Several developments suggest that venture capitalists (VCs) are retreating from their traditional corporate governance role of monitoring their portfolio companies. Startup founders are retaining more equity and control over their companies, and contrary to past practice, some VCs say they will never remove a founder. At the same time, startups are taking unprecedented risks – defying regulators, growing in unsustainable ways, and racking up billion-dollar losses. There have also been a series of high-profile scandals at the likes of Uber, WeWork, FTX, where VCs have proven unable or unwilling to prevent founder misbehavior.
In a new article, we propose that VCs have taken on a new corporate governance role: to persuade risk-averse founders to pursue high-risk strategies. Our proposal is based on the fact that returns to venture investing are driven by outliers, one or two “home runs” – portfolio companies that grow 10 times or more, and the most successful funds generate even more skewed returns. We argue that, while the importance of outlier companies to venture returns is universally acknowledged, its implications for corporate governance have not been fully appreciated.
After supplying capital, VCs need to motivate founders to implement the high-risk, high-reward strategies that can increase the company’s potential for rapid, exponential growth. Founders may be reluctant to take on so much risk. Founders typically invest a large percentage of their human and financial capital into their startups and consequently are unable to diversify firm-specific risk. By contrast, VCs and the large institutions that invest in venture funds can diversify idiosyncratic risk associated with any specific portfolio company.
In our model, VCs address the divergence in risk preference by striking an implicit bargain with founders. The founders agree to pursue the high-risk strategies that the VCs think will increase the chance of a home run. In exchange, the VCs agree to let the founders extract private benefits from the business. To develop this intuition, we model a hypothetical financing contract between a founder and a VC staged over two rounds of investment.
Like others, we predict that VCs will purchase preferred stock, but our explanation is different. Under the conventional view, the liquidation preference given to preferred stock provides downside protection and shields VCs against founders who overclaim. Our analysis suggests it also encourages founders to take risks. The liquidation preference reduces a founder’s payout in an underwhelming exit and increases their percentage of the returns in a home run. It effectively turns the founders’ common stock into a non-linear financial claim, akin to a stock option, that rewards founders who pursue high-risk strategies.
Risk-bearing also has implications for how each round of VC financing is priced. 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 away from the most efficient risk bearer (the VC) to an undiversified founder. To address this problem, our model predicts that VCs will compete on non-price factors. In particular, a VC can promise to protect the founder’s private benefits. This protection could be formal. For example, the VC might not bargain for board seats or other control rights. Or it could be informal. VCs can promise to give founders early liquidity when their startup grows, job security when it struggles, and a soft landing if it fails. In our model, VCs who develop a founder-friendly reputation have a competitive advantage in pricing each round of financing but are more exposed to poor performance after investment due to suboptimal monitoring.
Critically, our model does not require irrational behavior or underappreciation of the potential benefits of monitoring. Even when the potential benefit of VC monitoring is large, our analysis suggests a founder may prefer to raise capital from a founder-friendly VC to lower their risk exposure. VCs provide a variety of protections that shield founders from risk. When startups succeed, VCs facilitate the sale of founder equity – providing liquidity – in follow-on financing. When startups fail, VCs seek to arrange a “soft landing” – a face-saving acqui-hire for the startup’s employees or a new job for the founders. More generally, VCs are increasingly promoting themselves as founder-friendly, which is hard to reconcile with their role as monitors.
What does all this mean for corporate law? We think the rise of risk-seeking governance shows that Delaware courts have little power to shape behavior in Silicon Valley. The monitor model suggests that VCs behave roughly as corporate law envisions that directors should behave – they monitor managers, police self-dealing, and create incentives for performance. By contrast, the risk-seeking model explains that VCs behave more subversively – they skip monitoring, indulge self-dealing, and push managers to take risks. VCs and founders both get what they want out of the implicit bargain. But other corporate stakeholders, and society generally, may be stuck bearing unbargained-for risks.
 An acqui-hire occurs when an acquiring firm buys a startup primary to hire its employees and does not plan to continue the business. SeeJohn Coyle & Gregg Polsky, Acqui-hiring, 63 Duke Law Journal 281 (2013).
This post comes to us from professors Brian Broughman at Vanderbilt University Law School and Matthew Wansley at Yeshiva University’s Benjamin N. Cardozo School of Law. It is based on their recent article, “Risk-Seeking Governance,” available here.