The venture capital (VC) industry has expanded greatly over the past several decades as innovative startups have become a key driver of economic growth and innovation in the United States. Foundational scholarly accounts of startup governance focused on the VC-entrepreneur relationship and the contracting and governance mechanisms that VCs use to address information asymmetry, agency costs, uncertainty, and incomplete contracting. The “monitoring” model, resting on both theoretical and empirical foundations, focused on venture capitalists’ role in screening and monitoring portfolio firms and negotiating for contractual and governance arrangements that separate cash and control rights.

In a forthcoming chapter, I bring together scholarship and case law that builds on this foundational work and sheds light on how startup governance evolves over the life of the startup toward a successful exit or failure. The chapter highlights two key points that have become important themes in understanding contemporary issues in the governance of venture-backed startups.

First, while foundational scholarly literature focused on a vertical conception of venture-backed startup relationships between a venture capitalist as principal and entrepreneur as agent, more recent work has added the horizontal dimension of relationships between startup participants and dynamic change. Startups involve participants in overlapping roles that give rise to vertical and horizontal tensions among founders, investors, executives, and employees. Competing or misaligned interests arise not simply between VCs and founders, but also between and among preferred and common stockholders who can be differently situated in the startup. With each financing round, and as a startup hires additional executives and employees with varied types of incentive-based equity, the governance tensions tend to multiply due to the involvement of diverse participants with potential conflicts.

Second, scholars have increasingly explored the governance implications of the “power law” business model of venture capitalists, in which a small number of big winners in a portfolio can drive the success of a fund. In contrast to the focus on VC contracting at individual startups in foundational scholarly literature, more recent work has explored how the power law drives venture capitalists’ incentives and governance-related activity across the startups in their portfolio and the broader startup ecosystem. It has an impact on VC conduct in both downside and upside scenarios.

Specifically, VCs often care less about individual firm losses than about not missing out on grand slams and making sure that the successful startups in their funds reach outsized exits. Soft-landing acquisitions, acqui-hires, and state insolvency procedures known as assignments for the benefit of creditors allow startup participants to “fail with honor” and redeploy their talent and capital. These various ways of dealing with failure can help to efficiently and gracefully manage the end of the startup’s life and preserve relationships and reputations that are important for repeat players. Conversely, on the upside, or in the hopes for such an outcome, the power law dynamic can lead to a heightened emphasis on shaping the exit strategies pursued by startups and the rapid growth and scalability often needed to achieve outsized returns.

In sum, the chapter highlights that understanding venture-backed startup governance and failure involves taking account of the distinctive form of contracting and governance mechanisms deployed in VC financings, appreciating the pattern of dynamic governance change across the life of a startup for its varied participants, and including a broader view that incorporates the business model of venture capital.

A number of additional complexities and questions remain, while new issues of startup governance arise. The range of investors in venture-backed startups has expanded dramatically, for example, from a more diverse set of seed-stage financiers to mutual funds, private equity investors, and sovereign wealth funds entering companies in their later stages. Further, while some VCs have adopted founder-friendly practices, a variety of firms and strategies populate the industry. The impacts of these assorted investors on startup governance as well as variation by region and around the world adds to the broader picture. The ups and downs of the market, and the financial and social environment for startup and tech investing, also contribute to continued change. Impacts on stakeholders attract attention and with waves of innovation such as in artificial intelligence, new issues come to the fore about designing structures that can facilitate rapid growth while tempering the potential dangers of technology on society. In all, these observations underscore the dynamic nature of startup governance and failure, which continue to evolve in the 21^st century.

This post comes to us from Elizabeth Pollman, professor of law and faculty co-director of the Institute for Law and Economics at the University of Pennsylvania Carey Law School. It is based on her new chapter in the forthcoming volume, Research Handbook on the Structure of Private Equity and Venture Capital, available here. A version of this post appeared in the Oxford Business Law Blog.