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E-MailAndrew Jennings is an Associate Professor of Law at Emory University School of Law and Kimberly D. Krawiec is the Charles O. Gregory Professor of Law and Sullivan and Cromwell Professor of Law at the University of Virginia School of Law. This post is based on their article, forthcoming in the U.C. Irvine Law Review.
The ESG movement has spurred consideration of how investors express positive values in their startup investment decisions. Less examined is the mirror phenomenon—how startups in stigmatized industries access capital. In a move to fill that gap, in our forthcoming article, Vice Capital, we conduct an interview-based study, supplemented with descriptive data, on the funding of “vice” startups. Vice businesses are, to varying degrees, stigmatized, prohibited, or heavily regulated, with restrictions designed to protect the safety, well-being, and even morality of customers and third parties. These industries have traditionally been understood to include the adult, alcohol, tobacco, weapons, and gambling industries, among others.
We expand on a large literature regarding publicly traded vice firms by focusing on private vice startups. Like other new businesses, vice startups need capital. And as a general matter, financial and business considerations would be expected to drive prospective startup investors’ decision-making. But whether to invest in vice also requires investors to navigate their own moral, ethical, and aesthetic preferences, as well as those of their constituents. To understand how vice interacts with startup investment decision-making, we conducted forty-two confidential, semi-structured interviews with vice founders and investors. Those investors included venture capitalists; institutions that serve as limited partners, or LPs, in VC funds; and high-net-worth individuals. Our interviews also included legal and financial practitioners whose work relates to the study.
We supplemented interviews with descriptive data from PitchBook on startup fundraising, founder demographics, and exits. Although in our ten-year 236,012-startup sample, only 3.5% of firms were in vice industries (as we categorize them), their associated stigma and regulatory environments provide a window into how moral and reputational considerations shape entrepreneurship and capital markets. At a high level, respondents report that (1) the definition of vice is nuanced and changes over time, yet it is also sticky; (2) vice aversion manifests in the subjective preferences of investors and their constituents and is unlikely to be fully reflected in limited-partnership agreements (LPAs) or side letters between LPs and VC funds; (3) vice’s funding barriers are exacerbated by vice-specific regulatory and business-infrastructure hurdles; and (4) vice aversion can distort startup governance and increase cost of capital.
Defining “vice”
The term “vice” has evaded a consensus definition in the scholarly literature, and our study suggests that one might not be achievable. We show that what is and is not vice turns subjectively on judgments that follow diverse ethical, moral, and aesthetic sentiments. This subjectivity is nuanced even within vice industries. Alcohol, as an example, is a traditional vice industry. But we find that vice judgments can vary even between the wine, spirits, and beer sub-industries. When vice aversions overlap within a capital pool, the resulting restrictions tend to be mutually reinforcing. As a result, vice restrictions can perpetuate throughout the market for startup equity. More, although views on vice do shift over time with changes in regulatory environments and social mores, legacy vice restrictions are sticky in that they replicate across successive funds raised by VC firms.
Vice and venture contracting
Although some restrictions on a VC’s ability to invest in vice startups appear in formal contracts (such as LPAs or side letters), they are also often extracontractual in nature. In heeding extracontractual restrictions, general partners (GPs) of VC funds anticipate their LPs’ vice aversions. These extracontractual restrictions are enforced by a repeat-player dynamic between GPs and LPs. GPs seek to raise successive, and successively larger, funds over time. Reinvestment from prior funds’ LPs contributes to that goal, and so GPs tend to engage in investor-relations strategies that optimize for repeat business. Good investor relations includes not offending or embarrassing existing investors.
Vice and non-normative barriers
Investors’ normative aversions, however, are not the only funding barrier that distinguishes vice from non-vice startups. Vice startups also face regulatory and business-infrastructure hurdles. Public policy that restricts or burdens a vice business might dissuade investors who are unwilling to bear incremental legal or regulatory risk. Beyond regulatory hurdles, vice and vice-adjacent[1] businesses often lack access to—or bear greater costs to access—essential business infrastructure that non-vice startups take for granted. A startup in the sexual-wellness space, for instance, might run afoul of “no adult” policies of payment processors or advertising channels. Faced with difficulties in maintaining payment processing to sell products, or advertising channels to market them, it might appear an unattractive investment, even absent regulatory burdens or normative aversion on the part of investors.
Vice, startup corporate governance, and cost of capital
Vice status can distort startup governance and the market for startup equity. First, vice aversion within a VC/startup relationship can inhibit investor engagement in corporate governance. Residual risk or reputational concerns might cause VC investors to eschew traditional governance rights, like designating directors, to which they are contractually entitled. They might also prompt investors to enforce negative covenants that undermine a startup’s commercial prospects. Governance distortions around vice startups also point to vice as having, all equal, higher cost of capital. This higher cost appears on both the VC/startup and the LP/VC sides of the market and owes in part to high search and opportunity costs necessary to overcome mainstream aversions.
Implications
These findings suggest a few implications. First, private investors’ value judgments embed in the earliest stages of capital formation, long before public investors have an opportunity to weigh in. This point implies that, for better or worse, vice aversion helps shape the real economy in terms of available products and services. These effects include not only products and services for consumption, but they also limit investment options available downstream in public markets.
Second, and perhaps less obvious, is that vice aversion also influences the non-vice side of the real economy. For example, products that intersect with women’s sexual health, despite being quite attenuated from the sex industry, might nevertheless effectively be treated as such. In that light, even a non-vice firm can encounter the sorts of funding barriers associated with vice aversion, suggesting that normative investment aversion affects the non-vice real economy, too. This implication captures a broader observation that carries throughout our study: although vice lacks a shared social meaning, aversion to it nevertheless shapes our capital markets and real economy in subtle, systemic, and unexpected ways.
Endnote
1By “vice-adjacent” we mean businesses that offer products or services that are not squarely within a vice category but that are still stigmatized and have some proximity to vice businesses. For example, products designed to create sexual pleasure or appeal to prurient interests would fit within the “adult” vice. Meanwhile, products designed for sexual health or function, although perhaps not prurient in nature, would be adjacent to the “adult” vice.(go back)
