Risk-Seeking Governance

Brian J. Broughman

Vanderbilt University Law School

Matthew Wansley

Yeshiva University - Benjamin N. Cardozo School of Law

Date Written: February 1, 2023

Abstract

Venture capitalists (VCs) are increasingly abandoning their traditional role as monitors of their portfolio companies. They are giving startup founders more equity and control and promising not to replace them with outside executives. At the same time, startups are taking unprecedented risks—defying regulators, scaling in unsustainable ways, and racking up billion-dollar losses. These trends raise doubts about the dominant model of VC behavior, which claims that VCs actively monitor startups to reduce the risk of moral hazard and adverse selection. We propose a new model in which VCs use their role in corporate governance to persuade risk-averse founders to pursue high-risk strategies. VCs are motivated to take risks because most of the gains in venture funds come from the exponential growth of one or two outlier companies. By contrast, founders are reluctant to gamble because they bear firm-specific risk that cannot be diversified. To compensate founders for their risk exposure, VCs offer an implicit bargain in which the founders agree to pursue high-risk strategies and in exchange the VCs provide them private benefits. 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 ex ante pricing but are more exposed to poor performance ex post due to suboptimal monitoring. Stakeholders who are not party to the VC-founder bargain—and society at large—are forced to bear uncompensated risk.