The Tension Between Governance and Deal Flow

One subtle facet of venture I’ve observed lately is the inherent tension between corporate governance of a startup by an investor and that investor’s deal flow. LPs, the entities which invest in VC funds, obviously want their GPs to have meaningful ownership in the companies they invest in, as well as taking a seat on the companies’ Board of Directors. Here, the VC as the GP has to balance the interest of the LP (as a fiduciary) with the interest of supporting the founder (being a good citizen), and along the way, guiding the company and founder to subsequent rounds of funding at marked-up prices and, hopefully one day, an exit via M&A or IPO.

The last few years have put a strain on this equation. In an era of greater transparency and social graphs, VCs are often “referenced” by their earlier founders when looking at a new deal or getting new deal flow. In an era of cheap money with many different sources of capital, there is more competitive pressure on a traditional VC to make sure his/her deal flow and references are glowing, or risk the reputational damage from being associated with a disgruntled customer. The result has been, in my general observation, an environment in which being “founder-friendly” is of such vital reputational interest to the VC that it can oftentimes trump their fiduciary responsibilities. Further fueling the friendly vibe is the cheerleading and promotion required to score a “markup” for a portfolio company to improve one’s own stats as a VC.

Don’t hate the players, though, hate the game.

The result of this new world of VC is that, in the heat of the moment, a VC may (a) opt to over-promote a portfolio company to score a big markup or (b) may opt to look away and forgo fiduciary responsibilities in a distressed situation in order to maintain good reference-ability with the company, leadership, and employees. In scenario (b), the VC could be faced with the loss of $10-20M+ of capital deployed, but the longer-term cost of a damaged reputation can, in today’s world, negatively affect that VC’s deal flow if word spreads.

This is hard for the public to understand, and hard for me, too — I am still thinking this through and would welcome feedback or dissenting opinions.

When an article comes out about a company that implodes seemingly overnight, the rush from the press and Twitterati is to wonder “why is the Board absent?” It’s a fair question to ask, but folks may not like the answer: Because, deal flow.

Deal flow is the mother’s milk of everything in venture. LPs are obsessed with it when evaluating GPs. VCs are obsessed with it to make sure they get a good look at everything early. VCs who are not polite to founders in the pitch process or who rarely fund from their sources can see their deal flow evaporate. Most devastating is the mark of a bad actor. I’ve been in countless situations where the same names and the same feedback keep popping up about particular investors. Founders are smart and check references. That deal flow stops. And, it’s hard to get back.

The result of all of this is that governance takes the hit. Of course, there are many situations where the founder recruits investors and a BoD that he/she wants to be tough with them, and they often become friendly, but maintain their discipline and honesty. But there are other times when the train is moving really fast, the founder is at the helm, and the investors either don’t have enough legal control or simply political will or appetite to step in and get the car back on the tracks. It’s because VCs don’t really have as much control as the public may think they do (in today’s founder-friendly times), and because they’re likely already thinking about the next deal on the horizon.