Venture Capital: Lessons for Business Ethics (part 2)

Yesterday I posted the first of two blog entries on Ethics in Venture Capital. This is the second.

I noted yesterday that the relationship between venture capital (VC) firms and entrepreneurs is fraught with ethical challenges related to bargaining, information, control, and short term-ism. Those worries tell us something about the world of venture capital; but what do they tell us about business ethics more generally?

The key lesson, I think, is one I learned from Gary Pisano’s book, Science Business, though it isn’t a major theme of that book. The lesson is this: a funding model is also typically a governance model. This insight is at a very coarse level summed up by the old aphorism that “he who pays the piper calls the tune.” In business terms, providing financing means paying the piper. Governance is about getting to call the tune.

This is closely linked to the core lesson from another favourite book of mine, Henry Hansmann’s The Ownership of Enterprise. Hansmann’s book is an attempt to explain the patterns of ownership and control we observe when we look at the range of business firms that populate a market economy. When you look around at complex organizations like modern corporations, most of them tend to be owned by shareholders but managed by professional managers. What is it that explains how pervasive that particular setup is? Lots of other models are possible — partnerships, employee co-operatives, consumer co-ops, and so on. Law and even tax policy in most modern economies both permit and sometimes even encourage these other models, yet the shareholder-driven corporation dominates in most industries. Why? To make a long story short, Hansmann’s thesis is basically that the patterns of ownership we see can best be explained in terms of different stakeholders a) interest in, and b) ability efficiently to accomplish, effective oversight of managers.

So, back to VC. When VCs invest in firms, they often essentially assume ownership: they buy an equity stake in the firm and exercise control (via Board membership, among other mechanisms). But why are VCs involved at all, rather than other sources of funding, like employees or banks or non-expert shareholders? Basically, in Hansmannian terms, because VCs are better able to a) bear the risk involved in ownership of a startup company, and b) exercise the kind of knowledgeable control over the company (via supervision & sometimes appointment of managers) to make the risky investment worthwhile. But as I noted yesterday, the specific kind of (short-term) interest that VCs have in the firms they invest in raises a special set of ethical issues that look somewhat different from the issues faced in firms funded in other ways.

The lesson: if we want to understand the ethical challenges firms face, and why they do the things they do, we need to think in a detailed way about who owns them, the goals those owners have, and the extent to which the owners are exercising effective control.

2 comments so far

  1. Tom Herrnstein on

    I assume VC’s standard defense is that without their help there would be fewer innovative businesses thriving where long-term interests can then be taken into account, is that correct? If so, the argument would be that we shouldn’t see VC’s as ignoring the long-term interests in the employees or other stakeholders; rather, we should see VC’s as being specialists in nurturing worthy companies—helping them to survive a 3-5 year stage in their development.

    The argument could be continued in this direction: VC’s seem to be specialists in figuring out who should survive (which businesses can eventually be profitable). If instead we stressed having financiers interested in the stakeholders’ long-term interests of start-up companies from the beginning, we would get a less efficient market because too many investors would be forcing long-term thinking on new companies before it is clear if these new companies will be profitable or not. In short, investment capital propping up bad companies is bad for the economy. Unless VC’s are regularly duping established companies to buy hopeless start-ups or tricking investors to buy stock in such hopeless start-ups, it looks like VC’s are helping the market as a whole be more efficient.

  2. Chris MacDonald on

    Tom:

    Yes, that sounds right.

    I didn’t go into the social / economic role played by VCs, here, but perhaps I should have. One of the other bits I gleaned from Pisano’s book is that, in biotech (one area where VC is especially common) small companies have some advantages, both in terms of convincing universities to license key technologies, and in terms of attracting talent (by being able to offer an equity stake in the company). So, since VCs specialize in helping the small startups that are so important in biotech, VCs play a key role in commercializing innovation.

    Chris.


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