Taming Unicorns

Until the last decade, most startups that grew to become valuable businesses chose to go public. Late-stage startups with reported valuations over $1 billion used to be so rare that venture capitalist Aileen Lee called them “unicorns.” When she coined the term in 2013, there were only 39 startups claiming billion-dollar valuations. By 2021, despite the surge in companies going public through SPACs, the number of unicorns had passed 600. In a new article, Taming Unicorns, I argue that securities regulation needs to adapt to these new creatures.

Unicorns have developed a reputation for scandal, with the misconduct of some going undetected for years. Theranos, for example, provided customers with nearly 1 million blood tests that it later had to void or correct. Uber created software that illegally spied on regulators and allowed its drivers to evade enforcement. Juul advertised its nicotine vaping devices to minors, creating a market that regulators have struggled to suppress. In each of these cases, the victims of the misconduct included third parties, not just investors.

Of course, public companies commit misconduct, too, and it’s not yet clear whether unicorns are systematically more prone to scandal. But empirical research shows that the opportunity to profit from information about a company by trading its securities creates incentives to uncover misconduct. Private company securities aren’t widely traded, so private company misconduct is easier to conceal.

Traders can profit from information about a public company that is relevant to its stock price but not already reflected in that price. Information indicating that a company has committed misconduct will affect its stock price if it suggests an increased risk of regulatory penalties, litigation, or reputational damage. This gives short sellers, analysts, and financial journalists incentives to investigate public companies and reveal evidence of corporate misconduct. Their investigations increase the chance that corporate misconduct will be revealed and the speed with which it’s revealed. When managers expect that misconduct will be revealed and penalized later, they are less likely to commit misconduct. In this way, the market for trading public company securities creates the positive social externality of deterrence.

Consider the electric truck company Nikola, formerly a unicorn. In 2020, Nikola went public through a reverse merger. Once it was public, short seller Nathan Anderson decided to investigate. He issued a report alleging a pattern of corporate misconduct. He showed that a video Nikola had produced with its prototype truck traveling at high speed was staged – Nikola had towed the truck to the top of a hill and filmed it rolling down the hill in neutral. After Anderson released his report, the SEC and federal prosecutors launched investigations into whether Nikola misled investors. Its stock price lost more than half of its value. The company might never have been exposed if it had stayed private.

The market for information about private companies is broken because the market for trading private company securities is anemic. Securities regulation restricts both the sale and resale of private company stock. Private companies usually encumber their shares with a contractual right of first refusal. Many private companies practice selective liquidity: allowing directors and managers to cash out, while preventing a robust market from emerging. Consequently, investors, employees, business partners, and outside experts who have information about private company misconduct have little incentive to publicize it. Private company managers are more confident that they can successfully conceal misconduct and are less deterred from committing it.

The primary investors in many private companies are VCs, and they lack strong incentives to expose misconduct. VCs have asymmetric risk preferences. They invest their funds in a portfolio of startups and expect that most will generate modest or negative returns, and only a small number will grow exponentially. The outsize growth of the few successful startups will offset the losses of the balance of the portfolio. From a VCs’ perspective, the difference between a startup that implodes in scandal and one that fails to develop a product or find a market is insignificant.

VC investing is an auction with a winner’s curse problem. Startups pitch to many VC firms in each fundraising round, but they only need to accept funding from one bidder. In public capital markets, if most investors decide that a company is fraudulent or excessively risky, its stock price will decline. In VC markets, if most investors decide that a startup is fraudulent, the startup will raise funds from an especially credulous or risk-loving contrarian. The VCs that pass on a startup have no incentive to share their negative assessment with the public because they can’t trade on it. VCs avoid criticizing startups so they can maintain a founder-friendly reputation.

From the perspective of the securities laws, the restricted tradability of private company securities is a feature, not a bug. Securities regulation gives companies the choice of two regulatory regimes. Public companies must make periodic disclosures and take on greater liability exposure. In return, they can raise capital from retail investors. Private companies face few disclosure requirements and less liability. But they can only raise capital through private placements with investors who can fend for themselves – mostly wealthy individuals and financial institutions. The shares that those investors buy can’t be easily resold, which ensures that investors don’t create a secondary market of retail investors.

Security regulation’s narrow focus on investor protection and capital formation – and neglect of the deterrence value of trading – is becoming more costly now that venture-backed startups are staying private longer.  Startups are increasingly able to raise hundreds of millions or billions of dollars of capital from private markets. In 2018, for example, the SEC estimated that companies raised $1.4 trillion from public capital markets and $2.9 trillion through private placements. Until recently, the only way that a startup could raise that kind of money was through an IPO. Going public meant allowing trading, and trading brought the scrutiny of short sellers, analysts, and financial journalists. The increasing availability of private capital has severed the link between funding and tradability and the link between the capacity to harm and deterrence.

I propose a solution: Congress and the SEC should create a robust market for trading private company securities. Carefully designed regulatory interventions could push companies to let their shares to be traded, while protecting investors and companies, especially small businesses, that prefer concentrated ownership. The solution has three prongs.

First, the regulations constraining the secondary trading of private company securities should be liberalized. The SEC should eliminate Rule 144’s holding period for resales as to accredited investors – the individual and institutional investors that the SEC deems sophisticated and most able to bear risk. Congress should eliminate section 12(g)’s requirement that effectively forces companies to go public if they acquire 2,000 record shareholders who are accredited investors – a rule that leads private companies to limit trading. These changes would make secondary markets for trading private company shares more liquid and attract trading volume.

Second, the SEC should attach a regulatory most favored nation (MFN) clause to all securities sold through the safe harbors commonly used for private placements. An MFN clause would require that, if a company allows any of its securities to be resold, it must allow all its securities to be resold, as long as the resale is otherwise legal. A regulatory MFN clause would ban the practice of selective liquidity and nudge companies to allow their shares to be traded. Private company directors and managers could no longer cash out their own shares, while allowing their companies to avoid the scrutiny of robust trading. The MFN clause would have an exception for resales approved by unanimous shareholder consent to protect businesses that value concentrated ownership.

Third, the SEC should require that all private companies that let their securities be widely traded make limited public disclosures about their operations and finances. A limited disclosure mandate would protect investors by ensuring they had basic information about the companies in which they could invest. But it would be less burdensome than the public company disclosure system.

The net effect of these reforms would be to create a market for robust trading in unicorn stock among accredited investors. Most large, private companies would likely decide to allow their shares to be traded. Short sellers, analysts, and financial journalists would be attracted to the markets. Their investigations would strengthen deterrence of unicorn misconduct. The limited disclosure mandate, combined with the requirement that investors be accredited, would protect investors.

Deterrence has traditionally been understood as a salutary byproduct of securities regulation, rather than its objective. When large, private companies commit misconduct, the natural response is to increase the penalty for the underlying misconduct, not to interfere with the tradability of the company’s securities. From this perspective, policymakers should respond to the Theranos scandal by tightening regulation of blood tests. But stiffer penalties for misconduct only work when wrongdoers expect to be caught. Trading creates incentives to expose misconduct faster.

This post comes to us from Matthew Wansley, an assistant professor at Cardozo School of Law. It is based on his recent article, “Taming Unicorns,” available here.