Unicorn Shareholder Suits

Huge private companies like Epic Games or SpaceX are everywhere, creating gaps between the private-market reality and legal structures that were designed for public companies. This major economic shift has created a blind spot in the law and its analysis. Although an emerging literature explores the world of startups, whole areas remain unexamined. A key uncharted area is shareholder litigation: suits brought by investors against the company in which they own shares.

Shareholder litigation against public companies is frequent and expected. Given its importance, academic and industry analysis of shareholder litigation is extensive. To date, however, the analysis has focused almost exclusively on shareholder litigation against public companies. Given the shift from large public to large private companies, it is natural to ask how shareholders sue in the private context. Unicorn Shareholder Suits offers a systematic account of shareholder litigation against the private companies that now dominate the corporate landscape.

1. Structuring the Study

This original study identifies litigation filed from January 1, 2015 through March 31, 2020 against any U.S. company on a 2016 list of unicorns from CB Insights. The unicorns were private U.S. companies valued at one billion dollars or more as of December 2016. Extensive review of docket sheets and the underlying court documents identified shareholder litigation against these companies – lawsuits in which an investor or investors in a particular company sued that company and/or the company’s top officers or directors.

The definition of shareholder litigation is driven by the identity of the litigants. Since little is known about shareholder litigation against private companies, using this generous definition was particularly important to this study to avoid prejudging the legal theory, procedural form, or type of forum or investor.

2. Unicorn Shareholder Suits

The findings indicate that few suits are filed and that they look quite different than shareholder litigation on the public side. More detail is below about the study’s limitations – particularly the low number of suits – but three observations stand out:

• Shareholder suits against large private companies are relatively rare. The study identified shareholder litigation against only 6% of the companies on the 2016 unicorn list over more than five years. In comparison, an average of 4% of exchange-listed (public) companies faced federal or state securities fraud actions every year between 1997 and 2021 (Cornerstone Research). The private-company study captured a broader scope of shareholder litigation through its definition, but nonetheless identified a lower percentage of filings.
• There is no obvious substitute for federal securities class actions. The litigants, forum, and claims in the identified lawsuits vary, with no obvious substitute for the federal securities class actions that are the typical shareholder suit against public companies.
• The shareholder suits identified in the study were predominantly brought in state court based on state-law contract and fiduciary duty claims. Investors in private companies alleged fiduciary duty violations, contractual breaches and legal theories based in state corporate law.

Limitations and caveats apply. Some are inherent in most studies of startups (valuation!) or in the use of a particular snapshot at a particular point in time (2016 was early in the emergence of unicorn companies). But the main caveat is that there is little identified litigation so that the approach to these suits is necessarily qualitative and anecdotal rather than quantitative. Percentages must be taken with caution.

With that in mind, the article provides a summary chart and a narrative account for each litigation, aimed at identifying some of the ways in which shareholder litigation against large private companies is structured: what parties, what courts, and what claims.

3. Barriers to Litigation

Why are there relatively few shareholder suits against large private companies? And why no securities class actions? A potent mix of procedural limitations, the structure of private-company investment, and cultural constraints in the relationship among VCs and private companies explains why litigation against large private companies does not and will not look like its public counterpart. The reasons track characteristics peculiar to private companies: the absence of a market price, contractual shareholders, limited information, and founder-investor-employee dynamics.

First, the stock of private companies, by definition, is not publicly traded. The absence of a readily discernable market price limits the availability of class actions because it eliminates the predominance of common issues required to bring a lawsuit as a class. Absent an efficient market, no “fraud on the market” presumption is possible and shareholder plaintiffs must show individualized reliance (Basic; Halliburton). The lack of a market price also eliminates an information and evidentiary source for class actions: a visible drop in stock price. The overall effect is that federal securities class actions are largely disabled when it comes to private companies.

(For securities litigation experts/nerds only: in one respect shareholder securities class actions against private companies are broader than in the public-company context. Hint: SLUSA.)

Second, investors are contractual shareholders, investing at different points in the life cycle of the startup under different contractual terms. This investment structure limits the availability of securities class actions, making the predominance of common questions hard to establish and providing space for contractual terms that govern disputes – terms that would be unavailable in the public-company context.

Third, by definition, the private company is not a reporting company. It does not have to file annual reports and other disclosures, which would provide publicly available information, including information that enables litigation or government enforcement.

Finally, the incentives to litigate differ from those in large public companies, at least when early investments by angel investors and VCs are concerned. Depictions of the startup context portray a founder-favoring culture where shareholder litigation would be wildly out of place. The reaction to Benchmark’s suit against pre-IPO Uber is a suggestive illustration: one headline read simply “What Was Benchmark Thinking?”

But an explanation based on cultural clubbiness takes us only part way. As the investor population changes to encompass employees and retail and later-stage investors, incentives to sue shift. The availability of anti-fraud mechanisms is particularly important if retail investors enter the private market. And, while venture capital may be constrained from litigating because of the need to maintain reputation within a founder-friendly world, employee 5000 does not have the same incentives – or the other routes to relief.

The effect of these limitations is a world without class actions. Remaining litigation options rely on individual investor incentives or, in the case of group or representative litigation, on creative lawyering and receptive courts. Some steps can be taken by shareholder-plaintiffs and courts even without large structural changes (see Part VI). But overall there is a continuing need to map and address the gap between U.S. regulatory structures and the world of startups, tech unicorns, and other innovations – good and bad – that reflect a fundamental shift in how businesses raise money.