Startup Failure

Elizabeth Pollman is Professor of Law and Co-Director of the Institute for Law and Economics at the University of Pennsylvania Carey Law School. This post is based on her recent paper forthcoming in the Duke Law Journal. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? (discussed on the Forum here) by Lucian Bebchuk, Alma Cohen and Allen Ferrell.

Venture-backed startups famously aim for “exit.” On the path to building great companies, entrepreneurs raise rounds of venture financing and assemble a team to develop an innovative product or service that can grow fast. Success for startups is often framed as reaching a liquidity event, or exit, that provides financial returns and rewards to the investors, founders, and employees. There are two main ways to do this: sell the company or go public. Each of the two paths to a successful exit—going public or an M&A sale—have been the subject of significant scholarly examination and public debate in recent years.

Most venture-backed startups, however, never reach either of these paths, or if they do it is in a state of distress. Approximately 75% of venture-backed startups fail – the number is difficult to measure, however, and by some estimates it is far greater. In general, a startup can be said to fail when it ultimately falls short of reaching an exit at a valuation that would provide a return to all equity holders. This can occur for a wide variety of reasons—such as running out of cash, problems in the team, shortcomings with product development or business model, getting outcompeted, a lack of market need, or changed circumstances. The participants may not expressly call this a “failure”—and indeed they may work mightily to find a “soft landing” that allows them to characterize it otherwise—but it is distinctly an end that is not a going-public transaction or M&A sale that results in returns to all equity holders.

This third and most common path—startup failure—receives little attention in the scholarly literature, yet it is a critical part of the startup and venture capital ecosystem. The ability of startups, and their participants, to fail efficiently and “with honor” helps sustain the system out of which also grows some of the largest successes in the history of U.S. business.

My forthcoming article, Startup Failure, provides a theory of the law and culture facilitating failure and argues that it serves an important role in the startup and venture capital ecosystem. A range of options exists and has not before been explored in the big picture—as a system for dealing with the large number of failed startups that our venture capital ecosystem produces.

Although a developed bankruptcy system is considered crucial to entrepreneurship and the business environment, venture-backed startups are unlikely to turn to the formal bankruptcy process. The article begins by explaining why a formal bankruptcy process does not fit the needs of most distressed venture-backed startups and what we can learn from the rare exceptions.

Specifically, the typical capital structure of startups does not involve significant commercial liabilities that need to be satisfied. Further, venture-backed startups are, by their nature, melting ice cubes – the team’s talent and technological know-how, intellectual property or other intangible assets, and network effects of a growing enterprise can disappear quickly once it becomes known that the startup is in distress. Not only is the typical startup a melting ice cube, but it is also embedded in a network of reputational concerns and constraints in a venture capital ecosystem. Angel investors, venture capitalists, and venture lenders are all repeat players in venture investing and lending. Venture capitalists invest based on the “power law” that a small number of big hits may drive much of the returns for the fund. A long, drawn-out bankruptcy process is often the last thing that venture capitalists want to be involved in given opportunity costs and potential reputational harm. Particularly in a competitive environment for getting into startup deals, it is not worth squeezing the last dollar back from a startup. All of these reasons are in addition to cost and timing issues. Examples of startup bankruptcies ranging from Solyndra to FTX provide a study of the unusual exceptions that prove the rule: failed startups typically do not favor using the formal bankruptcy process.

What, then, happens to the great number of startups that are failing to achieve their founding dreams? A range of options exists and has not before been explored in the big picture—as a system for dealing with the large number of failed startups that our venture capital ecosystem produces. The alternatives to bankruptcy that venture-backed startups commonly use include M&A sales, acqui-hire transactions, and assignments for the benefit of creditors (ABCs). The low cost, speed, potential for private ordering, and light level of legal formality involved in these options allow venture-backed startup participants to “fail fast” and for assets and talent to be absorbed or redeployed without significant reputational harm.

Putting together the strong social and cultural norms in startup networks and the venture capital business model reveals the modus operandi of Silicon Valley’s approach to startup failures: normalize and redeploy. Entrepreneurs and employees often benefit from being able to take a swing and miss. Failure might result from a lack of luck or other factors beyond an entrepreneur’s control. Knowing that failing will not harm one’s ability to get a “regular” job or try again at entrepreneurship, so long as one aims to treat others well, may help to motivate the decision to launch an innovative startup or go work for one. In many instances, venture capitalists can provide implicit insurance to spread the risk of individual failure by being willing to make introductions to other portfolio companies, early-stage investors, and soft landing opportunities. More broadly, because buttressing entrepreneurs’ willingness to take on risk is integral to venture capital, it often redounds to a VC firm’s benefit to cultivate a reputation for supporting entrepreneurs in this way—whether in good times or in bad.

Notably, several developments are shifting the landscape of venture capital investing and suggest that the system may come under pressure to deal with the size, type, or number of failures. New entrants to venture-backed startup investing, longer timelines of staying private, higher valuations and amounts raised, and looming increased antitrust scrutiny of technology acquisitions all point to change that might test the adaptability of the existing law and culture of startup failure that aims to normalize and redeploy at low social and financial cost.

Therefore, in its final section, the Article sheds light on regulatory and doctrinal opportunities to advance the law’s approach to startup failure. For example, recent years have witnessed a number of legislative proposals and arguments to ratchet up antitrust scrutiny on acquisitions by large technology companies. Attention should be paid to calibrating regulatory responses so as not to impede the flow of dealing with large numbers of startup failures that do not pose significant competition issues. Likewise, state laws could promote efficiencies in dealing with failure by adding doctrinal clarity to challenging but commonplace scenarios that startup boards face in fulfilling their fiduciary duties, and spreading insights from California’s state insolvency procedures to growing startup hubs across the country.

The value of supporting failure often attracts less regulatory and scholarly attention than the shiny allure of success, but the two are entwined in the larger startup and venture capital ecosystem which funds high-risk innovative business and has enormous social and economic impact.

The article, forthcoming in the Duke Law Journal, is available here:

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