Reputation and Opportunistic Behavior in the VC Industry

The following post comes to us from Vladimir Atanasov of the Mason School of Business at the College of William and Mary; Vladimir Ivanov of the U.S. Securities and Exchange Commission; and Kate Litvak, Professor of Law at Northwestern University.

In the paper, Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence from Litigation against VCs, forthcoming in the Journal of Finance, we use a hand-collected database of lawsuits filed against U.S. venture capitalists (VCs) to examine the role of reputation in limiting opportunism in the VC industry. The lawsuits in our sample serve as a proxy for alleged opportunistic behavior by the defendant VCs. Based on the lawsuit plaintiff, we further identify whether the defendant VCs allegedly behaved opportunistically against founders, limited partners, other VCs, buyers of VC-backed startups, or other parties (angels, creditors, employees, etc.).

We choose proxies for VC reputation (or alternatively the intensity of VC relationships) with each of the four main types of plaintiffs as follows. First, the number of deals that a VCs invests in serves as proxy for the VC’s reputation with founders. Second, we use the amount of funds under management to proxy for the VC’s reputation with limited partners. Third, the VC’s network centrality, defined as the scaled number of relationships that a VC has with other VCs, serves as proxy for the VC’s reputation with other VCs. Last, we use the percentage of companies in the VC’s portfolio that go public to proxy for the VC’s reputation with buyers of VC-backed startups.

We study two relations between reputation and VC opportunism. First, we test whether reputation is negatively related to a VC’s propensity to be involved in litigation. We estimate a probit model at the VC-startup level and find that most proxies for reputation are negatively associated with the probability of a VC-startup investment ending in litigation. These findings suggest that more reputable VCs are less likely to behave opportunistically against entrepreneurs and other startup investors.

Second, we study the consequences of litigation on a VC’s business relationships with entrepreneurs, investors, other VCs, and buyers of VC-backed startups.  To control for possible endogeneity due to observable differences between litigated VCs and the rest of the VC universe, we implement several matching techniques to identify peer nonlitigated VCs that are observationally similar to the litigated ones. We then calculate peer-adjusted changes in each of our four reputation proxies as differences in differences – the post- minus pre-lawsuit measures for litigated VCs minus the post- minus pre-lawsuit measures for matched peers.

We find that litigated VCs invest in a smaller number of deals, raise smaller funds, and syndicate with a smaller number of VCs relative to their nonlitigated peers. The effects are economically large. Using 2002 as a base (the median lawsuit filing year), litigated VCs experience a mean peer-adjusted decline in deal flow of 430 to 1,840 investment rounds and a 380 to 690 million dollar decline in fundraising. The reputational losses are even larger when VCs are defendants to multiple lawsuits. Furthermore, we find that lawsuits filed by founders, especially when such lawsuits are lost by the VC, lead to more than three times larger peer-adjusted declines in the number of deals and funds under management relative to other lawsuits.

Overall, our findings indicate that reputational mechanisms discipline and deter wide-spread abuse of power by VCs, especially against founders. Our analysis also suggests that litigation can serve not only to directly remedy breach of contract, but also to indirectly support reputational mechanisms for contract enforcement by informing other counterparties of VC misbehavior.

The full paper is available for download here.

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