Several developments suggest that venture capitalists (VCs) are stepping back from their traditional corporate governance role of overseeing their portfolio companies. Startup founders retain more equity and control over their companies, and unlike past practice, some VCs say they will never remove a founder. At the same time, startups are taking unprecedented risks — defying regulators, growing unsustainably, and racking up billions of dollars in losses. There has also been a series of high-profile scandals like Uber, WeWork, FTX, where VCs have proven unable or unwilling to prevent bad behavior by founders.
In a new paper, we propose that VCs have taken on a new corporate governance role: persuading risk-averse founders to pursue high-risk strategies. Our proposition is based on the fact that venture capital investment returns are driven by outliers, one or two “home runs” – portfolio companies growing 10x or more, and top performing funds generate even more biased returns. We argue that although the importance of outlier companies for venture capital returns is universally recognized, its implications for corporate governance have not been fully appreciated.
After providing capital, venture capitalists must motivate founders to implement high-risk, high-reward strategies that can increase the company’s potential for rapid and exponential growth. Founders may be reluctant to take so many risks. Founders typically invest a large percentage of their human and financial capital in their startups and are therefore unable to diversify company-specific risks. In contrast, venture capitalists and large institutions that invest in venture capital funds can diversify the idiosyncratic risk associated with a specific portfolio company.
In our model, venture capitalists resolve the divergence in risk preference by entering into an implicit agreement with the founders. Founders agree to pursue high-risk strategies that VCs believe will increase the chances of a home run. In return, the VCs agree to let the founders privately profit from the business. To develop this intuition, we model a hypothetical financing contract between a founder and a VC spread over two rounds of investment.
Like others, we expect VCs to buy preferred stocks, but our explanation is different. According to the conventional view, the liquidation preference given to preferred stocks provides downside protection and protects VCs from founders overclaiming. Our analysis suggests that this also encourages founders to take risks. Liquidation preference reduces a founder’s payout on a disappointing exit and increases his percentage of returns on a home run. It effectively turns common stock of founders into a non-linear financial claim, similar to a stock option, that rewards founders for pursuing high-risk strategies.
Risk taking also has implications for the pricing of each venture capital funding round. When VCs pay more for a startup’s equity, they increase the founder’s share of residual returns, but also amplify inefficient risk sharing. A price increase transfers uncertain payouts from the most efficient risk carrier (the VC) to an undiversified founder. To solve this problem, our model predicts that VCs will compete on factors other than price. In particular, a VC can undertake to protect the private profits of the founder. This protection could be formal. For example, the VC may not negotiate board seats or other controlling rights. Or it could be informal. VCs can promise to give founders early cash when their startup grows, job security when it struggles, and a soft landing when it fails. In our model, VCs that develop a founder-friendly reputation have a competitive advantage in pricing each funding round, but are more exposed to poor post-investment performance due to suboptimal follow-up.
Importantly, our model does not require irrational behavior or underappreciation of the potential benefits of surveillance. Even when the potential benefit of VC oversight is significant, our analysis suggests that a founder may prefer to raise capital from VC-friendly to reduce their risk exposure. VCs offer a variety of protections that shield founders from risk. When startups succeed, VCs facilitate the sale of the founder’s equity – providing liquidity – in follow-on funding. When startups fail, VCs look to stage a “soft landing” – a face-saving hire for startup employees(1) or a new job for the founders. More generally, VCs present themselves more and more as founder-friendly, which is difficult to reconcile with their role as monitors.
What does all this mean for corporate law? We believe the rise of risk-seeking governance shows that Delaware courts have little power to shape behavior in Silicon Valley. The oversight model suggests that venture capital firms behave much as corporate law expects directors to behave – they monitor managers, monitor personal transactions, and create performance incentives. In contrast, the risk-seeking model explains that VCs behave more subversively: they ignore oversight, engage in personal dealings, and push managers to take risks. VCs and founders both get what they want from the implied market. But other business stakeholders, and society at large, may be forced to bear unnegotiated risks.
(1) An acqui-location occurs when an acquiring company buys a primary startup to hire its employees and does not plan to continue the business. SeeJohn Coyle and Gregg Polsky, Acqui-rental63 Duke IOh Jjournal 281 (2013).
This message comes to us from Professors Brian Broughman of Vanderbilt University Law School and Matthew Wansley of the Benjamin N. Cardozo School of Law at Yeshiva University. It is based on their recent article, “Risk-Seeking Governance”, available here.