Investor Opportunism and Governance in Venture Capital by Brian J. Broughman

The asymmetry of control between founders and VCs and their diverging interests can lead to conflict and opportunistic behaviors like firing a founder to cancel their unvested options, diluting founders and other employees, and forcing an exit when it is advantageous for VCs. There are methods to curb opportunism, but no one method alone is perfect.

  • How helpful? Scale of 1 to 5

5.

  • Topic Tags

VC control, founders control, opportunism, divergent interests, founders replacement,

  • Relevant questions addressed

Is there room for opportunism in startup governance?

How do the different interests and positions of different groups translate into actions?

Are there ways to prevent or constrain opportunism?

  • Summary bullet points
  • Financing contracts allocate control, but they are inherently incomplete and do not predict every possibility
    • There are inherent differences in investor and founder interests, which might lead to conflict
      • Founders have non-pecuniary, private benefits and the two groups are likely to hold different financial claims
      • This is what makes board control and selecting board seats so important.
    • If one actor has a very high level of control, they may behave opportunistically to benefit themselves rather than the firm as a whole
  • VC control is more likely and it presents some benefits.
    • Potentially improved firm performance through monitoring and replacement of executives
    • Helps VCs in realizing exit opportunities if founders don’t agree
  • But it creates the possibility of investor opportunism
    • CEO replacement
      • VCs could fire a founder to cancel unvested options or to buy back vested options for cheap
    • Later round financing
      • VCs might force founders and other parties to get diluted in later rounds
    • VC exit
      • VCs might force a sale or IPO when and how it will benefit them, disregarding other parties
  • There are methods for founders to curb VC opportunism
    • Renegotiation, at least for situations not included in the original contract. This allows to negotiate after an event has happened and once there is better information available
      • The costs of renegotiation increase as more parties or more individuals are involved
      • Renegotiation may fail if the parties do not see eye to eye
    • State-contingent control
      • Founder control is necessary to protect their private benefits, but VC control is necessary for their involvement
      • It would be beneficial to make control contingent on future events
      • It might not be a viable solution if there are no measurable metrics for those future events
    • Shared control
      • Control evenly distributed between founders and VCs, with an independent director as a tie-breaker
      • Neither party can threaten to impose their preferred action over the other
    • Reputation and norms
      • If opportunism has significant reputational costs the controlling party will refrain
      • This works if the parties are in a long-term relationship or are repeat players
      • It also works if there is communication between parties and other market participants and information travels well
    • Corporate law
      • Presents parties with fiduciary obligations
      • Directors must act in the best interests of the company
      • This is not always effective as courts tend to not judge boards of directors and when they do it is not always clear how the mechanics of established corporate law should work in respect to startup governance
  • Follow-up links

Venture Capital, Agency Costs, and the False Dichotomy of the Corporation - https://papers.ssrn.com/sol3/papers.cfm?abstract_id=893906

A control theory of venture capital finance - https://www.jstor.org/stable/764967?seq=1#metadata_info_tab_contents