The venture capital market shows no signs of easing back on the throttle.
Undeterred by the pandemic, VC funding reached record levels of $156.2 billion in 2020 after hitting around $140 billion in both 2018 and 2019. Investors are sitting on a tremendous pile of power right now. Combined with the exponentially rising number of startups crammed together in the space, we could be looking at an explosion in VC funding for years to come.
The recent VC market has been wild, to put it mildly. Investors and entrepreneurs alike should be excited about the opportunities in the VC market, which generated nearly $300 billion in liquidity in 2020. Further, a prolonged buyer’s market has transformed people’s risk tolerance, leading to faster-paced and larger-scale investments than we’ve ever seen in the past. The average VC fund is now valued at $257.2 million — almost double the year before.
However, whenever there are huge sums swirling around the promise of massive paydays in short timelines, it’s going to beget some unscrupulous market behavior. With much to gain — and so much to lose — skyrocketing growth in the VC market has also resulted in the precarious growth of unethical behavior.
With an ever-lengthening list of startups lined up and clamoring for an opportunity, many on the buyer’s side of the negotiating table have found it unnecessary to maintain a reputation for professionalism or even ethical investing behavior. After all, with so many targets vying for attention, why bother playing by the rules?
Troublingly, this cavalier attitude in VC investment has been increasingly accepted in recent years. But thankfully, it’s starting to have consequences that are both apparent and alarming. Unethical practices are propagating cracks in the foundational principles of efficient markets, and the people currently gaming the system could cause its collapse later.
If this corner of the capital markets arena is to earn the reverence other, more grown-up investment sectors benefit from, the VC community needs to collectively admit that unethical behaviors are getting more common and more corrosive to VC’s foundations. Then, it needs to take steps to make ethical investing behavior the standard practice.
What Does Unethical Investing Look Like?
It might surprise onlookers that today, venture capitalists are not bound by any codes of conduct or formal ethical rules. In the absence of such standards, it’s hard to define what qualifies as “bad” behavior and to hold people accountable. This might explain why unethical behavior has been allowed to proliferate in recent years: It’s subtle and resists enforcement.
Peering through the ambiguity, however, there are some common practices in the VC world that would eschew ethical standards:
- Fund creep: Over time, VCs have come to expect that startups will meet ever-higher standards for revenue and development. Known as fund creep, this phenomenon is bad for startups because it creates unreasonable expectations about how fast startups can (and should) grow. Putting sky-high standards on early-stage companies only makes it harder for promising startups to begin raising early-stage capital, which continually evacuates the earliest capital markets of investment. Sacrificing risk appetite for the ability to prepare limited partnerships for a risk-free ride amounts to nothing more than one side continually moving the goal posts.
- Bias: The recent frenzy over “meme stocks” such as GameStop and AMC reveals the powerful influence of investment bias on decision-making. Investors tend to move as a herd, following the lead of others even if it results in a departure from tenets of their investment strategy or core criteria. Far from being objective and impartial, investors operate with deep biases — many of which are incorrect or stray into unethical territory.
- Misbehavior: Venture capitalists hold the purse strings and pick the winners. They have tremendous power, and it too often goes to their heads. Ask, and you will find the startup community holds a rich tapestry of stories of bad investor behavior, ranging from rudeness to outright abuse. Unfortunately, discrimination and harassment thrive under these conditions. Although most VCs are polite professionals, some have evolved into predators, often without facing many (if any) consequences. An industry that tacitly permits such misbehavior clearly has an issue in terms of its ethical standing.
- Tainted guidance: The close, mentorlike relationship between VCs and the founders they invest in can result in difficult ethical issues. For example, VCs might push founders toward industry-damaging strategies to kick-start growth. More subtly, but just as treacherously, VCs can fail to advocate for management skills in founding teams, resulting in companies that have great products and services, but poor leadership. It’s unethical for VCs to use their influence to push founders in directions that, although good for ROI, are bad for the company and industry.
A good way to identify unethical behavior is to work backward from the consequences. Unethical behavior often results in no-show meetings or funding that fails to materialize. It can also result in negative reviews on sites like TheFunded.com, which exists to expose bad VC behavior and hold people accountable.
No matter the direct consequences, continued unethical behavior can brand a VC with a shady reputation that makes it harder to gain the trust of founders and other investors. More than just “wrong,” unethical behavior is very bad for business.
A Code of Conduct for Ethical Investing
Ethics are a complicated and nuanced subject, and well-meaning people can come to opposite conclusions about what distinguishes ethical and unethical behavior. As noted earlier, this ambiguity likely contributes to unethical behaviors in venture capital because the boundary remains so ill-defined.
To remedy this, we propose to establish the standard through a code of conduct for ethical investing in venture capital. A code shared by all investors would clarify a rubric to decide what is and isn’t acceptable — the first step toward promoting professional behavior throughout the industry.
A code of conduct will take time and consensus to develop. However, we believe that any code should reflect these core tenets:
- Treat ethics and integrity as the highest goals.
- Put investors’ interests above personal interests.
- Apply care and good judgment to all job functions.
- Model professional behavior for others to follow.
- Enrich (and never degrade) capital markets through participation.
- Cultivate and share professional knowledge.
People would look at venture capitalists differently if practitioners followed a code of conduct and encouraged others to do the same. They would seem less like untrustworthy opportunists (an unfortunate, but not inaccurate reputation accrued in recent years) and more like principled investors eager to bring new ideas to the market.
The first step for any VC industry group will be to develop and agree upon a code of conduct. The second, much harder step will be getting everyone to adopt it while holding accountable those who don’t. Frankly, ethics are a hard sell if people either fail to see the long-term reputational benefits or don’t inherently agree with the reasoning behind the boundaries.
Therefore, it helps to frame the argument in terms of opportunity rather than obligation. VCs live and die by their reputation; a bad one can brand a VC as someone to avoid conducting business with — no matter how much money they have to spend. Alternatively, a positive reputation for ethical behavior can distinguish a VC as someone who helps startups thrive, opening a multitude of doors in the process. In that context, embracing an industrywide code of conduct just makes sense.
How Founders Can Identify Ethical Investment Funds
There might not be an industrywide code of conduct yet, but that doesn’t mean ethical investing is entirely absent from venture capital. On the contrary, there are actually plenty of investors and VC firms that hold themselves to the highest ethical standards.
The problem is that everyone makes this claim, and no one admits to being a bad actor. For founders, separating the ethical investment funds from the rest isn’t as easy as it might seem.
It’s up to the founder to conduct proper due diligence. Founders shouldn’t accept money without first investigating who’s offering it. Look into investors’ histories, characters, and business dealings to uncover whether they take ethical investing seriously or use it as shallow branding. This investigative process isn’t about disqualifying VCs for minor indiscretions or an imperfect reputation. Founders can decide what is and isn’t acceptable, but first, they need the data.
To help make the decision, obtain references and testimonies from other founders in the VC’s portfolio. Those founders likely have the most honest perspective of a VC’s ethical limits. They know what working with a VC is like after the excitement of inking the deal is over and the reality of the partnership sets in. Their insights should carry weight. If it’s not possible to speak to portfolio founders directly, look for interviews or podcasts where they talk about their VC.
Other ways to perform due diligence include speaking to local investor groups that have encountered a particular VC in the wild before, either directly or indirectly. Beware of competitive bias. But otherwise, learn as much as possible from other investors; they might know about unethical behavior that wasn’t reported on. Ask how the firm handles pro rata rights for early investors, for example. A negative reputation should be a red flag — and so is a lack of reputation thereof. VCs with little to no history are harder to gauge from an ethical perspective, making them riskier to partner with as a result.
Social media and search engines are also valuable tools for due diligence. A deep dive down the Google rabbit hole can uncover important information about a VC, including from the time before they worked in venture capital. Use LinkedIn to learn more about an investor’s background, connections, and philosophy. Don’t be afraid to write down alarming details and address them directly with the VC. Remember, though, that this isn’t a purity test. Rather, it’s a means of feeling out a partnership before committing to it. Communication and collaboration are important in any partnership, especially around difficult ethical issues — so it’s important to test these aspects early. Be upfront about any concerns, and then judge the VC by how he or she responds.
Founders are allowed — even obligated — to conduct due diligence on any potential partner, and they can walk away for any reason. Unethical or even rude and dismissive behavior are valid reasons to look for other VCs to work with.
Ascend Venture Capital: Committed to Ethical VC Investment
Venture capital is often considered the investment vehicle that makes the future possible. Long known for disruptive ideas, innovative thinking, and bold risk-taking, the VC industry is now in need of a reputation for ethical guidelines. Long-term survival depends on it.
Once venture capital demonstrates a history of consistently ethical behavior, it will take a big step away from the fringes and toward the center of grown-up capital market sectors. Founders will feel more confident accepting VC funding knowing that funds are going to support sustainable, long-term development rather than go toward a quick payday.
At Ascend Venture Capital, we believe strongly in not just the merits of ethical investing but also its vital importance. That’s why we hold ourselves to a strict code of conduct and why we’re pushing others to do the same. Every VC that stakes such a reputational claim makes the investment landscape better for all.
If you share our commitment to ethics, please contact us or sign up for our newsletter at your convenience.
Image by Aaron Burden