As Washington considers ways to reform corporate governance, Peter Rip, a general partner at Crosslink Capital in San Francisco, suggests that regulators and boards could take a page from the venture capital industry’s playbook.
A severe misalignment has developed between corporate America and its stakeholders. Financial regulation is seen by many as the universal solution to right the economy. Regulation alone is only a harness on a wild horse. Like that wild horse, companies only achieve peak performance when external controls are combined with internal discipline and self-control. Many public companies, especially those in the financial services industry, lost that discipline and self-control.
Congress cannot mandate long-term thinking, but directors of public companies can. As a venture capitalist, I’m interested in building successful businesses that result in profits for the creators of that business and its shareholders.
My industry uses a Darwinian process of capital allocation within and across companies to ensure the best ideas rise to the top. Corporate America, its public boards, and now, the United States government would be well served to take a few pages on governance from America’s venture capital-backed companies.
Finance Growth With Equity, Not Debt
Venture capital is equity capital, not debt. Limited use of debt places an emphasis on creating truly low-cost producers, not financial engines. Research released last month from the Federal Reserve Bank of New York corroborates the beneficial effects of avoiding debt. In a study surveying 30 years, researchers found that companies started when credit was difficult to obtain had better odds of long-term survival than firms started under more liberal credit environments. Apparently a low-debt diet increases long-term business survival by forcing good habits to develop early, just as a low-calorie diet does for humans.
Owners Act Like Owners, Not Employees
Directors in venture-backed companies are representatives of major shareholders. They are not recruited, typically do not accept directors’ fees or consulting agreements, and certainly are not window dressing. The spread between chief executive and rank-and-file salaries is usually a fraction of what it is in public companies. Senior executives have equity ownership, and it is their long-term compensation. Incentives between owners and managers are aligned because they are the same people.
Accountability Is Everything
Venture-backed companies are small (at least when they start out) and they grow only by generating cash. There’s no sophisticated financial engineering taking place and no slush or rainy-day funds hidden in the books. There is no place to hide. Unlike in public companies, boards of venture-backed companies have no reluctance to replace C.E.O.’s or key managers when things aren’t working. “Wait until next year, again” is not tolerated because the companies cannot afford it. Cash is king. Crucial measures of value creation are monitored with frequent board meetings to see if promises made are promises kept. If not, change happens.
This focus on accountability keeps venture-backed companies healthy. Employee morale and productivity thrive when accountability is visibly part of the culture. Accountability leads to transparency and the communication of objectives. The result is better performance and value creation.
It’s About Capital Efficiency
While we invest in many companies, only a select few prosper and become giants. Our job is to allocate equity capital to the best and let go of the ones that are less efficient. It may sound harsh, but this has been the core tenet of capitalism since Adam Smith. Boards of venture-backed companies operate the same way internally, financing only the most promising projects and killing ones that fail to produce.
Evidence from the World Bank documents the advantage of these practices, finding that over a 30-year period, companies owned by private equity firms outperformed comparably to public- or government-owned companies in productivity growth. One-third of the gain was because of a greater willingness to close inefficient facilities, and two-thirds was from better management practices. A focus on capital efficiency drives productivity growth, and productivity is the profit margin in the United States economy.
The conversations in the body politic today are about government regulation and government ownership as solutions to our crisis of governance. While there may be short-term needs, true governance reform is not a government program. Reform must begin in the boardroom, not in a Congressional hearing room.
Peter Rip is a general partner at Crosslink Capital and sits on the boards of LucidEra, iCurrent, Like.com and Vast.
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