All Venture Booms End with a Return to Governance

We are in the early innings of learning about all of the excesses that happened on the way up. The corrective influence will be a greater focus on governance.

It feels like we are in the very early stages of seeing what happens at the tail end of the latest venture boom. Stories are written about companies that falsified data, misrepresented financials, and otherwise weren’t what they represented themselves to be to investors, employees, and the public. I suspect we will hear many more stories of this sort over the coming quarters, and the scale of deception will cause many people to question the decisions they made during the boom times. Beyond the ones that make the headlines, there will be others that quietly shut down and where insiders learn of misdeeds that don’t make the headlines.

That is very much a story about past misdeeds. All of those should be examined, and we, as investors, should reflect on our decisions and the things we chose to overlook when things were up and to the right. Given that we are discussing the past, I think the most interesting and important question is what comes next. I think a lot of the mistakes that were made will be cast as a lack of due diligence or attention to detail. Regardless of the cause, I think the cure is very apparent - we will go back to a world in which due diligence and governance will become much bigger issues for companies earlier in their development.

I want to make a distinction between what I consider due diligence (the work that is done before investing) and governance (the ongoing work that is done to make sure that companies are doing what they say they are doing and that there are proper controls and checks and balances in place around spending and reporting). The natural reflex is to pivot toward more due diligence, particularly regarding revenue, bookings, and user metrics. This is necessary but not sufficient. I think we will pivot toward a world where “trust but verify” is the ongoing norm, with more emphasis on the verify piece relative to the trust piece. I am not saying that every startup played fast and loose with data and reporting when things were going well; this was not the case. But I think that standards around verification will tighten and go back to what they looked like in earlier eras of the venture business. Here is what I think this means for founders who are fundraising before a Series B round:

• We will see a strong push for audited financials at Series A - Audited financials are expensive and somewhat cumbersome for early-stage companies. They are probably unnecessary at the pre-seed and seed stage. And, in a world of intense competition, waiving this requirement is an easy way to sweeten a deal and improve a term sheet. Given the reputational and financial risk to firms around companies that misrepresent information, I suspect that requirements for audited financials will creep into term sheets earlier in companies’ lives than we saw in the last 3-5 years.
  

• Board seats and the associated control provisions will become a bigger conversation in all but the hottest deals. There will still be companies that can raise meaningful amounts of capital without giving up a Board seat. But I think Board seats will be back on the table as part of fundraising conversations. Investors will have a heightened appreciation of the liability associated with being a Board member and will also insist on more from portfolio companies to serve as Directors. I am unsure how this dynamic will play out. Still, it will be a new conversation for many companies that have raised multiple rounds without serious conversations around Board governance.
  

• The burden of proof for substantiating core KPIs will increase - I am not entirely sure how this will play out, but there will be a lot more scrutiny around non-financial KPIs and user metrics. I think investors who feel burned by trusting reported numbers will look for more comfort and assurance; I’m just not entirely sure what the trusted system of record will be to document and report these numbers.

During boom times, investors compete to win deals in many ways. Some give on terms, some on price, and some on governance. I think the record will show that many investors gave on multiple dimensions during a period when founders had lots of leverage and choice. We are returning to a period where I think the balance will reset, and we will land where I hope most companies have greater oversight and we can put more trust in the reported data and KPIs.

If you are a founder raising from a venture fund that has had to deal with a high-profile case of misrepresented data or malfeasance, you should expect extra scrutiny from the firm along these dimensions. Once bitten, twice shy. And if your only fundraising experience was the world of 2019-2021, the new diligence and governance world will likely feel quite jarring.