The Business Ethics Blog

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.