A few days ago I was asked by an entrepreneur how he could figure out “which VCs he could trust.”  I was struck by the question.  Not because it isn’t a question I get asked regularly by entrepreneurs, but because as I began to answer the question I realized that in the answer was an explanation of what is wrong with the general financial economy. But, to get to that conclusion, first I’ll need to answer the entrepreneur’s question.

A private investment, i.e., an investment by a single investor into a company is a negotiated face-to-face transaction.  That’s one of the primary things that is different from a public offering, where people purchase shares on a securities exchange from an issuer they never meet.  In a private investment, the investor generally has the opportunity to ask questions and spend time with the entrepreneur.  So, through the transaction the entrepreneur gets to know the investor, and vice versa.

Then, after the investment is made, the entrepreneur and the investor usually engage in on-going communication.  In fact, a good entrepreneur makes it her business to keep investors informed, since the best path to subsequent capital is usually through the existing investors.  It’s always easier to sell someone you know a risky investment, than to educate someone new. And, let’s face it – when an investment isn’t that risky, there are plenty of people who will want to invest if the returns are there – even in an economic down turn.

You can see clearly, therefore, that a privately negotiated investment really is hand-to-hand capitalism. There is a great deal of information exchanged about the investment, but also over time, the entrepreneur and investor exchange a great deal of information about each other.  If the entrepreneur is not forthcoming about bad news, or the investor turns out to be very hard to manage, the other party in the transaction forms an opinion.  The opinion can be positive, negative or neutral depending upon the actions of the entrepreneur and investor, but the consistent outcome is that information is gathered that can be shared with others.

Trust is a shorthanded way for people to ask a number of distinct but interrelated questions. The questions will vary by context, but for an investment transaction there are a number of big themes:

• Does this person keep his word?

• Does this person lie? Are the things that I am being told true?

• How will she react if her interests diverge from mine? Will she keep my interests in mind?

• Will she keep my secrets?

• If I fail will she be unreasonable in dealing with the outcome?

Certainly, you can see how determining trustworthiness is an important thing for both entrepreneurs and investors in an investment.  So, how can you determine the trustworthiness of a VC?

Well, if you recall that VCs are in the business of making investments and then monitoring their investments, it actually becomes very easy.  All you have to do is ask entrepreneurs who have dealt with the VC previously.  They will have a wealth of data about how the VC was to work with – how trustworthy he was.   Most VCs publish their prior investments on their websites, and a Google search will usually turn up additional information.  You can also ask the VC for entrepreneur references – in fact, they will respect you more if you do.

Service providers who work with the venture community: lawyers, accountants, bankers and business consultants, will also be a good source of information.  The point is that VCs “leave footprints in the snow.”  You can learn a great deal about a VC’s trustworthiness simply by asking the opinion of others.

The good news in all this is that VCs know that they leave footprints.  And, this knowledge often is the best governor on their behavior.  Everyone has “off days” or off transactions, where the entrepreneur and VC don’t get along well, and there is no trust. But, there is usually a pattern of behavior – an entrepreneur should seek multiple data points.  Additionally, the things that one entrepreneur might value in a VC’s behavior could differ from another entrepreneur’s requirements.  Therefore, the most important thing that each entrepreneur should look for is a VC that shares his values.  That is a very personal choice, but the good news is that with diligent work and some digging it is something that an entrepreneur can figure out.

So, that’s how you figure out if you can trust a VC….. but what’s the larger market point I alluded to above?  

Well, if you consider what is going on in the financial markets right now, isn’t so much of it a lack of trust?  Market participants don’t trust each other enough to lend.  Credit swap holders don’t trust the creditworthiness of their counter parties.  Purchasers of municipal bonds don’t trust the information that they are being provided by municipalities.  These are all recurring themes you will have seen over the last few months as explanations for market upset.  And, it really is true (forgive the pun) – so much of the larger financial markets depend upon trust.  And, here’s the punch line – unlike in a privately negotiated investment, the parties don’t get to know each other, and they don’t have an ongoing relationship. There is no real way to personally develop trust, or to directly determine trust.

Here’s an example – mortgage backed securities.  Who makes the mortgage?  The original lender. Do they know the borrower? Generally not.  What happens to the mortgage after it is made?  It goes into a pool of mortgages.  Are individual mortgages easy to look at?  Nope.  Can you figure out easily if the borrower is trustworthy?  Nope.  Can you figure out easily if the credit officer who agreed to the loan wasn’t motivated by a quarterly bonus and ignored credit requirements?  Uh, Uh.  Get the picture?

So, what substitutes for direct information between people?  How do they develop trust without a personal relationship? Third party credit rating agencies, investment bank research reports, market reputation of the mortgage originating entities and publicly required securities reports are all substitutes for the lack of direct connection between the borrower and lender, or entrepreneur and investor in the public markets.  That’s the way public markets work, and have worked for years. But, what has happened to each of these substitutes?  Well, read the press – market participants have lost faith in each of these things.  So, what do you have – the last two months of turmoil in the world wide financial markets that’s what.

As you hopefully have noticed, notwithstanding some pretty dedicated punditry in September and October, the world wide financial system hasn’t melted down.  That is because the governments of the world have in some significant ways taken questions of trust out of the equation for certain key financial transactions.  For example, trust becomes irrelevant if the US Government is guaranteeing the repayment of commercial paper or Freddie Mac mortgages.  Of course, some people don’t trust the government, but for the great majority, the substitute of US Government credit for others has helped to calm the market.  They trust that the US Government will pay its obligations.

The bigger question is whether you will see a return of trust in the financial markets without governments substituting their own trustworthiness.  My expectation is the answer to that question is “yes”.  There are many reasons for this belief – the largest one of which is that the financial system invariably has corrected for prior trust crises, because sooner or later commerce depends upon it. And, wealth is created through commerce.  Whether this happens promptly, or more slowly over the next year to two, it will happen.  The question will be whether government can (or should) act to accelerate that return to equilibrium.

The current market consensus is that governments should act to accelerate the return of trust.  So, you should expect that a great deal of near term activity by government to “try to return trust to the market.”  This activity will largely be expressed through the minutia of market regulation.  

The last time there was a “trust crisis” as profound as the one currently prevailing, the US Government enacted a wide range of rules to structure and manage the sale of securities, the trading of securities, the management of investment companies, the ownership of public utilities and the ownership of financial institutions. And, this is just a partial list.  The period from 1933 through 1940 saw a profound change in how the US economy was managed and financial transactions occurred.  There were many well thought out laws passed, but at the most basic they were all fundamentally about creating trust.

Now, as we head into an election on Tuesday, “reform” is on everyone’s lips.  Active legislation, probably as far reaching as that adopted seventy years ago, is very, very likely – whoever wins the election.  And, here’s the rub – we are going to depend upon politicians that we elect to exercise their collective judgment in an efficient and careful way.  Make no mistake, we are not asking them to regulate – we are asking them to accelerate the return of trust to the financial markets.  And, in what may be the ultimate irony, we have to trust our politicians to do the right thing.  If they don’t do a good job, who will intervene to restore our trust in them?