In a research paper written by Prof. Elizabeth Pollman, titledStartup Governance, and published through the Institute for Law and Economics, a joint research center of the Law School, the Wharton School, and the Department of Economics in the School of Arts and Sciences at the University of Pennsylvania, the author tackles the corporate governance issues facing unicorns. There have been a number of privately held companies that have faced corporate governance issues, which, in some cases have delayed their IPOs, and, in other cases, perhaps even contributed to the withdrawal of their IPOs. Despite the growing number of unicorns and the prominence of a number of these companies, there has not been much analysis of some of the governance challenges. As Pollman writes, the US securities laws merely distinguish between non-reporting and reporting companies. Perhaps because of the traditional triggers for SEC reporting, private companies have been presumed to be closely held. However, given changes in financing patterns, companies are remaining private longer, conducting more financing rounds, and their securities may be broadly held. The securities of a large, successful private company usually will be held by a heterogeneous group of investors, including friends and family, angel investors, employees and consultants, venture capital funds, sovereign wealth funds, cross-over funds, private equity funds, family offices, hedge funds, and other institutional investors. Traditional agency theories for understanding corporate governance are not particularly helpful in navigating increasingly complex capital structures such as those that have become commonplace for unicorns. Moreover, much of the traditional case law and analysis has focused on conflicts between venture capital investors and founders or other common stock holders (conflicts between holders of common stock and holders of preferred stock, such as in the context of a bankruptcy, liquidation, down-round, or sale), and has assumed that VC holders exercise significant governance rights. As capital structures have become increasingly complicated, and as the types of investors in these companies has multiplied, it is now more common to have multiple classes of investors with varying and sometimes limited governance rights as well as to have significant investors that have only a passive economic interest. Passive investors will be less likely to perform the traditional corporate governance "monitoring" role that has long been associated with VC investors. Boards also tend to differ over a startup's lifetime. Most startups begin with boards that are, as Pollman notes, founder-controlled, and transition to more investor-controlled boards or boards where control is shared. Over time, it is likely for there to be diverging interests as between the founders and the investors. With more complex capital structures, it becomes more likely to see diverging interests arising among preferred stockholders who may have different series, with different rights and different pricing. The author argues for a more evolved approach to thinking about startup governance that recognizes the changes that have arisen as more private companies remain private and courts should apply traditional fiduciary law and other corporate law principles more flexibly in order to account for these changes.
Originally published June 30, 2020.
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