Risk-Seeking Governance

Venture capitalists (‘VCs’) are retreating from their traditional role as monitors of their portfolio companies. Startup founders are retaining more equity and control over their companies, and VCs are promising not to replace founders with outside executives. At the same time, startups are taking unprecedented risks—defying regulators, scaling in unsustainable ways, and racking up billion-dollar losses. And there have been a series of high-profile scandals—Uber, WeWork, FTX—in which VCs proved unable or unwilling to prevent founder misbehavior. These trends raise doubts about the standard account, which claims that VCs actively monitor startups to reduce the risk of moral hazard and adverse selection.

In our article ‘Risk-Seeking Governance’, we propose a new theory—VCs use their role in corporate governance to persuade risk-averse founders to pursue high-risk strategies. We are motivated by the fact that returns to venture investing are driven by outliers. The success of a venture fund depends on finding one or two ‘home runs’—portfolio companies that grow 10x or more, and the most successful funds generate even more skewed returns. The importance of outlier companies to venture returns is universally acknowledged, but 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.  

Similar to the standard account, we predict that VCs will purchase preferred stock, but our explanation is different. Under the conventional view, preferred stock reduces adverse selection at the time of investment. Our analysis suggests it also encourages founders to take risks. The liquidation preference associated with the VC’s preferred stock reduces the founders’ payout in an underwhelming exit and increases their percentage of the returns in a home run. It effectively turns the founder’s 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 ex ante pricing. 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 pay-outs 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 dimensions. 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. 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.

Critically, our model does not require irrational behaviour or underappreciation of the potential benefits of monitoring. Even when the potential benefit of VC monitoring is large, a founder may prefer to raise capital from a founder-friendly VC to lower their risk exposure. Our analysis can help explain founder-friendly VC behaviour. VCs facilitate the sale of founder equity—providing liquidity—in follow-on financing. When startups fail, VCs seek to arrange a face-saving acqui-hire 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 behaviour 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 more generally, may be stuck bearing un-bargained for risks.

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By Brian Broughman, Professor of Law at Vanderbilt University Law School and Matt Wansley, Associate Professor of Law at Benjamin N. Cardozo School of Law.

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This blog article was originally posted on OBLB part of a series on The Law and Finance of PE and Venture Capital.