Online Extra: Silicon Valley's Blurry Ethical Vision

Even after a purge of tech-bubble excesses, the incestuous business culture where CEOs and VCs mingle too closely persists

One by one, the institutions that contributed to the greed, excesses, and abuses of late 1990s capitalism are being investigated and -- hopefully -- cleaned up. Yet Silicon Valley, which built the money machine that pumped up the the NASDAQ stock bubble, remains largely unapologetic. Now, with another bull market, the danger is the Valley won't feel enough pressure to fully reform. The possible result: A financial aftershock that could compound the damage from the Big One and once again spoil the Valley's credibility with investors.

Look at what's going on in the public markets. In the past three months, a bumper crop of more than 15 tech companies have gone public or announced their intention to do so, and some of these outfits aren't making money. Among them: Online travel site Orbitz and luxury Web retailer RedEnvelope (REDE ). Hello? Doesn't anybody remember the IPO lunacy of 1999?

But the Valley's more serious problem now isn't the public markets. It's the incestuous business culture that gave rise to the you-scratch-my-back, I'll-scratch-yours excesses of the late '90s. CEOs of tech companies are still invited to invest in the funds of venture-capital firms. Lawyers sit on the boards of companies with which their firms do business. Investment bankers invest their own money in venture firms and startups.


  In some cases, these people are trading on the power and influence of their businesses for their own personal gain. Their webs of intertangling relationships set them up for conflicts of interest. And the interwoven culture creates an environment where insiders get the benefit of valuable information and investment opportunities that the great mass of the investing public doesn't. "When it comes to business ethics in Silicon Valley, I think they just don't get it," says Gary Lutin, a former investment banker who now advises shareholder groups.

The Valley has had a partial cleanup, with government leading the way. The Securities & Exchange Commission's so-called Reg-FD ruling prevents companies from sharing sensitive information with analysts before it tells the general investing public. The Sarbanes-Oxley Act laid out strict rules for corporate governance in publicly traded companies. And New York Attorney General Elliot Spitzer's settlement with the securities industry put distance between investment bankers and securities analysts, and ended the practice of "spinning" -- where investment banks handed CEOs stock in IPOs as an inducement to do business with them in the future.

For those who didn't understand basic business ethics before, the unfairness of these practices has now been spelled out in blazing lights.


  Some insiders insist that the Valley has been brought back into equilibrium. True, they agree, values got out of wack -- especially with the rush to collect IPO shares and take companies public that were barely more than a business plan. "The system was abused. Greed and arrogance were prevalent. Some people rushed to the Valley to be part of it, but a lot of people were repulsed," says a software company chairman who asked to remain anonymous. Now, this exec says, "The Valley has returned to its roots, which is focusing on innovation and creativity."

Yet it's clear to others that some not-so-wholesome legacies still need purging. These are subtle things. It's not a matter of breaking laws, but blurry vision when it comes to ethics. As the Valley matures, practices that seemed O.K. in the early days are no longer appropriate now that the tech industry plays such a vital role in the public markets and the overall economy. Says a longtime Valley executive who asked not to be identified: "We need more rules, unfortunately. And we need more common sense."

Venture capitalists certainly have some cleaning up to do. It's part of a VC's job to sit on the boards of 6 to 10 startups. As these companies mature and their strategies shift, they frequently become competitors. Yet the venture capitalists who helped bring them to life are loath to abandon board seats.


  It wasn't until last Mar. 12, for instance, that Michael Moritz of Sequoia Capital, who sat on the boards of both Yahoo! (YHOO ) and Google, resigned from Yahoo's board. That was months after Google launched Froogle, a search engine for shoppers, and started competing directly with Yahoo. Moritz has said he was careful to recuse himself if a conflict arose. Why not avoid even the appearance of a conflict -- and do it immediately?

CEOs should make sure they're squeaky clean, too. They ought to avoid taking financial gifts from anybody. Yet most valley executives have been invited into exclusive clubs operated by the VC firms called "side funds." They get to invest right alongside pension funds and money managers, and share in returns that top 50% in boom years. One CEO told BusinessWeek he made $139 million from such investments in a single quarter.

Do these CEOs get a ride on the gravy train just because they're nice guys? Nope. They get these rich payoffs because they're in a position to do favors for their VCs' patrons. That's not a place any CEO of a publicly traded company should be.

And what happens if the venture firm invests in a competitor to the CEO's company? He potentially profits from the emergence of a challenger to his own company. "What hasn't changed is the world of private equity and venture capital, and those relationships. It's a clubby community. It's still going on," says a long time Valley financier.


  You would think the Valley's lawyers would be supersensitive to potential conflicts of interest, but often they're not. Larry W. Sonsini, chairman of law firm Wilson Sonsini Goodrich & Rosati, for instance, sits on the board of Brocade Communications (BRCD ), even though his firm does legal work for the storage software company, which paid it $5 million last year.

Sonsini wasn't available to comment. Mario Rosati, another partner in the firm, says partners are allowed to sit on boards of companies, but it's limited to special cases. Still, why not be above reproach?

Much of what needs to be done to clean up the Valley's business practices can't be fixed with new laws or rules. What's needed is a new code of conduct, which will have to come from within. This is a two-stage process. First, people have to recognize that what they're doing ain't right. Then they have to change it.

Since Silicon Valley's culture is so ingrained, it will likely take a long time to graft on a new set of values. All the more reason to start right now.

Commentary by Steve Hamm, senior writer covering technology from New York

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