Unicorniphobia

Once upon a time, a successful startup that reached a certain maturity would “go public” – selling securities to ordinary investors, perhaps listing on a national stock exchange, and taking on the privileges and obligations of a public company under the federal securities regulations.

Times have changed. Successful startups are now able to grow quite large without public capital markets. Not so long ago, a private company valued at more than $1 billion was rare enough to warrant the nickname “unicorn.” Now, over 800 companies qualify.

Legal scholars are worried. A recent wave of academic papers makes the case that, because unicorns are not constrained by the institutional and regulatory forces that keep public companies in line, they are especially prone to risky and illegal activities that harm investors, employees,  consumers, and society at large.

The proposed solution, naturally, is to bring these forces to bear on unicorns. Specifically, scholars are proposing mandatory IPOs, significantly expanded disclosure obligations, regulatory changes designed to dramatically increase secondary-market trading of unicorn shares, expanded whistleblower protections for unicorn employees, and stepped up SEC enforcement against large private companies.

This position has also been gaining traction outside the ivory tower. A leading adherent was recently appointed director of the SEC’s Division of Corporation Finance. Big changes may be coming soon.

In a new paper, “Unicorniphobia,” I challenge the view that unicorns are especially dangerous and should be tamed with bold new securities regulations. I raise three main objections.

First, pushing unicorns towards public-company status may not help and may actually make problems worse. According to the vast academic literature on “market myopia” or “stock-market short-termism,” it is public company managers who have especially dangerous incentives to take on excessive leverage and risk; to underinvest in compliance; to sacrifice product quality and safety; to slash R&D and other forms of corporate investment; to degrade the environment; and to engage in accounting fraud and other corporate misconduct, among many other things.

Those incentives allegedly flow from a constellation of market, institutional, cultural, and regulatory features that operate distinctly on public companies, not unicorns, including executive compensation linked to short-term stock performance, pressure to meet quarterly earnings projections (AKA “quarterly capitalism”), and the persistent threat (and occasional reality) of a hedge fund activist attack. To the extent this literature is correct, the proposed unicorn reforms would merely amount to forcing companies to shed one set of purportedly dangerous incentives for another.

Second, proponents of new unicorn regulations rely on a rhetorical sleight of hand. To show that unicorns pose unique dangers, these advocates rely heavily on anecdotes and case studies of well-known “bad” unicorns, especially Uber and Theranos, in their papers.  Yet the authors make little or no attempt to show how their proposed reforms would have mitigated any significant harm caused by either of these companies – a highly questionable proposition, as I show in great detail in the paper.

Take Theranos, whose founder and CEO Elizabeth Holmes is currently on trial over charges of criminal fraud and, if convicted, faces a possible sentence of up to 20 years in federal prison. Would any of the proposed securities regulation reforms plausibly have made a positive difference in this case? Allegations that Holmes and others lied extensively to the media, doctors, patients, regulators, investors, business partners, and even their own board of directors make it hard to believe they would have been any more truthful had they been forced to make additional disclosures. As for making unicorn shares easier to trade so short sellers and market analysts can sniff out frauds, the fact is that these market players already had the ability and incentive to expose Theranos indirectly by taking a short position in its public company partners like Walgreens, or a long position in its public company competitors, like LabCorp and Quest Diagnostics – and simply failed to do so.  Proposals to expand whistleblower protections and SEC enforcement seem equally unlikely to have made any difference.

Finally, the proposed reforms risk doing more harm than good. Successful unicorns benefit not only their investors and managers, but also their employees, consumers, and society at large. And they do so precisely because of regulations now on the chopping block. Altering this regime as these papers propose would put these benefits in jeopardy.

Consider one company that has recently generated an enormous social benefit: Moderna, Inc. Before going public in December 2018, Moderna was a secretive, controversial, over-hyped biotech unicorn with no products on the market (or even in Phase 3 clinical trials), barely any scientific peer-reviewed publications, a history of turnover among high-level scientific personnel, a CEO with a penchant for over-the-top claims about the company’s potential, and a toxic work culture.

As I argue in my paper, had the proposed new securities regulations been in place during Moderna’s “corporate adolescence,” they might have disrupted the company’s development and prevented it from developing the highly effective COVID-19 vaccine as rapidly as it did. Our response to the global coronavirus pandemic has benefitted, in part, from our current approach to securities regulation of unicorns.

The lessons from Moderna also apply to efforts to use securities regulation to combat climate change. According to a recent report, 43 unicorns are operating in “climate-tech,” developing products and services designed to mitigate or adapt to global climate change. These companies are risky. Their technologies may fail; most probably will. Some are challenging entrenched incumbents that have powerful incentives to do whatever is necessary to resist the competitive threat. Some may be trying to change well-established consumer preferences and behaviors. And they all face an uncertain regulatory environment that varyies widely across and within jurisdictions.

Like other unicorns, they may have highly-empowered founder CEOs who are demanding, irresponsible, or messianic. They may also have core investors who do not fully understand the science underlying their products, are denied access to basic information, and press the firm to take risks to achieve unrealistic results.

And yet, one or more of these companies may prove essential to combatting climate change. As policymakers and scholars work out how securities regulation can address  climate change, they should not overlook the potentially important role of unicorn regulation.

This post comes to us from Professor Alexander I. Platt at the University of Kansas School of Law. It is based on his new paper, “Unicorniphobia,” forthcoming in the Harvard Business Law Review and available here. A version of this post appeared on TechCrunch here.

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