Ellen Pao, Kleiner Perkins, and the Future of Venture Capital

As we speak, Ellen Pao is suing her former employer, Kleiner Perkins Caufield & Byers LLC (KPCB) for gender discrimination. Her claims, grounded in the Fair Employment and Housing Act (FEHA), provide a powerful set of remedies for women who are subject to gender discrimination and retaliation, both of which Ms. Pao alleges in her lawsuit. If Pao wins, she could walk away with more than $100 million in compensatory and punitive damages.

The case was filed back in 2012, but the trial just commenced in March of 2015. Why did it take so long for the trial to begin? Ellen Pao’s legal team needed to establish that her claims were not subject to a set of mandatory arbitration agreements. These arbitration agreements were embedded in what lawyers call special purpose vehicles (SPVs) or Funds. In order to avoid arbitration, Pao’s team needed to show that the mandatory arbitration clauses in these agreements did not preclude addressing Pao’s legal claims in court.

Ms. Pao’s legal team was successful. And that’s important for two reasons. First, many venture capital firms will probably revise their employment agreements to ensure that all compensation disputes are subject to arbitration. This will have practical implications for investors keen to join venture capital firms as junior partners.

Second, the most enlightened venture capital firms will examine this case for meaningful lessons. For starters, the case has dragged the costs of internecine warfare into sharp relief. After all, the combatants in this courtroom drama have spent the last 3 years trying to sort this out. Both sides have sustained significant reputational damage, and KPCB could soon face a very expensive verdict.

But for those who care to look, there’s a deeper lesson here. Venture capital firms do not function optimally when the senior and junior investment partners do not equally share skin in the game. Misalignment breeds toxic competition within a firm. When junior parters focus on managing their own status vis a vis their peers, they are drained of the horsepower they need to source, engage and grow the most promising young companies. Like all children of disengaged parents, these companies achieve far less than they should.

The expiration date for this organizational model is up. In the future, the best firms will be ones that take the principle in Michael Lewis’s Moneyball to heart: Take talented, undervalued people — those sidelined by whatever metrics happen to be currently fashionable — and create an environment that leverages the power of the entire team.

How Pao Escaped Arbitration
When Ellen Pao took a job with Kleiner Perkins, she signed an employment agreement that didn’t have an arbitration clause. However, when she acted on behalf of various funds that Kleiner raised — that is, when she made investment decisions — Pao was required to first sign contracts that included mandatory arbitration clauses. The legal purpose of these clauses was to prevent disputes between Kleiner’s funds and its investment partners from being publicly litigated.

Early in this case, KPCB’s lawyers argued that the mandatory arbitration clauses in the relevant fund agreements applied to Pao’s legal claims. The trial court did not agree, and denied KPCB motion to compel arbitration. When Kleiner’s legal team appealed the decision to the California Court of Appeal (COA), the COA rejected Kleiner’s arguments.

The COA’s decision is complex, but the gist is this. First, Pao did not agree to arbitrate employment disputes in her principal employment contract with Kleiner Perkins. Second, the arbitration clauses in the fund agreements do not cover the types of legal claims Pao is bringing against the firm. Third, KPCB cannot rely on arbitration clauses in the fund agreements because Pao’s claims do not seek to (i) vindicate the rights and privileges in the fund agreements (ii) while strategically avoiding the application of contractual obligations imposed by those agreements.

The upshot for future employment disputes is crystal clear. If you want the benefits of mandatory arbitration, a fair arbitration clause must be included in the employment contract itself.

The Future of Collaboration
In the wake of cases like Ellen Pao’s, venture capital firms, startups and mature technology companies are adopting mandatory arbitration for a host of reasons. Litigation is costly and very distracting. The dirt that gets raised is saved for posterity, a fact surely not lost on the dramatis personae in the Pao case. And finally, compensation and promotion decisions become a matter of public record.

This is precisely why arbitration is becoming increasingly popular with technology companies. Arbitration promises a confidential, private venue within which parties can settle their disputes. Some might worry that arbitrators have nettlesome biases, but there is little empirical evidence that this is the case. As Melinda S. Riechert, a partner at Morgan, Lewis and Bockius, observes, “arbitrators take their jobs quite seriously, the process is generally fair, and also has the benefit of being much speedier than a trial.”

It’s tempting to assume that arbitration is a step in the wrong direction. After all, sunlight is a disinfectant, and without litigation, how will employees ever gain the leverage they need to protect their interests? Arbitration, after all, prevents a plaintiff from shaming a defendant publicly. There’s an alternative perspective, one grounded in realpolitik, that one should consider as well: If firms are constantly worried about having every internal decision examined under a microscope in open court, the value of secrecy will increase and the technologies once used by plaintiffs to right wrongs — particularly open, unguarded discussions over email and text — will be abandoned in favor of furtive discussion in smoke filled rooms.

The truth is somewhere in the middle. Public litigation certainly does give some leverage to plaintiffs, but defendants are incentivized to fight tooth and nail when punitive damage awards are unpredictable. Moreover, firms like KPCB certainly have a legitimate interest in keeping hiring decisions and compensation practices private. But this interest in privacy can be overvalued — particularly when compensation and promotion decisions are based on defensible, reasonable principles. When hiring and promotion practices are finely tuned, rarely will they need to be subject to expensive, protracted litigation.

So, how do we make sure teams gel? How do we make sure that individuals are rewarded when they put aside petty rivalries for the sake of the group’s success? Well, we begin by getting rid of outmoded beliefs. Let’s leave behind the idea that women with aggressive styles should be ostracized. Similarly, we should abandon the intuition that quiet, introverted men don’t have good ideas. In a nutshell, we need to expunge all of the unhelpful narratives and biases socialization imparts to us. We need to get over all the assumptions that stand between us and actually working together.

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