March 23, 2006
Why Venture Capitalists Might Not Care About Reputation
Posted by Bobby Bartlett

There’s an interesting article in today’s New York Times (article here) about a recent lawsuit involving and its venture capital investors. According to the article, the company’s former CEO has sued Baker Capital—one of’s primary VC backers—over a venture capital financing that occurred in 2005. Baker initially invested in in 2004 when it purchased $17 million of the company’s Series F preferred stock. (A separate article about the initial financing is here). Typical of VC financings, Baker obtained the right to appoint two directors to the board and it also negotiated for a variety of stockholder veto rights, including the right to veto a sale of the company.

Problems arose in 2005 when ran short of cash. The complaint alleges that the company's management secured an acquisition offer from Liberty Media for $67.5 million, which would have resulted in all investors receiving a pay-out on their investments. The board of directors allegedly approved the Liberty offer; however, it was vetoed at the stockholder level by Baker Capital. Left with no alternative but bankruptcy, the company was then forced to accept a new financing led by Baker that resulted in significant dilution to all other investors. Baker contends that the Liberty offer was never presented formally to the board and that it “saved by providing it with needed funding at a time when no one else would do so.”

For me, the most interesting aspect of the story is that the dispute actually reached the courts. For years, the conventional wisdom has been that the VC industry is too small and well-connected to permit opportunistic behavior by either VCs or founders. Take, for instance, the following statement by VC-gurus Josh Lerner and Paul Gompers of Harvard Business School:

“[W]hile the controls that venture capitalists demand may be essential, they also create the potential for abuse. A venture capitalist’s reputation for fairness is the only assurance an entrepreneur has of being treated with respect. Established venture groups typically care deeply about their reputation for treating entrepreneurs fairly and openly.” PAUL GOMPERS AND JOSH LERNER, THE MONEY OF INVENTION: HOW VENTURE CAPITAL CRATES NEW WEALTH 12 (2001).
The notion is that a VC investor who acts opportunistically towards an entrepreneur in one company will obtain a reputation for opportunism among other entrepreneurs in the closely-knit start-up world, thus hurting the VC’s ability to invest in the next Google, eBay, etc. Likewise, entrepreneurs should be wary of developing a reputation for litigiousness, lest they hurt their ability to form and finance future start-up companies.

Cases such as indicate that the traditional reputational markets in the VC industry may be breaking down. In fact, the case is one of a number of recent founders-vs.-VC lawsuits that have begun to pop up (e.g,. similar suits have been filed against the VC backers of and Nishan Systems). Why might this be happening? I think the primary answer lies in the fact that the VC industry isn’t the same as it used to be. Reputational sanctions for opportunistic behavior are strongest in settings involving close-knit communities. The significant growth of the VC industry over the past decade makes it unlikely that the VC community resembles those communities where norm-based reputational sanctions have displaced legal sanctions. For instance, the membership of the National Venture Capital Association has grown from 87 firms in 1980 to over 900 firms in 2003 with over 9,000 investment principals. Add to this the difficulty of proving a “bad act” worthy of reputational sanction (did Baker’s financing “save” the company or oppress it?), and I think it becomes evident that reputation probably plays less of a role in the VC market today than it did in the past.

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