POLLMAN

THE UNIQUE CHALLENGES of GOVERNING STARTUPS

on research by

ELIZABETH POLLMAN

Visiting Professor of Law As venture-backed startup companies comprise an increasingly important segment of the American business landscape, an article by University of Pennsylvania Law School Professor Elizabeth Pollman closely examines the unique challenges involved in governing such companies within the framework of existing corporate law. The article, “Startup Governance,” forthcoming in the University of Pennsylvania Law Review, provides an in-depth analysis of the governance problems in venture-backed startups throughout the companies’ life cycles, brought about by the tensions between and among shareholders, founders, investors, executives, and employees who commonly play overlapping roles.

Pollman is a Professor of Law whose work is focused on business law. Her teaching and scholarship have addressed issues of corporate personhood, the constitutional rights of corporations, law and entrepreneurship, corporate governance, and startup companies.

“All five of the world’s largest companies by market capitalization — Apple, Alphabet, Microsoft, Amazon, and Facebook — began as venture-backed startups[,]” writes Pollman. “They defied existing theory by growing to significant size with ownership shared between founders, investors, executives, and employees. In the years since these trailblazing startups crossed over into public company status, record-breaking amounts of capital have flowed into new private companies.”

“All five of the world’s largest companies by market capitalization — Apple, Alphabet, Microsoft, Amazon, and Facebook — began as venture-backed startups.”

Even as startups proliferate, no legal definition of a startup company currently exists, and corporate law does not supply special rules for their governance. For the purposes of the article, Pollman defines startups loosely as companies “typically started by entrepreneurs and backed by outside investment with the goal of developing an innovative product or service, creating high growth, and exiting.” She notes that startups differ from traditional closely-held corporations in that their goals are usually either to go public or be acquired by another corporation rather than continue indefinitely in their initial form.

Among the challenges of governing a startup is the wide range of investors, each with different and sometimes competing sets of interests. As startups grow and pursue different types of funding, Pollman explains, their capital structure becomes increasingly complex as a result. In the first instance, the company’s founders “usually split the entire ownership pie by issuing the initial common equity to themselves as founders’ stock.” At the next stage of funding, angel investors — wealthy people who invest their own money into early-stage companies — provide the initial source of outside funding. As they pursue more significant growth, “many startups next seek additional financing from venture capital investors,” writes Pollman. “VCs are professional investors — general partners of funds organized as limited partnerships — who put other people’s money to work.” VCs also commonly provide oversight and mentorship to the companies they invest in as a method of protecting their investments. Finally, some late-stage startups also pursue funding from other types of investors such as mutual funds and sovereign wealth funds.

In seeking funding from these varied groups, “the typical pattern is for a startup to engage in sequential rounds of issuing convertible preferred stock with various protective terms and designated board seats,” writes Pollman. “In contrast to public companies, which generally have a single class of common equity, startups usually issue a new class of equity every 12-24 months in order to raise money to grow the company.” The result over time is “an increasingly complex capital structure” that includes “not only founders and employees, but also a variety of shareholders with different associated valuations, cash flow, and control rights.”

Pollman illuminates the conflicts that can arise between the many groups involved in funding and running startup companies. For example, she notes, “[venture capital investors] and founders often diverge with respect to risk level, liquidity needs, and

ELIZABETH POLLMAN

private benefits, which are often implicated in critical boardlevel decisions on financings, strategic direction,” and whether and when to sell the company or take it public. Diverging interests can also arise between shareholders, even those with the same type of equity, whether common or preferred stock. In venture-backed startups, these tensions tend to multiply over time because each round of financing increases the number of participants with varied interests and claims.

Pollman’s observation regarding increasing governance complexity in startups helps to shed light on several debates. Notably, although VCs are theorized to be strong monitors, recent years have witnessed a number of high-profile oversight failures in startups. Pollman explains that the overlapping role that VCs commonly play as both investors and directors may weaken monitoring as they seek to protect their relationships with company founders. Furthermore, rather than investing in compliance or internal controls, startup boards have incentives to prioritize growth in order to fuel the company’s valuation and eventually reach an exit that generates returns for all participants without putting them at odds with each other. In addition, the article’s detailed account of increasing governance costs and liquidity pressure also provides a new explanation for why some companies might chose to go public — a particularly timely insight in an era of “unicorn” IPOs and direct listings.

Finally, Pollman argues that, as currently structured, traditional corporate law doctrine is ill-equipped to address many of the governance challenges that arise from startups’ unique structures. Examining In re Trados, Delaware’s most notable fiduciary duty case involving a startup, Pollman shows how courts may overlook the needs of “heterogeneous shareholders to resolve complex governance issues by contract and a board with constituency directors that is re-negotiated over time.” Her discussion of traditional doctrine offers a path forward for courts to “adapt their application of longstanding corporate law principles to fit startups and ensure the continued viability of the corporate form for innovative business” based on a more nuanced understanding of their issues.

“As large numbers of startups increasingly pursue growth and transformational technology while remaining private, they have come to represent an essential part of the economy and have a significant impact on employees, communities, and other stakeholders,” Pollman writes. “It is time that far greater attention be devoted to understanding their internal dynamics and the recurring problems they face.”