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May 21, 2024 | Tom Ballard

Vanderbilt Law Professor co-authors paper describing change in VCs approach to risk

To incentivize the necessary level of risk-taking, venture capitalists have adopted a “founder-friendly” posture.

Risk-Seeking Governance,” a paper co-authored by Brian Broughman at Vanderbilt Law School and Matthew Wansley at Cardozo School of Law, offers an explanation for what the authors describe as a sea-change in the way that venture capital is behaving related to risk taking.

The two law professors note that Venture Capitalists (VCs) historically have mitigated risk through active governance – taking seats on the boards of their portfolio companies, staggering investments over multiple rounds, and replacing founders with outside executives when companies begin to scale. They do this to account for adverse selection and moral hazard. Founders know more about their company’s prospects than a VC, and they may operate their company for their own benefit.

That strategy appears to have changed in recent years, to the extent that VCs choices can no longer be explained by scholars’ traditional, “monitoring” models of VC governance. Founders are more likely to control their boards and own larger shares of equity. They hold onto Chief Executive Officer positions for longer as well; some VCs have gone so far as to implement no-removal policies. What happened?

To incentivize the necessary level of risk-taking, VCs have adopted a “founder-friendly” posture, offering founders larger returns on successful exits, greater job security, more control, and soft landings in the event of failure. Certain behaviors have remained in the VC playbook, but the rationale has shifted; VCs purchase preferred stock not only to mitigate losses in the event of a company’s failure, but also to reward founders who are willing to take big risks.  VCs are increasingly competing on non-price dimensions.  When bargaining with a risk-averse founder, VCs who have cultivated a founder-friendly reputation have a competitive advantage.

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