INTRODUCTION 156 I. THE DISTINCTIVENESS OF STARTUPS AND THEIR LIFE CYCLE 162 A. Legal Boundaries and Definitions 163 B. Two Dimensions of the Startup Life Cycle 165 1. The Nature of the Business 165 2. The Complexity of the Capital Structure 170 II. A FRAMEWORK OF STARTUP GOVERNANCE 176 A. Fundamental Startup Governance Issues 178 1. Vertical Issues 179 a. Shareholders vs. Board 179 b. Board vs. Founders or Executives 184 c. Shareholders vs. Founders or Executives 185 2. Horizontal Issues 188 a. Preferred vs. Common 189 b. Preferred vs. Preferred 191 c. Common vs. Common 193 B. Increasing Governance Issues Over Time 196 III. IMPLICATIONS AND FUTURE PATHS 200 A. Understanding Challenges 200 1. Monitoring Failures 200 2. Extreme Late-Stage Governance and Liquidity Pressure 209 B. Applying Corporate Law 216 CONCLUSION 220 INTRODUCTION
The world's largest companies in 2019 by market capitalization--Apple, Alphabet, Microsoft, and Amazon--all began as venture-backed startups. (1) They defied existing theory by growing to significant size with ownership shared between founders, investors, executives, and employees. (2) In the years since these trailblazing startups crossed over into public company status, record-breaking amounts of capital have flowed into new private companies. (3)
Over three hundred "unicorn" startups have reached private valuations described as one billion dollars or more. (4) Many of these companies have also reached the ten-year mark and face critical inflection points in their life cycles. (5) Thousands of other startups are following on their heels or hope to do so. Our economy and society are increasingly dominated by companies that start in the proverbial garage or dorm room and, for a critical period, operate with a venture-capital style of ownership and governance.
Corporate law and theory have not kept pace in giving due attention to this development and adapting general principles to fit the special features of startups. (6) Courts apply traditional contract strictures to the preferred stock that venture capitalists hold not as public company debt, but rather as a stake in a distinctive system of shared equity and governance. (7) Recent case law requires startup directors to maximize value for common shareholders, without recognizing that in startups these shareholders do not have a monolithic set of interests and do not represent the firm value. (8)
Corporate law literature remains similarly rooted in traditional paradigms of public and closely held corporations that do not map on well to startups. Landmark works on the separation of ownership and control in public corporations and a principal-agent theory of the firm have oriented the field to view reducing managerial agency costs "as the essential function of corporate law." (9) A smaller body of work on controlled and closely held corporations has, by contrast, highlighted that these corporations do not share the hallmark feature of widely dispersed shareholders and instead face the potential problem of minority shareholder oppression. (10)
Amid this dichotomous approach to corporations, (11) a separate body of venture capital and entrepreneurship literature has emerged to examine specific governance issues in startups. Key work in this field includes, for example, the study of venture capital financing (12) and the use of preferred stock. (13) Some scholars have recently begun studying unicorns, the largest startups by valuation, and have advocated for increasing disclosures and strengthening mechanisms that impose discipline on founders. (14) Yet, despite growing influence and concern, no article has provided a full account of the unique features of startups and their governance.
This Article takes aim at that goal. With their focus on technology and innovation, and their correspondingly high levels of risk and emphasis on growth, startups are different from both public corporations and traditional closely held corporations. As a result, their governance is also different. This Article provides an in-depth, holistic analysis of the governance problems in venture-backed startup companies that exist through various stages of their life cycles. Specifically, it offers a framework showing that startups involve heterogeneous shareholders in overlapping governance roles that give rise to vertical and horizontal tensions between founders, investors, executives, and employees. These tensions tend to multiply as a company matures and increases the number of participants with varied interests and claims.
This original account of startup governance shares features with traditional models but also differs in significant ways that have wide-ranging implications for corporate law and theory. Prevailing accounts, whether focused on public corporations and their shareholder-manager conflicts, or closely held corporations and their issues of controlling shareholder opportunism, present the corporation in static terms as facing one essential governance issue that is either vertical or horizontal in nature. (15) Corporate law literature has also often characterized shareholders as homogeneous in their interests and has excluded employees from analysis, recognizing their relevance to the corporation in only contractual terms. (16)
This approach is a poor fit for startups. Participants in startups often occupy overlapping and shifting roles. For example, a venture capital (VC) firm is a shareholder and may additionally hold a designated seat on the board. This complicates conventional applications of principal-agent theory as participants may have a dual status as both principal in one context and agent in another.
In addition, startup shareholders are heterogeneous. In light of extreme levels of uncertainty and asymmetric information, startups typically issue common stock to founders and raise money from investors by issuing rounds of convertible preferred stock with varying terms and layered contractual rights. (17) This capital structure creates significant divergences in preferences among shareholders. Furthermore, employees make essential investments of human capital and hold common equity or options. (18) In many instances the interests of founders and executives align with those of employees, but in some situations they diverge because of differences in control, potential deal payouts, and post-exit opportunities. Conflicts therefore arise not only between preferred shareholders, and between preferred and common shareholders, but also between common shareholders--a point that even scholars focused on startups have generally left unexplored. (19)
Setting out the full picture of vertical and horizontal tensions highlights the distinctiveness of startups and also uncovers an important pattern: The governance tensions tend to multiply as the startup business evolves and the complexity of its capital structure grows. Unlike public companies and other closely held corporations, which do not display predictable or linear patterns of governance change, venture-backed startups that survive foreseeably face increasing potential conflicts.
While it may seem intuitive that startups increase in governance complexity as they continue to operate, this account is missing from the existing literature. Because startups are often unprofitable for long periods while they develop innovative products or services, they usually raise outside investment and continue to do so to fuel growth. (20) Each round of financing may bring investors with different terms and interests into the capital structure, adding to potential governance conflicts. (21) Further, employees are typically hired on an ongoing and increasing basis, and become staggered in their option vesting schedules and exercise prices. Thus, as a startup company matures, it expands the number of participants with varied interests and claims affecting its governance structure. (22)
These central contributions of the Article help elucidate vexing issues of current debate and open future directions for corporate law. Part I discusses the distinctiveness of startups and their paradigmatic life cycle. It sets out legal boundaries and definitions, and identifies two dimensions of the startup life cycle that drive governance issues: the evolving nature of the business and capital structure. Part II provides a holistic analytical framework of the recurring issues of startup governance, both vertical (such as between the board and founders) and horizontal conflicts (such as between shareholders). It includes all startup participants and shows how they have diverging interests and might be involved in more than one type of governance issue, serving overlapping roles. Furthermore, it observes that governance issues tend to increase over time because of the evolving stage of business and increased complexity of the capital structure.
Part III explores how these observations help to explain current developments and illuminate implications for lawmakers. First, with scandals at companies such as Uber and Theranos making headline news, recent accounts of startups have bemoaned unaccountable companies with large social footprints and compliance failures. (23) This Article's framework helps show how a startup's evolving governance structure pushes toward prioritizing growth and puts key participants in overlapping roles, which can result in conflicts of interest and weaken oversight. This explanation solves a puzzle left open by existing literature, which assumes that VCs will serve as strong monitors. Further, it reveals cause for concern that likely cannot be solved with the standard corporate governance proposal for greater board independence. Startup governance may insufficiently constrain the social costs created by growing, innovative companies.
Second, the law and finance literature has examined various reasons for companies to go public but has overlooked what the framework offered here posits--complex...