Hitting the headlines: reputational risk in VC

All venture capital firms want explosive growth in their portfolio companies, but it can come with an unwelcome side effect: poor governance.

It’s not been a good year on the reputation front for the tech industry. In recent months, Facebook, whose growth was turbo-charged by a series of venture capital funding rounds, has dominated headlines thanks to revelations that political consultants Cambridge Analytica harvested the personal data of up to 87 million users without their permission.

A series of exposés at start-ups – most of them venture-backed – have revealed a “toxic bro culture” created by young, male chief executives with too much cash and too little business experience.

And the consequences of negative headlines can end up at the doors of the venture capital firms backing these companies.

Investing in venture is inherently riskier than most other types of investment on several fronts, and reputation is no exception.

In this industry “there’s primacy placed on giving entrepreneurs and venture capital firms themselves unfettered freedom to be creative”, explains Ian O’Donnell, a partner in Goodwin’s private investment funds group based in San Francisco.

“You don’t want [the entrepreneurs] to feel like they’ve got a lot of constraints around them, or policies and procedures they have to deal with,” he says. Most entrepreneurs aren’t keen on filing reports or dealing with corporate bureaucracy, which is why they are entrepreneurs. “[The attitude is]: ‘I don’t want that corporate life, I want something free and my own.’  A byproduct of that kind of culture is increased headline risk.”

Kirsten Morin

This culture encourages fund managers to compete with one another based on how “founder-friendly” they are, which has led to an “imbalance in the power of the entrepreneur”, says Kirsten Morin, co-head of global venture capital at Aberdeen Standard Investments.

“There’s been a movement of VCs wanting to be founder-friendly and I think that’s a reflection of the broader environment where it’s hyper-competitive, deals move fast, prices have escalated,” she says.

Growth at all costs comes with risks, not least the potential for poor corporate hygiene, says Theresa Hajer, head of venture capital research at Cambridge Associates, adding “the writing will be on the wall for lots of companies that will stumble”.

Many venture-backed companies are so focused on hypergrowth they have “lost sight of proper culture-building and implementing appropriate governance protocols along the way”, Morin says.

This is exacerbated by companies staying in private hands for longer. If the venture investors who backed the company during the first and second rounds, and didn’t put any constraints around it, go on to make third- and fourth-round investments, without any other institutions coming in, the start-up can turn into a substantial business without having to come into line with established norms and practices.

Keeping a sharp eye

Limited partners, of course, are not blind to these headlines; reputation risk is top of mind with institutional LPs, both at the venture capital firm level and the underlying portfolio company level, says Hajer.

This concern manifests itself in the due diligence questionnaires LPs send to fund managers. “Any time anything happens in the news, it ends up in the due diligence questionnaires in the next cycle from the institutional LPs,” says John Dado, partner at Cooley. “Whether it’s environmental, social and governance policies or personal conduct policies, harassment, cryptocurrency trading policies, whatever is market-topical it ends up being in the diligence for the institutional investors that are diligence-heavy investors.”

Some LPs request a withdrawal right if a reputational risk issue comes up or a deal-by-deal opt-out, says Goodwin partner David Watson. It’s primarily pension plans and sovereign wealth funds that make these requests, which are rarely accepted.

“It’s very difficult for a manager to accept a right to withdraw or opt out of a deal based on something as vague and open-ended as a reputational risk concern,” Watson says.

“There’s one investor I’m aware of that treated it as a dealbreaker, backing out of a couple of very successful fundraisings because they couldn’t get what they wanted in terms of an opt-out right due to reputational concerns. They’re the only one that I know who has done that; others get comfortable with it and still invest.”

One way fund managers can try to prevent these issues and have some remedies if they do happen is by sitting on the board.

Venture fund managers are often one of many investors in a business, and depending on how large their stake is, a board seat is not guaranteed. However, there are ways to make sure they are still plugged in to the company.

Theresa Hajer

“If they’re not on the board, perhaps they have an observer seat, or information rights if they don’t have that, or they meet with the founder outside of board meetings so they can continue to be informed or involved,” Hajer says.

“You establish a trust with the founder so you can be that first call; they come to you not only with the good news but with the bad news, and if you’re a real partner you’re going to step up and work together to figure it out.”

Part of the deal

For many who choose to invest in start-ups, the potential for headline risk is just something they have to live with.

“I don’t necessarily think there’s anything the industry can do about that because one of the ingredients of successful start-up companies is giving people a free and open culture,” says O’Donnell.

“The VC is faced with a bit of a dilemma: do you ask the entrepreneur to become more compliant with best practices, knowing that the cost may be upsetting the entrepreneur and being excluded from the next round of financing?”

But Hajer argues sometimes those guardrails are exactly what entrepreneurs are looking for when they seek to partner with a venture capital fund. “Where there’s a limitless amount of capital, what founders want is guidance and coaching, and that can also mean being firm and taking a tough position, calling out founders where they need to, setting guidelines, but in a fair and very aligned way.”

One thing seems certain: as long as venture capital can produce strong returns, LPs will keep committing capital. However, there’s a chance some of that capital may start coming with caveats.

“There are a number of trustees, mostly at state pension plans but some universities, that seem to be as focused on reputational issues and social issues as they are on returns. Managers of pension plans can feel they’re required by trustees to not invest in certain types of companies,” Watson says.

“I would not be surprised if there are a few examples of some pension plans saying, ‘I can’t invest in certain types of companies, which historically were not on our list.’  But I’ll be surprised if they back away from venture entirely.”