Startup Governance

Elizabeth Pollman is Professor of Law at University of Pennsylvania Law School. This post is based on her article, recently published in the University of Pennsylvania Law Review. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups (discussed on the Forum here); Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley (discussed on the Forum here); and Do Founders Control Start-Up Firms that Go Public? by (discussed on the Forum here), all by Jesse Fried and Brian Broughman.

In the past year, we have seen many “unicorns”—startups described as having private valuations over one billion dollars—hit the ten-year mark and reach important inflection points. They have defied existing corporate theory by growing to a large size with ownership shared between founders, investors, and employees. Record-breaking amounts of capital have flowed into these and thousands of other startups.

With their focus on technology and innovation, and correspondingly high levels of risk and emphasis on growth, startups generally have a different style of governance from both public corporations and traditional closely-held corporations. In a forthcoming article, I aim to provide a comprehensive framework for understanding the unique combination of governance issues in venture-backed startups over their life cycles.

A Framework for Understanding Governance of Venture-backed Startups

Prevailing accounts of corporate governance, whether focused on public corporations and their shareholder-manager conflicts, or closely-held corporations and potential controlling shareholder opportunism, tend to present the corporation in static terms and as facing one essential governance issue that is either vertical or horizontal in nature. Corporate law literature has often characterized shareholders as homogeneous in their interests. It has also generally excluded employees from analysis and recognized their relevance only in contractual terms.

This approach is a poor fit for understanding the governance of startups, which evolves over time and involves participants who often occupy overlapping and shifting roles. For example, a venture capital investor is a shareholder and may also hold a designated seat on the board—creating a dual status as both principal in one context and agent in another.

Furthermore, startup participants are heterogeneous. In light of the high level of risk and asymmetric information, startups typically issue common stock to founders, stock options to employees, and raise money from investors by issuing rounds of convertible preferred stock with varying terms and layered contractual rights. This creates a capital structure that can give rise to significant differences between shareholders concerning control, potential deal payouts, and post-exit opportunities. Conflicts can arise among preferred shareholders, between preferred and common shareholders, and among common shareholders—a point that even scholars focused on startups have generally left unexplored.

Setting out the full picture of both vertical and horizontal tensions that exist in startups uncovers an important pattern: the governance tensions tend to multiply as the startup business evolves and the complexity of its capital structure grows. Venture-backed startups that survive predictably face increasing potential conflicts.

This pattern arises because startups are often unprofitable for long periods while they develop innovative products or services and they usually continue to raise outside investment. Each round of financing may bring investors with different terms and interests into the capital structure. In addition, employees are typically hired on an ongoing and increasing basis, and become staggered in their option vesting schedules and exercise prices. As a startup matures, it expands the participants with varied interests and claims affecting its governance.

Among other contributions, this framework and central observation helps to explain two phenomena that have been making headlines—monitoring failures at startups and companies going public even when private capital is available.

Monitoring Issues in Startups

Recent governance scandals at startups challenge the existing literature which assumes that venture capitalists are strong monitors because they have significant investments at stake and often participate in board governance. The potential for monitoring weakness becomes clearer, however, once we recognize the relationship between the venture capitalist and entrepreneur is not simply a vertical principal-agent relationship. It is instead part of a system of startup governance that puts heterogeneous participants in overlapping roles that creates both vertical and horizontal tensions.

As these potential governance conflicts typically increase over time, board members—whether investors or founders—will likely push the company to grow fast to continue raising capital without significantly diluting participants and to achieve an exit that benefits all participants without putting them at odds with each other. To the extent that company culture or compliance issues imperil the company, board members have an incentive to monitor and invest in controls; otherwise, they will likely prioritize profits or growth.

Further, the article points out that VCs are repeat institutional players in a reputation-based market for investments, which can affect their ability to provide governance oversight. As investors they could be characterized as principals in the startup, but in competitive markets VCs also effectively get hired by founders who have options for financing. Competitive and reputational constraints can encourage investors to adopt founder-friendly stances, particularly among the highest echelon of startups, in order to remain in a founder’s good graces to participate in subsequent rounds and for reputation in having access to other companies’ deals.

Unless a startup reaches maturity and prepares to go public, there may be little incentive to cede control and build an independent, public-company-style board. Founders value the ability to pursue their vision for the company; VCs appreciate founders’ ability to create an innovative culture and also want their own seat on the board. Not all startups have independent directors and those that do might envision their role more as a tie-breaker than a monitor. Going forward, the article highlights that this structure and the potential for oversight weakness merits further attention as the social and economic impact of startups are felt in communities around the world.

Extreme Late-Stage Governance and Liquidity Pressure

Finally, the article’s framework of startup governance also helps explain why some companies might eventually choose to go public even when they do not need to raise capital: increasing governance costs and liquidity pressure from heterogeneous shareholders.

Staying private for long periods while growing and adding participants with diverging interests involves significant governance complexity and cost. Raising new rounds of financing requires complex renegotiations among an increasingly diverse group of shareholders. Late-stage financing often raises the bar for an exit down the road, for example, by giving protective terms to the newest investors regarding the price and timing of an IPO that guarantees them a return, potentially at the expense of founders, employees, and earlier investors.

Extended periods of staying private also strains the timelines associated with VC funds and employee equity-based compensation. Secondary trading, third-party tender offers, and company-sponsored share buybacks provide a partial release valve for participants’ liquidity needs and governance conflicts, but these transactions also create new risk and challenges that must be managed. A lengthy list of problems for startup employees in particular can arise from the extended pre-liquidity period.

The article’s discussion of these issues adds depth to understanding the extreme late stage of startups. The framework offered suggests that we can expect increasing complexity to remaining private and an ownership structure of different types of participants with vesting and investing timelines that can be delayed, but will eventually push toward an exit. Going public releases liquidity pressure from a diverse group of equity holders, including employees, and offers a chance to unwind a complicated and largely contractual governance structure.

The complete article is available for download here.

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