The Unicorn Governance Trap

Renee M. Jones is a Professor at Boston College Law School. This post is based on her recent article, forthcoming in the University of Pennsylvania Law Review Online.

On October 3, the board of directors of Uber reached a truce after a tumultuous summer marked by high-profile resignations, bitter acrimony, and lawsuits among Uber’s principal investors. As reported, Uber’s board agreed to eliminate special voting rights accorded to early investors including Travis Kalanick, its former CEO. The board also set a timeline for a late-2019 initial public offering (“IPO”). It is somewhat ironic that months of roiling conflict at the quintessentially “disruptive” company were resolved through a retreat to the old-school convention of a “one share, one-vote” shareholder voting regime. Another key feature of the board’s rapprochement, a timeline for a future IPO, also harkens back to once-dominant venture capital financing norms. These proposed reforms align with recommendations included in my article, the Unicorn Governance Trap, forthcoming in University of Pennsylvania Law Review Online.

The breakdown of Uber’s board in the summer of 2017 was precipitated in part by former Attorney General Eric Holder’s scathing report on Uber’s corporate culture. Holder’s report focused on sexual harassment and other misconduct by senior Uber managers. At the time, Uber was grappling with a host of other controversies, including a messy lawsuit alleging complicity in the theft of intellectual property from a Google affiliated company, and a criminal investigation for using software to elude detection by local regulators as Uber commenced unauthorized operations in their cities.

Like Uber, other private companies have stumbled recently due to founder misconduct or fraud. Theranos was devastated in the fall of 2015 when investigations revealed that its main product, an innovative blood testing technology, did not really exist. In 2016, Zenefits’ CEO Parker Conrad was forced to resign when the company admitted to violating laws by allowing unlicensed employees to sell insurance. More recently, Social Finance CEO Mike Cagney resigned amid allegations of sexual harassment, lax internal controls, and a frat-like atmosphere at the $4 billion start-up.

The article highlights governance problems presented by persistent unicorns—privately-held companies with a market valuation of $1 billion or more. It argues that part of the explanation behind scandals at Uber and other unicorns lies in changes to the traditional venture capital (“VC”) structure for financing start-up companies and expanded opportunities for liquidity for their investors. These changes in the norms of start-up financing can be traced, in turn, to a series of Securities Exchange Commission (“SEC”) reforms instituted in recent decades. Together these reforms allow corporations to linger for protracted periods in a corporate “Neverland,” shielded from what had once been looming pressure to demonstrate to the world that they were ready to grow up and become publicly-traded companies.

Although corporate scholars have taken note of the growing significance of unicorns, legal commentary has focused mainly on disclosure issues. There has been little academic discussion of the unique governance challenges posed by an increasing number of unicorns with no discernable plans to pursue an IPO, the traditional exit strategy for start-ups. The article argues that in the absence of an impending IPO, unicorns lack sufficient incentives to develop governance structures and practices appropriate for enterprises of their scale. At the same time, many VCs have made the strategic decision to cede control to founders at an early stage, hampering their ability to step in and prevent or correct misconduct. Uber investor Benchmark’s pending lawsuit against Travis Kalanick illustrates this governance trap. Despite lacking board control, Uber investors managed to force Kalanick to resign after Holder’s devastating report. Yet, after his resignation, Kalanick retained his board seat and allegedly interfered with the board’s efforts to select his successor.

An economy in which large-scale private enterprises characterized by a separation of ownership and control can grow and thrive presents challenges for corporate law theory. This phenomenon has been facilitated by the confluence of amendments to the federal securities laws and an increased willingness of private investors to cede control of the companies they finance to unseasoned and untested entrepreneurial CEOs. With the expansion of electronic trading in start-up company shares, the separation of ownership from control has become a new reality for many unicorns. These market developments have introduced to unicorns the same agency problems that plague public companies, without the tools—voting, litigation or exit—public company shareholders rely on to discipline managers.

The article explains how market trends and deregulatory reforms weakened or eliminated mechanisms that imposed discipline on start-up company founders. Recent scandals at unicorns suggest that investors have erred in placing blind faith in the honesty and capabilities of start-up founders. Policymakers should learn from these disasters and close regulatory loopholes that allow unicorns to persist in limbo between private and public status for extended periods of time.

The article provides an overview of how the IPO has shifted from the preferred exit strategy in the eyes of entrepreneurs to a regulatory morass to be shunned. It traces developments in the market for start-up company shares and regulatory reforms that facilitated the proliferation of unicorns. The article next highlights unique governance risks posed by unicorns, addressing both societal and investor protection concerns. Finally, the article offers suggestions on how to address unicorn risks and raises fundamental questions about the future of unicorns in our economy.

The full article is available for download here.

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