4. LawFirm2 shows an even tighter focus. As depicted in Figure 6b, this San Francisco-based firm is a classic "specialist": All but four of its fourteen financings occupy either Quadrant 2 or Quadrant 4 -- and in the latter instance, its six Flexible agreements fall so close together that their plot symbols cannot be individually distinguished. These narrowly targeted efforts stand in stark contrast to LawFirm3, another San Francisco-based firm, whose contracts appear in Figure 6c. LawFirm3's financing agreements scatter almost randomly across the coordinate plane, with only limited clustering and little standardization: Whereas over half of the LawFirm2 agreements produce contiguous or overlapping plot symbols, none of the LawFirm3 agreements do. The pattern is one of extreme generalism, with few clear preferences, whatsoever. 16 If this account is correct, it suggests that the precise empirical patterns of Rights Elaboration and Relational Duration observed in Silicon Valley may be typical of new organizational communities, but not generic to all business settings. It seems likely that levels of normative and cognitive structure would follow quite different trajectories in other contexts, such as when two pre-existing business communities are brought into new contact with one another, or when an established business community experiences an exogenous economic shock. 26
  29. 29. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Taken as a whole, these results suggest at least two distinct ways in which the development of community norms may reflect the actions of inter-organizational pollinators. First, and most obviously, when a specific pollinator adopts and promulgates a specific model, the fate of the model and the fate of the pollinator become closely intertwined. Thus, for example, as LawFirm2 has grown, the Flexible contracts that LawFirm2 favors have proliferated as well. In addition to such direct paradigm-pushing, however, Figures 6a, 6b and 6c also suggest that community norms may reflect more subtle aspects of pollinator behavior, as well. In particular, the contrast between LawFirm2 and LawFirm3 illustrates the fact that law firms may differ dramatically in the degree of generalism or specialism that they embrace and in the degree of standardization that they impose on their counseling efforts. These strategic choices may, in turn, determine both the degree of commercial success that these law firms enjoy and the degree of structuration that the community experiences. In most situations, the greater the specialism of inter-organizational pollinators, the faster the typification of community activities.17 Multivariate Models: In addition to the foregoing bivariate examinations, one can also employ multivariate regression-like techniques to explore the relative importance of various determinants of contractual structure, when other determinants are statistically "held constant."18 17 This proposed relationship between specialization and typification presumably depends upon the total number of pollinators in the community and the total number of archetypes that they propound. Clearly, a community with fifty generalists each supporting the same menu of five models will experience more rapid typification than a community of fifty specialists each supporting a single model of its own. 18 In the present investigation, OLS regressions address the factors affecting a contract's location along the axial dimensions of "rights elaboration" and "relational elaboration," while logistic regressions address the factors affecting a contract's odds of falling into each of the six archetypal clusters. Specifically, the OLS regressions reported below employ dimension coordinates as their dependent variables, while the logistic regressions employ a series of six dichotomous dummy variables, each coded "1" for a given cluster and "0" for all others. Methodologically inclined readers will note that the "multiple-dichotomy" approach to cluster membership employed in these logistic regressions is similar -- but not identical -- to conventional "multinomial logit" analysis (e.g., Aldrich & Nelson 1984:73-77). Suchman (1994) provides a detailed comparison of relative strengths and weaknesses of the two approaches. 27
  30. 30. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Table 3 presents OLS models that regress each VCFC's position on the two MDS axes against various temporal, institutional and economic predictors.19 Several features of these results merit comment. The first noteworthy aspect is the relatively high predictive power that these models achieve based on only a handful of variables. With six independent variables, Model 1 manages to explain over 40% of the variance in Rights Elaboration (R2=.44; p<.0001), and Model 2 explains a similar percentage of the variance in Relational Elaboration using just five regressors (R2=.41; p<.0001). The individual parameter estimates in Table 3 reveal temporal factors to be by far the strongest predictors of scores on both dependent variables. In a pattern that accords well with the graphical data presented in Figure 4, above, Table 3 depicts a fairly steady increase in the expected duration of venture capital relationships, coupled with a curvilinear trend in legalism: The relatively small number of cases in the present data set limits the feasibility of large- scale multivariate models -- particularly models including interaction effects and other possible sources of multicollinearity. To address this difficulty, the analyses reported here each employ only a limited selection of regressors, chosen as follows: First, a preliminary multivariate model estimated parameters for the full complement of independent variables. Then, a backward stepwise analysis sequentially removed independent variables, until all remaining items displayed significance levels of p<.15 or better. Finally, a "compromise" model combined (a) all variables identified by the stepwise selection algorithm, plus (b) any additional items displaying a significance level of p<.25 or better in the initial all-variables regression. Although somewhat ungainly, this technique proved surprisingly robust: In all cases, the "full" model, the "minimal" model and the "compromise" model agreed quite closely, and the estimated parameter values showed remarkable stability. Consequently, the present write-up reports "compromise" models, only. 19 In these models, YEAR measures the impact of drafting date, and YEAR2 tests for the existence of non-linear time trends. LAWFIRM2, LAWFIRM3 and OTHER LAW FIRM are binary variables identifying the drafting law firm for each contract (with LawFirm1 being the omitted, comparison category). SOURCE 2 and OTHER INVESTOR are binary variables identifying the lead venture capital fund in each deal; SOURCE 2 identifies the smaller of the two funds that provided contracts for the study, with the larger source fund serving as the omitted, comparison category. SILICON VALLEY COMPANY is a binary variable, coded 1 if the start-up is headquartered in or near Silicon Valley. SEMICONDUCTOR, MISCELLANEOUS ELECTRONICS, NETWORKING/TELECOM, SOFTWARE and BIOTECH are binary variables identifying the primary industry of the start-up (with computer systems being the omitted category). The remaining variables measure characteristics of the transaction itself: VC STAKE is the percentage of corporate ownership that the investor syndicate is purchasing, VALUATION is the implied valuation of the company as a whole, NUMBER OF INVESTORS is the total size of the investor syndicate, and INVESTOR DIVERSITY is a measure of the concentration of ownership across the various members of the syndicate. 28
  31. 31. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Here, as before, Rights Elaboration appears to rise until the mid-1980s and then to decline slightly thereafter. Beyond these powerful temporal effects, however, Models 1 and 2 show only a limited number of additional significant relationships. Model 1 reveals a handful of differences in Rights Elaboration across industries, but no clear overall pattern emerges. Model 2 finds only one significant non-temporal influence on Relational Duration: start-up location. Apparently, non-local companies enter into significantly shorter-term financing relationships than do start-ups headquartered within Silicon Valley (p<.04). This result comports equally well with either (a) an explanation highlighting Silicon Valley's cultural emphasis on "company- building," or (b) an explanation highlighting the elevated transaction costs involved in long-term contractual relationships between remote parties. Unfortunately, the current investigation (which only examines agreements involving Bay Area investors) offers little potential for adjudicating between these two competing accounts. Significantly, while Table 3 certainly illustrates the importance of community structuration, it provides little evidence that inter-organizational pollinators play an important role in this structuration process: None of the variables identifying drafting law firms or lead investors are significantly associated with the overall level of Relational Duration or Rights Elaboration. Although disconcerting, this result is not entirely unexpected: The cluster analysis, above, clearly demonstrates that the map of Silicon Valley financings contains numerous non- linear patterns that are not well-summarized by mere location along the coordinate axes. Before dismissing the relevance of law firms and venture capital funds in the structuration process, one would be wise to examine the determinants of cluster membership, as well as the determinants of axial location. This task requires a series of six logistic regressions, each focussing on membership in a single contract-cluster. Table 4 presents such an analysis. Although this table contains several intriguing individual parameter estimates, the general patterns that emerge across all six models are the present investigation's primary concern. One such pattern is the fairly consistent predictive strength of these models. All six logistic regressions reach conventional levels of 29
  32. 32. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN significance, with most models obtaining a pseudo-R2 of roughly .25, on the basis of only four to eight regressors. Two equations -- for the "idiosyncratic" cluster and for the "pre-programmed" cluster -- do substantially better, achieving pseudo-R2 scores of .482 and .615, respectively. These results attest to the relevance of temporal, inter-organizational and economic factors, taken together, in explaining the distribution of contracts among archetypes. Looking at these three groups of determinants individually, one can delineate a number of additional regularities. First, and most obvious, is the fact that either Year or Year2 (or both) achieve significance in all six logistic regressions. This finding reconfirms the previously-noted importance of temporal dynamics in the structuration process: The popularity of contractual archetypes clearly changes over time, even with other exogenous factors held constant. A second general pattern appears in the degree to which economic factors show substantial coefficients. Industry significantly effects the likelihood of adopting Idiosyncratic, Weak, and Pre-programmed contractual forms, while Investor Diversity significantly influences the chances of adopting Pre-programmed and Legalistic forms. In total, four out of the six clusters display significant economic effects of some kind. Finally -- and perhaps most strikingly -- while Table 3 indicates that potential pollinators have little actual impact on the overall level of contractual elaboration in Silicon Valley, Table 4 suggests that pollinators play a pervasive role in determining what form that elaboration takes. In four out of the six logistic regressions, institutional sponsors exert a substantial influence on the probability of employing particular contractual archetypes: Investors affect the odds that contracts will adopt the Weak and Pre- programmed forms, while law firms affect the odds that contracts will follow the Pre- programmed, Close and Flexible models. Specifically, within the Silicon Valley legal community, the two San Francisco-based firms (LawFirm2 and LawFirm3) produce a disproportionate number of Pre-programmed contracts, with LawFirm2 showing an additional inclination toward Flexible agreements, and with the large Palo Alto-based firm (LawFirm1) emphasizing the Close approach. 30
  33. 33. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN Taken together, these multivariate models paint a relatively complex picture of the determinants of contractual form in Silicon Valley. Although temporal dynamics clearly occupy a position of paramount importance and economic conditions significantly affect several specific archetypes, the activities of law firms and venture capital funds exert substantial and pervasive influences as well. Either lead investor, or drafting law firm, or both, is a significant predictor of membership in virtually every archetypal cluster -- even after controlling for time, company characteristics, and deal structure. This suggests that the structuration of financing practices in Silicon Valley was, indeed, driven in large part by the activities of concrete organizational entities in the community's legal- and financial-services sectors. The foregoing evidence demonstrates that one cannot explain the genesis of venture capital financing practices in Silicon Valley without reference to the institutional mechanics of community development. Overall, then, the quantitative data on venture capital financing contracts offer fairly detailed empirical evidence of institutional structuration. From 1975 to 1990, Silicon Valley developed a limited repertoire of relatively standardized financing archetypes, with the choice of structure in any given transaction turning largely on factors of historical timing and network- embeddedness. During this period, the contractual approach that each start-up employed depended heavily on which models were "in" at the time of the financing -- and on which models were being "pushed" by the law firm handling the drafting work. Thus, the preceding quantitative analyses largely confirm institutional theorists' predictions about the trajectory of institutionalization and standardization in new industries. In doing so, the results also illustrate the substantial impact of local business culture and of social-influence processes on what might, at first blush, appear to be isolated, rationally-engineered financial transactions. Conclusion This investigation highlights a number of noteworthy aspects of the role of law firms in the structuration of emerging organizational communities. As Silicon Valley illustrates, the 31
  34. 34. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN structuration process involves a gradual building of (a) conceptual and material connections, linking initially disparate groups of organizations; (b) descriptive and prescriptive accounts, identifying which situations are alike and which are distinct; and (c) instrumental and ritual decision rules, delineating which attributes are beneficial, proper, and appropriate for specific organizations in specific situations. Moreover, this incremental process of mutual-adaptation seems to be channeled in significant ways by the interventions of concrete intermediary actors, such as law firms and venture capital funds. These apparently ancillary organizations provide new start-ups with pre-processed infusions of relevant know-how -- serving, in effect, as inter- organizational pollinators. Over time, such interventions exert a perceptible impact on the emergence of local business practices, fostering (among other things) a distinctive set of highly standardized contractual models.20 For sociologists of law, this study offers two significant messages, -- one empirical and the other theoretical. First, at an empirical level, the study brings some concrete evidence to bear on the vexing question of what, exactly, corporate lawyers do. In particular, the project documents the development of a specific "legal device" -- the standard-form VCFC -- and it demonstrates how the construction of this device was intimately intertwined with the emergence of a specific organizational community -- Silicon Valley. As one interviewee put it, "Silicon Valley made venture capital, and venture capital made Silicon Valley." By tracing the trajectory of this reciprocal process, the preceding analysis helps to delineate the contribution of local law firms to the making of both. Beyond this empirical contribution, however, the project offers a theoretical contribution as well, illustrating the conceptual leverage that one can obtain by linking the study of corporate 20 In some ways, this portrayal of incremental rule-building resembles the Law and Economics account of a social system moving toward efficient governance principles (cf. Ellickson 1991 [describing emergence of "efficient" customs]). On the whole, however, the foregoing analysis paints a picture not of progressive optimization, but rather of social construction and historical path-dependence (DiMaggio 1991 [describing social construction of an organizational field]; Arthur 1989 [predicting path dependent development of certain economic systems]) -- two aspects of governance that the law and economics tradition tends to ignore (but see Klausner 1995 [analyzing path dependence in the development of standardized contracts]). 32
  35. 35. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN legal practice to the study of organizational environments. In Silicon Valley, at least, lawyers do not just engineer technical "devices" that allow specific clients to capture excess economic value in specific transactions; Silicon Valley lawyers also play a key intermediary role in institutionalizing the characteristic beliefs, rituals and practices of an entire organizational community. If we think of law firms in organizational terms, however, it also becomes clear that lawyers may not be the only actors competing to fill this particular niche. Clearly, for example, venture capitalists engage in a substantial amount of inter-organizational pollinating, as well. Consequently, research on corporate law cannot be disentangled from research on the various populations of clients, competitors and collaborators that make up the corporate law firm's organizational environment. This perspective opens the door to an intriguing (but as yet unresolved) debate about whether Silicon Valley's "pollinator" model of legal practice can survive the maturation of the organizational community that it helped to produce. On the one hand, the larger institutional structure of the American legal system clearly places law firms in a privileged structural position from which to engage in pollination activity: First, as independent consultants, law firms enjoy fairly intimate contacts with a wide pool of organizational clients, and these contacts generate a broad vicarious experience-base from which lawyers can synthesize relevant know-how. Second, lawyers occupy a privileged position from which to disseminate relevant know-how, as well. The American legal system leaves new companies little choice but to seek professional legal assistance for even the most basic of organizational acts, and as a result, attorneys enjoy early and frequent contact with new companies, at precisely that point in the organizational lifecycle when demands for constitutive information are most intense. Finally, not only do attorneys observe a wide range of clients and enjoy numerous opportunities to impart advice, but also they do so in the context of relatively low perceived opportunism. Although lawyers' and clients' interests can and do diverge, professional ethics and prevailing cultural assumptions tend to minimize (or at least to obscure) these conflicts to a much greater extent than is the case with 33
  36. 36. VENTURE CAPITAL FINANCING CONTRACTS MARK C. SUCHMAN many other potential intermediaries. Your lawyer is "yours" in a way that your banker, your OSHA inspector, and even your accountant never will be. So, in short, the larger institutional structure of the American legal system places attorneys in a nearly ideal position from which to monitor wide ranges of organizational behavior, to convey the results of these observations to new companies at times of maximum permeability, and to have this advice be received with relatively little skepticism or suspicion. As a result, as long as Silicon Valley continues to attract new, "unsocialized" entrants, law firms may continue to find themselves well-situated to perceive, promulgate and institutionalize the community's distinctive beliefs and practices. In this view, the Silicon Valley law firm's pollinator role is secure for the foreseeable future. On the other hand, the structuration model clearly suggests that the organizational environment may place scope conditions on theories about corporate lawyering, in much the same way that it places scope conditions on theories about the structures and operations of other, more commonly studied, organizational populations. If so, there is good reason to wonder whether the influence of Silicon Valley lawyers can outlive the current, formative period of the community's history. It is easy, in day-to-day research, to take the law for granted, and to lose sight of the fact that the legal environment is a social construct, resting in large part on specific acts of collective categorization. The evidence from Silicon Valley highlights such social construction processes, precisely because the region's cultural and legal categories still remain only partially constructed. Given this, however, It seems possible that many of Silicon Valley's distinctive legal practices are not themselves permanent attributes, but are instead reflections of this unsettled (and presumably transitory) state of affairs. From this perspective, one might predict that as local business activities become increasingly institutionalized and well-understood, a number of changes in legal practice will ensue: New entrepreneurs will have less need for general business counseling; a wider range of legal work will be routinized and moved in-house; and any pollination that remains will increasingly be absorbed by specialized consulting firms. If this account of environmental 34