Ethics of failure and the rule of transparency

Benedict Evan’s outstanding recent post “In praise of failure” pointedly demonstrates how startups and venture work: a few big successes making up for many failures (and some middling outcomes). This is like no other business – imagine a world where Fortune 1000 companies posted for Senior Directors of Operations who are “right at least 50% of the time”.  Startups are as much or more about failure than success… and so startup ethics are too.

While the power law of venture is well understood, ethics in the context of this asymmetry are much less discussed. The basic business code of ethics that we learn in our early careers is designed for the established company, the going concern. Is it any different for startups? Recent fraud and ethics accusations about Theranos and UBeam, Penny Kim’s recent expose of startup employee scamming, as well as a few positive recent experiences got me thinking about this. Lots of startups spend time outlining their values (a critical exercise), but few explicitly consider ethics in this exercise. They go hand in hand.

The rote modern core of business ethics says when working with customers, employees and investors alike:

• do what you say you’re going to do
• communicate directly
• be honest; don’t steal
• be diverse and embrace diversity
• don’t break the law
• do no harm to the external world (society, environment, etc)

These seem good and obvious, but ethics are not about the 95% of unethical situations that are black and white – stealing from the till, sexual harassment in the workplace, swiping confidential information – they are about the gray areas: (1) promising something to a customer you think you have a 50% chance of delivering on-time, (2) influencing a customer RFP process outside of the rules, (3) signing up for a competitor’s account or demo, or (4) not telling your employees you only have 9 months of cash left (how about 6 or 3?). These situations come up in Fortune 1000 companies, but slower growth trajectories, established products, hierarchical command/control, and years of established process reduce the frequency and breadth of the gray area. Not so in startups. The two common themes that permeate these examples are an asymmetry in risk consciousness (as in (1) and (4), you are aware of risks that others aren’t) or hidden conflicts of interest as in the case of the customer RFP.

If I polled 100 startup founders and VCs on each of the four gray areas above, I would expect a lot of disagreement over what is ethical and what is not. Okay, I did, and here’s what they said:

Here is the thing about gray areas – there isn’t a right answer. I certainly have my opinions and offer some guidelines below, but I know startups that operate consistently on either sides of these ethical dilemmas. Given the “front page of the newspaper” rule, tracking on one side or  the other is not just a question of preference, but also a question of how much risk a startup takes. Within a startup and across its employees, approach should be consistent as to what path a company takes – the high road, or the less-high road. An ethically lower-risk organization is only as pure as its weakest link; conversely, if you decide to take the less-high road, you’ll need to find employees who are comfortable with that added risk. My view: it’s best to avoid the gray areas with transparency.

Avoiding ethics gray areas with “the rule of transparency”

I think about startup ethics along their three main constituencies: customers, employees and investors. The rule of transparency is simple; being transparent with these groups tends to resolve conflicts of interest and risk asymmetries that create ethical gray areas.

Transparency solves almost every ethical issue with investors and employees. When you take on new investors, make sure they know the risks of startups, and then communicate, communicate, communicate as you go. Few who understand the risks up front – and who are kept informed along the way – will fault you for bad news you’ve warned them about. Experienced angels and VCs know what they’re getting into, but the rub can be with “friends and family”. They may not understand the true level of risk at a startup. Think twice about having Uncle Joe or Aunt Marge on the cap table unless they’ve done a lot of startup investing before.

Employees follow a similar vein. Most startup employees are fairly wise about the level of risk they are taking in a new job. They have clearly signed up for medium and long term risk, so there is little asymmetry on risk perception when an employee starts, assuming you are being honest about the current state of the business (something Penny Kim didn’t benefit from). The trouble comes with short term risks during employees’ tenure, when you are running out of cash in a few weeks or a few months. Be transparent. Employees probably already know about problems through the rumor mill. If you habitually communicate and then eventually have a big layoff, your employer brand has a better shot at weathering the Glassdoor gauntlet. I’ve also seen employees rally and drive big turnarounds when they truly understand the risky state of a company. There is nothing like a good shared crisis to drive progress.

The customer constituency is more complicated. Your investors and employees know from the beginning that you are more likely than not to fail, but should customers know this? Herein lies the tension: If startup customers knew there was at least a 50% chance a startup fails, startups would never have customers… or at least not many. So evolved the “fake it until you make it” mentality in startups. It is simply not practical to telegraph every risky point in a startup’s arc to customers, but that’s not an excuse to leave customers hanging if your startup is about to hit the wall. Indeed, founders, executives and boards should take heroic efforts to provide continuity for customers in the down state. We owe them that for taking the risk on us.

I recently saw this in action when a company we were involved in reached the end of its runway with all paths exhausted and employees soft landing at another company. With nothing left for founders and investors, the Board shifted focus from traditional “shareholder” interests to ensuring continuing operations for customers, finding someone to acquire the asset for a song to keep the lights on. Despite the big fail, this is one of the most inspiring startup moments I’ve ever seen.

This is not to say looking out for customers at the end absolves you of being transparent along the way. It is a fine line to walk, but customers are often more forgiving and understanding the more they know. If you didn’t have a better/differentiated product, they would just go to Salesforce, Oracle, or Cisco – that’s why you have their attention in the first place. You can then induce their taking some risk with discounts, development partnerships and strong personal selling.

If you haven’t already, check out the ethics poll results HERE and please share your thoughts below on this topic.