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E-MailDonald Langevoort is a Professor of Law at the Georgetown University Law Center and Hillary A. Sale is Professor of Law at the Georgetown University Law Center and an Affiliated Faculty Member at Georgetown University McDonough School of Business. This post is based on their recent paper.
In academic and public commentary, entrepreneurial finance is usually portrayed as a quintessential American success story, an institutional structure whereby expert venture capitalists with strong reputational incentives channel much-needed equity to deserving entrepreneurs, then subject them to intense monitoring to assure they stay on the path to hoped-for success in the form of an initial public offering or public company acquisition. Yet, in recent years there have been gross embarrassments and allegations of outright criminality, at companies like Uber, Theranos, and the subject of our paper, WeWork. In short, we argue, fiduciary deficits and rent-seeking behaviors abound and the costs are borne not just by the venture capitalists or other investors.
Although we do not quarrel with the historical record of success, we are focused on the changes in the market for start-up capital that may well have contributed to the recent bouts of rent-seeking and extreme. Indeed, our title’s reference to corporate adolescence underscores the ever-lengthening period of time that high-tech start-up companies have before undergoing the so-called rites of passage to public adulthood. We argue that the private privileges allow for a build-up of bad choices and testy behaviors commonly observed in human adolescents, e.g., risk-taking and rule-breaking, thereby embedding in the firm’s habits and culture problems that may later be hard to fix.
We deploy a business-school like case study drawn from the extensive reporting on the WeWork story and its eight rounds of private financing before a failed IPO. It starkly poses a question that many—investors, board members, lawyers, and regulators, among others—will find difficult to answer. How could this happen as against all the high-powered incentives and smart-money discipline that supposedly exists in venture finance? And what if anything could or should have been done differently to overcome the pitfalls of start-up adolescence?
We examine the array of conflicts at WeWork and in start-up financing more generally that reveal not only that the situation is a risky one, but also that it is one where the risks and costs fall on less sophisticated investors, retail and institutional, and with unfortunate spillovers to the capital markets generally. The WeWork board, like many others, exhibited multiple fiduciary deficits resulting in what is a cautionary story about private governance failures. Our frustration extends to the recent pushes by Congress and the SEC to increase the number of retail investors eligible to invest in this space, in the name of “opportunity” that is more likely to turn into opportunism.
We conclude by arguing that current funding and governance systems are not designed for long-term “startup” governance, and WeWork reveals the systemic slack and flaws. Our exploration of the motivations, incentives and opportunities in start-up financing reveals an accumulating set of deficits that makes the current state of affairs more problematic than the conventional account would suggest. From founder control enabling self-centered, biased and risky behaviors, to funders with diverse incentives and capital sources, to start-up market “valuations” issues, the result is failed information-forcing systems and governance safeguards and directors who focus on constituent protections and not on their fiduciary duties. Truly sophisticated upstream investors may be savvy enough to negotiate this thicket; those less sophisticated who are increasingly being invited to take part will face more opportunism than opportunity.
The complete paper is available for download here.
