Why are large private companies often characterized by poor corporate governance?  WeWork provides a recent high-profile example.  For reasons that now seem implausible, WeWork attracted billions of investment dollars.  Perhaps it was the company’s “vision” or the sheer personality of its co-founder, Adam Neumann, or maybe there was just too much venture capital money looking for the next big thing.  For whatever reasons, WeWork was valued at $47 billion in January 2019, despite having never turned a profit in a rather traditional business.  By the fall of 2019, the WeWork IPO was cancelled, and the company’s value plummeted to about $8 a share.

Perhaps this story vindicates existing market regulation.  When WeWork approached the public markets, the transparency required by federal securities law ultimately triumphed, and the company corrected course.  But why did corporation and securities laws enable the WeWork train wreck in the first place?  Why were the substantial direct and collateral costs to the WeWork stakeholders, not least its investors, not avoided? In a new article, I explore the answers to these questions and some of the reasons for the persistently poor governance of unicorns – startups valued at $1 billion or more.

Startups fail all the time, and it is tempting to argue that innovation requires taking risks.  There is much to this now-traditional argument; on the other hand, WeWork and other unicorns are not small, relatively inconsequential companies.  Failures of big companies have widespread consequences.  While certainly a dramatic case, WeWork is far from alone in the “weirdo sparkly unicorn governance” category.[1]  Uber, Theranos, Zenefits, and a host of other companies struggled with bad governance while unicorns.

This problem may be expected to get worse.  Thanks to plentiful private market funding, sustained low interest rates, the burdens of being a reporting company under the federal securities laws, and changes in those laws that enable some companies to stay private longer, the number of unicorns has been steadily rising.  Startups are able to stay private long after they first raise capital, and late-stage startups can now raise large amounts of capital.  As of December 2020, there were approximately 500 unicorns, with a cumulative valuation of almost $1.58 trillion.[2]  Maybe bad governance can be ignored when companies are small, but problems are not so easily dismissed when billions of dollars and large numbers of people are involved.

Given the number of zeroes on their (non-GAAP) financial statements, one might expect unicorns to have basic corporate governance mechanisms.  Many unicorns, however, are led by founders who maintain control over the company, often with the aid of multi-class share structures.[3]  Unicorns may also lack many of the standard checks on corporate decision-making.  Their boards and upper management are often selected and approved by the founder.  Such boards tend to be homogenous (some estimate that over 90 percent of U.S.-based unicorn directors are men) [4] and disinclined to discipline the founder.

One might think that shareholders at WeWork, or any other unicorn, would be protected by basic principles of corporation law, which vest control in elected directors and professional managers subject to fiduciary duties.  In practice, however, unicorn shareholders have few ways to hold corporate managers and directors accountable for the majority of their decisions.   Given the strength of the business judgment rule, the high threshold for Caremark claims, and the procedural exigencies of shareholder derivative suits, fiduciary duties are hard to enforce.

Federal securities laws also hardly discipline unicorns.  Since the establishment of the agency, SEC enforcement has focused on public companies.  When companies grew in significance to society by raising capital in the public markets, requiring transparency and punishing fraud helped ensure sound governance and protected investors.  With the advent of enormous private companies, however, the line between public and private companies has blurred.  Unicorn investors, often Accredited Investors participating in Reg D/Rule 506 private placements, include not only traditional venture capital and hedge funds, but also other more passive or aggregate funds that enable participation (albeit indirect) by Main Street investors.

Unicorn governance problems don’t harm only investors.  They impose substantial hardships on employees, customers, suppliers, lenders, and local economies in addition to shareholders and creditors.  WeWork, for example, ended up firing thousands of employees and shut down businesses ranging from a restaurant co-working company to a school.

Some commentators argue that founders need to be compensated for startup risk by first-mover advantage.  Stealth mode is essential for success.  The disclosure and transparency that result from reporting company status would allow copycat competitors to steal that first-mover advantage, reducing incentives for innovation.  Apart from being speculative, these arguments offer at best a romanticized vision of the technology founder.  Many companies both achieve their founders’ visions and have decent governance.  There is no necessary causal connection between bad governance and realizing creativity.

Can we rein in unicorns?  Arguably, no changes in the terms of the law are needed to foster effective, or at least professional, corporate governance.  What may be needed, however, are changes in how those terms are understood in practice and enforced.  Fiduciary duties should be adequate to prevent self-dealing, make directors vigilant, and compel management to make informed and independent decisions in the best interests of the company.  In the same vein, some provisions of the federal securities laws should be applied to unicorns.  For example, Rule 10b-5 prohibits misleading statements and misrepresentations by all companies, public and private.  One might even imagine modest new regulation.  For one example among many, federal securities laws could be amended to require companies of a certain size, measured by valuation or public float,  –to begin reporting.

There is little reason, however, to think that the laws will change anytime soon.  Wall Street Journal reporters are as responsible for uncovering the mischief at WeWork as the traditional gatekeepers.  Especially in the wake of the pandemic, both public and private technology companies are swimming in capital, and many valuations are soaring.  For the foreseeable future, unicorns are likely to lurch through the economy.  There may be more scandals, more lost investment, and more collateral damage to stakeholder interests.  At some point, unicorns may cause losses of sufficient magnitude to inspire legal reform of their governance.  But that is hardly something to count on.

ENDNOTES

[1] Matt Levine, WeWhoosh, Bloomberg Opinion (Sept. 9, 2019), https://www.bloomberg.com/opinion/articles/2019-09-09/we-might-not-be-working.

[2] The Complete List of Unicorn Companies, CB Insights, https://www.cbinsights.com/research-unicorn-companies.

[3] See Amy Deen Westbrook & David A. Westbrook, Snapchat’s Gift: Equity Culture in High-Tech Firms, 46 Fla. St. U. L. Rev. 861, 865 (2019).

[4] See Jennifer S. Fan, Innovating Inclusion: The Impact of Women on Private Company Boards, 46 Fla. St. U. L. Rev. 345, 350 (2019).

This post comes to us from Amy Deen Westbrook,  the Kurt M. Sager Memorial Distinguished Professor of International and Commercial Law and co-director of the Business and Transactional Law Center at Washburn University School of Law.  It is based on her recent article, “We(‘re) Working on Corporate Governance: Stakeholder Vulnerability in Unicorn Companies,” available here.