Venture capital-backed companies have a significant impact on our economy. They fund less than 0.25% of new businesses, yet over 47% of U.S. companies that went public between 1995 and 2018 had venture capital backing. VCs drive innovation by taking huge risks to chase big rewards.
Traditionally, VCs have managed risk through active involvement. They secure seats on company boards, stagger investments, and often replace founders with external executives as companies grow. This approach, scholars say, helps counter issues like adverse selection and moral hazard. Founders usually know more about their company’s prospects than VCs do and might run the company for their own benefit.
However, this strategy seems to have shifted recently. VCs’ choices now don’t align with traditional “monitoring” models of governance. Founders are keeping more control over their boards and retaining larger equity shares. They are also staying in CEO roles longer, with some VCs even adopting no-removal policies. What’s driving this change?
Research from Vanderbilt Law School provides an explanation, introducing a new “risk-seeking” model for understanding VC behavior.
Skewed returns
The top venture capital (VC) firms achieve success through highly skewed returns, experiencing many failures but also one or two companies that yield massive returns on investment. Achieving such skewed returns involves not just selecting the right deals but also influencing how these firms are managed after investment.
To encourage the necessary risk-taking, VCs have adopted a “founder-friendly” approach. They offer founders larger returns on successful exits, greater job security, more control, and soft landings if things go wrong. While some traditional VC behaviors remain, their purposes have changed. VCs buy preferred stock not just to mitigate losses but also to reward founders willing to take significant risks. VCs now compete more on non-price factors. A VC firm with a founder-friendly reputation has an edge when negotiating with cautious founders.
The authors incorporate these non-price factors into a model that explains why startups are increasingly adopting high-risk strategies. Founders, in response to this new governance style, accelerate growth through “blitzscaling”—hiring rapidly without thorough vetting, launching unfinished products, expanding at a loss, engaging in predatory pricing, and even selling illegal products with the hope that widespread use will lead to legal changes.
“Risk-Seeking Governance” contrasts this new model with the traditional “monitor” model that scholars have used to explain VC and founder behaviors. It also highlights how this shift has led to high-profile scandals at VC-funded companies like Uber, WeWork, and FTX, where VCs were either unable or unwilling to curb founders’ misbehavior.
“The risk-seeking model explains that VCs behave more subversively—they skip monitoring, indulge self-dealing, and push managers to take risks,” the researchers explain. “VCs and founders both get what they want out of the implicit bargain. But other shareholders and society more generally, may be stuck bearing unbargained-for risks.”
A beneficial strategy
Risk-seeking governance appears effective in key areas: institutional investors keep funding VC activities, and founders reap substantial benefits. Although angel investors holding equity without these perks might find the situation problematic, they can diversify their risk and, in some cases, sell their shares on a secondary market.
Employees with equity, however, have fewer ways to mitigate their exposure to their employers’ aggressive, high-risk strategies. For society at large, this governance model could be costly if it relies on monitoring private companies in lightly regulated industries.
“We doubt that there is a simple policy intervention that could harness the strengths of risk-seeking governance while curbing its excesses,” the authors conclude. “But we hope that by providing a more accurate account of how VCs behave, we have helped to illuminate the choices that we face.”
