This is the fifth in our series of ten frequently asked questions from investors in venture capital partnerships.
Question: Please differentiate between the governance of a VC fund versus the governance of companies in a VC fund’s portfolio? Is one more important than the other?
Answer: This is a very important question, and it starts with recognizing that VC funds, as partnerships, are governed very differently from portfolio companies, which are corporations. The VC fund may have one managing partner that sets the tone and controls the entire firm, or it may have a collegial distribution of governance among several senior partners. The best way to understand how a VC fund is governed begins with an analysis of the fund’s investment committee, its deal due diligence process, and the specific allocation of the fund’s investment capital among the individual partners. An important question to ask is, do the partners evaluate themselves and each other on an annual basis or at all? You might be surprised to learn that many VC funds lack an internal feedback loop, that the partners may not communicate openly among each other, and that the partners themselves may lack a formal measure of accountability among each other, even though the economics are divided formally in the management company agreement.
Turning to portfolio companies, the board of directors is responsible for the governance of the company, and here we have a very interesting dynamic which often leads to board dysfunction—the VC directors have inherent conflicts of interest as representatives of their funds and as fiduciaries who must act in the best interests of all of the shareholders. In addition there is a major tension and conflict between the management team and the VC directors—the management wants more share ownership, and the common equity is at the bottom of the seniority stack behind the various series of preferred equity rounds. The VCs want capital efficiency, which means they want management to do more with less. Compounding the complexity is the fact that most VC-backed companies replace their CEOs twice between the founding and the liquidity event. So you can imagine that the VC boardroom governance equation is very complex and rife with opportunities for problems.
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