The Effect of Litigation on Venture Capitalist Reputation

Abstract:     
A large literature examines how contractual terms protect VCs against misbehavior by entrepreneurs. But what constrains misbehavior by VCs? We provide the first systematic analysis of how alleged VC misconduct affects VC reputation using a hand-collected sample of 296 lawsuits involving 221 venture capitalists during the period 1975-2007. We first estimate an empirical model of the propensity of VCs to get involved in litigation. We find that older VCs and VCs with more deal flow and larger funds under management are more likely to litigate; however, the effect is concave. In addition, early-stage VCs and VCs with past litigation history are more likely to participate in litigation. We then analyze the relationship between litigation and VC fundraising, deal flow and network centrality. We find that litigation does not go unnoticed: in subsequent years, VCs involved in litigation as defendants raise significantly less capital than their peers (matched on age, size and performance), invest in fewer and lower quality deals, and syndicate with fewer VC firms. The biggest losers are VCs who participate as defendants in multiple lawsuits.

Keywords: venture capital, financial contracts, litigation, reputation markets, contract theory

JEL Classifications: G24, G33

Working Paper Series