Brian Broughman’s Role of Independent Directors in VC-Backed Firms shows why these closely held firms have independent directors – not as monitors, as in publicly held firms, but as arbiters between venture capital investors and entrepreneurs, who often have conflicting interests.  The article is an admirable example of Coasian institutional economics, combining a good understanding of theory with a thorough exploration of the factual background, as Broughman carefully works through the competing hypotheses and possible problems with the data. 

Broughman not only makes a significant contribution to the venture capital literature, but correctly notes at the end the broader implication of the potential power of private ordering to solve opportunism problems better than second-guessing by non-expert judges.  In fact, as Broughman observes, fiduciary duties aren’t available to solve these opportunism problems between VCs and entrepreneurs.  Broughman puts this down partly to the business judgment rule.  I think the business judgment rule is a complete explanation – see, e.g., Directors’ Duties in Failing Firms http://ssrn.com/abstract=880074.  That’s particularly so since it’s virtually impossible to second-guess resolution of VC-entrepreneur disputes.  Though Broughman neatly divides these into categories according to whether the VC or entrepreneur comes out ahead, decision-makers have to make Bayesian judgments that are uncomfortably close to wild guesses about the future. Indeed, as Broughman observes, not only are fiduciary duties unnecessary to solve this problem, but they might unravel the independent director solution to it.  I see this as another example of how law can actually undermine rather than creating trust by interfering with the parties’ contractual governance mechanisms, in this case the board.  See my Law v. Trust, http://ssrn.com/abstract=247224

My main comment or criticism is a suggestion for thinking beyond venture capital.  After all, venture capital firms are not the only closely held firms in which arbiters might address conflicts among investors.  Consider, for example, private equity buyout firms.  Here we have potential conflicts among the private equity limited partnership and the owner-managers of the buyout firm (who may be the incumbent managers of the pre-buyout firm).  There are also potential conflicts between the institutional investors who are limited partners of the buyout funds and the general partners who are affiliated with the buyout firm.  Things get even hairier in a “privlic” equity firm like Blackstone Group, which adds public investors to the mix.  It might seem that arbiter directors would work here, too, to reassure the passive investors that the buyout firm won’t, say, maximize fees at the expense of investment returns.   Indeed, the buyout firm’s partners’ power and possible perverse incentives might seem to discourage outside investment – what Broughman calls the “participation constraint” – even more here than in VC firms.  Yet despite these considerations, the limited partnerships apparently have only advisory boards, and I haven’t read of any arbiter directors in the target firms (though possibly this is something Broughman could study).  I discuss these governance structures in Uncorporating the Large Firm, http://ssrn.com/abstract=1138092.  In other words, what’s special about the VC context?

I think that looking at other contexts is not just an interesting future research project, but deserves some space here. As Coase noted in his work on the firm, the question of why here requires an answer to why not elsewhere.  Also, despite all the careful data Broughman compiles, I still need a little more convincing on the why here question.  I suspect that the “neutral” arbiters generally will have an incentive to side with the main repeat player, the VC firm.  This, of course, should make entrepreneurs suspicious of this solution. The same would be true of the repeat player private equity buyout firm. 

Broughman hints at the answer in discussing the reputational constraints associated with repeat dealing in Silicon Valley. However, Broughman focuses on how these constraints affect the arbiters, rather than looking more broadly at how they affect the VCs and entrepreneurs.  In fact, reputation likely has a big effect, particularly on VC conduct.  See Atanasov, Ivanov, and Litvak, The Effect of Litigation on Venture Capitalist Reputation, http://ssrn.com/abstract=1120994.  Broughman cites this article to show that entrepreneurs rarely litigate against VC firms.  But the authors’ point is that there are actually a fair number of suits and that although the entrepreneurs rarely win (which has to do with the legal rules discussed above), the litigation appears to inflict some reputational damage on the VC firms.

One possible conclusion from all this (and here I’m engaging in rank speculation) is that while the arbiter-director is a weak constraint in most contexts, including private equity, it has more punch in the VC context because of the small-town aspect of Silicon Valley, which magnifies the reputational effects not only of arbiters appearing too biased, but of VC firms undercutting the arbiter mechanism. 

Reputational constraints might be considered exogenous in the sense that they’re part of the contracting environment (though of course the parties do choose this environment). One might also look at endogenous factors – namely, other contractual terms that can substitute for arbiters. 

In short, arbiter directors need to be examined within the whole constellation of governance terms intended to constrain conflicts, comparing venture capital with related contexts such as private equity that apparently do not rely on arbiters.  I recognize that this significantly extends the project. Perhaps this paper could at least hint at the potential relevance of this analysis.

Of course there’s always more that an author could do, and it’s easy for a commentator to find more work for the author – particularly when the commentator finds the paper interesting enough to trigger such thoughts.  But Broughman’s done more than enough to make a significant contribution to the literature that promises more such interesting work in the future.

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