Governance for innovation Part 1: the rise of Venture Capital

How can organizational governance best support innovation? This is an important question because it is by no means self-evident that conventional approaches to governance work for innovation–they are more likely optimized for compliance or accountability, but not to support the process of innovation. However, to test and scale an innovative idea in the market is a legitimate purpose for an organization; and ongoing innovation may also be an integral part of its long-term sustainability. Governance for innovation is therefore about how, in the words of the ISO 37000 definition of governance, to ‘direct, oversee and hold accountable’ an organization so that it has the best chance of success at innovating.

Optimizing governance for innovation is clearly only one aspect of what I will call governance by design. Readers will recognize in the phrase ‘governance by design’ echoes of its established and better-known cousin, privacy by design. Privacy by design was first introduced in the 1990s as a way of embedding privacy in a much wider, deeper foundation than a focus on compliance alone. Similarly, governance by design aims to optimize governance for purpose; and my focus in this article is on how governance can promote and sustain innovation. 

In this article, I want to trace one approach to governance which has enabled innovation at large scale in the past fifty years. The rise of venture capital as an early stage financing source has consciously experimented with different ways of optimizing governance of companies to manage higher risk, not always successfully. This an offshoot from the modern corporate governance movement. In a next article, I will look at a different approach altogether: the open source movement has taken a different approach to mobilizing talent, and now also capital, for innovation which is breaking out beyond software alone. I have pointed out in a previous article how these two distinct streams may have more similarities than first meets the eye.



‘How venture capital made the modern world’ 

This title from a recent podcast suggests the importance of venture capital as a force shaping the world in which we live through financing companies which have introduced major innovations touching most aspects of modern life. But venture capital has always been about more than the capital alone. It also comes with a distinct approach to governance: in particular, it has sought to align interests of founders, funders and employees so that startup companies could be active vehicles for experimentation outside of the ‘walls’ created by large company governance. 

The podcast in question was in fact an interview with journalist Sebastian Mallaby who traces the history of venture capital from its early roots in the US in the second half of the twentieth century in his recently published book, The Power Law: Venture Capital and the Making of the New Future. Mallaby identifies Arthur Rock, a New York broker, as the founding father of modern VC. Rock developed his innovative approach in the 1960s, anchored on the principle that all parties–himself and his partners in the firm he established called Davis & Rock, as well as the limited partners who provided capital, and the company founders and senior employees–would share a clear common purpose: to give the startups the best chance of success. There were three key features of this emerging VC approach which affected governance.

1) VC investor occupying a board seat

First, the VC investor expected to assume a board seat in an investee. In this way, the VC’s voice would be heard directly in decision making as well as indirectly as coach and advisor. This voice was to encourage taking risk in the clear knowledge that failure would mean financial loss for the VC. Equally, not to try hard enough to create a superstar firm would also likely result in failure for a VC fund which relied on the power law of 80/20 returns.

2) Aligning of incentives

Second, alignment of incentives to grow the value of the firm was achieved by assigning equity to all material parties–the founders, as well as key employees who received share options. In this way, the distinction between owners and ‘hired hands’ which often characterized managers and employees in larger corporations was reduced.

3) Using the lean startup approach

Third, financing followed a stepped approach in which experimentation happens in a tightly phased manner with the financing provided only for the next stage. This has more recently evolved to become the lean startup approach, which aims to reduce risk and also increase focus at each stage of startup life. VC’s were very willing to double down financially on their exposure to experiments showing likelihood of success while limiting loss at those which fail to get traction. Of course, the staging also provided a sense of direction: at later stages, when investees prepared for IPOs to list on public markets, their governance would have to step up to meet the level of the codes and requirements of that market. 

With a rich eye for detail, Mallaby traces how these initial concepts took root and flourished starting in Silicon Valley and then spreading globally; and also how they mutated over the years. As the VC industry developed, so the supply of risk taking capital became more plentiful, changing the balance of power between those with the money and founders with the ideas. This also changed the governance approach of some VCs. For example, Peter Thiel and partners established Founders Fund in 2005 with an emphasis on its ‘founder friendliness.’ This manifested in a commitment not to vote its interests against a founder ever, and by being generally content not to have a seat on the board. Not all the newer generation of VCs followed this more hands-off approach; but it did diversify the range of options available to founders and created something of a natural laboratory in optimal forms of governance for early-stage and scaling entities. As in a laboratory, not everything worked as intended or hoped: Mallaby also recounts at length some of the highly publicized more recent controversies around VC funded investments like Uber and WeWork, and even the outright failures like Theranos, all of which can be attributed in large part to poor governance. 

What does VC tell us about governance by design?

In my view, the VC approach to governance best illustrates two principles of governance by design. 

First, the principle of risk alignment among stakeholders. In the case of VC, this was achieved at least in part through the allocation of equity to founders, stock options to employees and the risk of financial loss to funders geared to absorb losses. Clearly, however, risk alignment is not a once for all process: part of the role of governance is to keep risks aligned with the evolving expectations and appetites of stakeholders. Not all VCs could achieve that before exiting.

Second, the principle of proportionality as applied to governance: this is the concept of striking a balance between risks and controls. Financial regulators have in recent years adopted the principle of proportionality, acknowledging that it is needed to guide the application of increasingly complex new financial regulation which has come out in recent years. VC’s apply proportionality when they calibrate their engagement with an investee to its size or stage, level of risks and also to their own capabilities. They neglect it, however, when they effectively opt out of governance in favor of trusting the CEO/ founder in all things. Regulators recognize that while proportionality means tailoring regimes to circumstances, it does not mean undermining essential safeguards. In the context of corporate governance, one of those safeguards is a functional board of directors. The question of how early a startup should establish a board of directors beyond the founders alone is much debated. In their book, Startup boards, Brad Feld and Mahendra Ramsinghani make the strong case for establishing a board of directors early in the life cycle of a company; and optimizing its composition, structure and practices to accommodate the rhythms and risks of early-stage life. 

The VC approach to governance will no doubt continue to evolve. My hope is that even as VCs seek to support successful innovation, they will also pay attention to innovations in governance which can support that purpose. 

A subsequent article will explore the open-source approach to innovation and how it differs, as part of the exploration of what governance by design means.