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Risk-Seeking Governance
- Source :
- Vanderbilt Law Review. October, 2024, Vol. 77 Issue 5, p1299, 80 p.
- Publication Year :
- 2024
-
Abstract
- Venture capitalists ("VCs") are increasingly abandoning their traditional role as monitors of their portfolio companies. They are giving startup founders more equity and control and promising not to replace them with outside executives. At the same time, startups are taking unprecedented risks--defying regulators, scaling in unsustainable ways, and racking up billion-dollar losses. These trends raise doubts about the dominant model of VC behavior, which claims that VCs actively monitor startups to reduce the risk of moral hazard and adverse selection. We propose a new theory in which VCs use their role in corporate governance to persuade risk-averse founders to pursue high-risk strategies. VCs are motivated to take risks because most of the gains in venture funds come from the exponential growth of one or two outlier companies. By contrast, founders are reluctant to gamble because they bear firm-specific risk that cannot be diversified. To compensate founders for their risk exposure, VCs offer an implicit bargain in which the founders agree to pursue high-risk strategies and, in exchange, the VCs provide them private benefits. VCs can promise to give founders early liquidity when their startup grows, job security when it struggles, and a soft landing if it fails. In our model, VCs who develop a founder-friendly reputation have a competitive advantage in ex ante pricing but are more exposed to poor performance ex post due to suboptimal monitoring. Stakeholders who are not party to the VC-founder bargain--and society at large--are forced to bear uncompensated risk.<br />INTRODUCTION 1301 I. THE MONITOR MODEL 1307 A. Challenges of Venture Investing 1307 B. Monitoring as a Solution 1309 1. Equity Incentives 1309 2. Staged Financing 1309 3. Preferred Stock [...]
- Subjects :
- Government regulation
Company business management
Investor relations -- Laws, regulations and rules -- Models -- Research
Venture capitalists (Persons) -- Laws, regulations and rules -- Models -- Research
Corporate governance -- Laws, regulations and rules -- Models -- Research
New business enterprises -- Laws, regulations and rules -- Management -- Research
Corporation law -- Research
Risk-taking (Psychology) -- Models -- Research
Subjects
Details
- Language :
- English
- ISSN :
- 00422533
- Volume :
- 77
- Issue :
- 5
- Database :
- Gale General OneFile
- Journal :
- Vanderbilt Law Review
- Publication Type :
- Academic Journal
- Accession number :
- edsgcl.805632311