Founders, investors, board members, employees and all participants in venture-backed companies should understand the basic principles of corporate governance. By corporate governance we generally mean the system through which the corporation is managed and controlled. Different rules and practices will apply depending on the type of organization, ownership structure, stage of the company, investor base, size, geography or industry. Thus, applying a “one-size-fits-all” or “check-the-box” approach to governance will usually not work since context matters.
In terms of the legal structure of the company, significant distinctions will apply depending on whether the entity is a (1) publicly traded corporation (with variations if the company is a large, mid or small cap), (2) private corporation (other distinctions will apply if the company is venture-backed or family-owned, for example), (3) limited liability company, (4) partnership, (5) non-profit corporation, (6) foundation, or (7) state-owned enterprise (SOE), among other structures.
In this article, we will only focus on corporate governance for U.S. private, venture-backed corporations. Specifically, we will focus on the basic corporate governance framework for venture-backed companies, and we will address at least three governance issues when dealing with these types of companies: 1) the late stage “unicorn” phenomenon and its governance consequences, 2) conflicts of interests and “dual fiduciary conflicts” and 3) multi-class share structures.
The Basic Corporate Governance Framework for U.S. Venture-Backed Companies.
Traditionally, U.S. venture-backed companies are structured as corporations, incorporated in the state of Delaware (for reasons beyond the scope of this article, Delaware is the “most important jurisdiction” for corporate law in the United States). As a corporation, governance design should focus primarily on the rights and responsibilities between three core constituents: a) management, b) boards of directors, and c) shareholders. The role of other stakeholders (such as employees, customers, suppliers, creditors, environment, community, etc.) is the first place where different legal traditions and/or organizational theories will differ regarding the weight and relevance that each will have in the decision-making process of the corporation. There is of course a long-standing debate about the purpose of the corporation in society, but that is a debate that is also beyond the scope of this article.
We should only note that in the U.S., at least since the 1980s, there has been a strong view, backed by Delaware courts, tending towards “shareholder primacy”, meaning that both management and directors have a duty to maximize shareholder value on behalf of the corporation. The stakeholder perspective is considered with social enterprises, B corps and public benefit corporations, and some investors, such as Larry Fink, the CEO of BlackRock, have reinforced the stakeholder view by stating that “companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”
However, the governance challenges of private startups are typically different to those in public companies, despite sharing the same basic corporate legal construct. One of the classic distinctive governance features of U.S. public companies is the so-called “separation of ownership from control” posited by Adolf Berle and Gardiner Means in their seminal book on “The Modern Corporation and Private Property” in 1932. Their premise was that with the dispersion of ownership in U.S. equity markets, the interests of managers and shareholders would diverge, driving “self-interested managers” to benefit themselves at the expense of shareholders. Instead, in startups, the owners (founders and investors) are generally all represented in the board of directors, at least initially. A typical startup board will have one or two founders, one or two investors, and rarely an independent director (some have argued that independent directors occupy a tie-breaking seat on the board when used in this context). This is a diametrically different scenario to the composition of a large public company board, where boards are mostly independent.
Moreover, boards of private venture-backed companies typically will focus on growth with a mission to “swing for the fences”, whereas boards of more mature public companies will typically have more oversight, regulatory and compliance duties. The changing nature of the board will follow a spectrum from startup to fully fledged public company, with the same core functionality but with important distinctions along the way.
There are some other important features of U.S. public company governance that can be distinguished from private markets, such as:
- Board independence: The typical large U.S. public board is comprised mostly by independent directors (~85% of all S&P 500 board members are independent).
- Major voice and influence by institutional investors: Institutional investors went from owning 7–8% of the equity in U.S. public markets in the 1950s to over 70% of the equity in public markets today. Asset managers such as BlackRock, Vanguard, State Street, Fidelity and other large pension funds such as CalPERS, CalSTRS and the New York City funds have become a very powerful force in public company governance, challenging management and directors more often and commanding larger percentages of shareholder votes. Coalitions and guidelines provided by the Council of Institutional Investors (founded in 1985, at a time of corporate takeovers, imperial CEOs and insulated boards of directors), Commonsense Governance Principles (a set of governance principles proposed in 2016 by a group of 13 CEOs and heads of major investment firms including the likes of Warren Buffett, Jamie Dimon, Mary Barra, Larry Fink, Bill McNabb and Ronald O’Hanley), and the Investor Stewardship Group (a group of 50 U.S. and international institutional investors that in aggregate invest over $22 trillion in the U.S. equity markets), have all pushed for a stronger pro-shareholder agenda. Moreover, the role of proxy advisors such as ISS and Glass Lewis have also become a cornerstone feature of public company governance.
- Activist Investors: The assets under management of hedge funds who make concentrated bets on individual companies with an effort to influence governance-related matters through proxy battles, publicity campaigns, shareholder resolutions, litigation, and negotiations with management have gone from $2.7 billion in 2000 to $121 billion in 2017, increasing their influence over CEOs and boards of public companies. Moreover, many activist investors have switched their aggressive tactics against management to a more collaborative “behind the scenes” approach, sometimes partnering with institutional investors to leverage their clout, such as in the recent joint campaign by Jana Partners and California State Teachers’ Retirement System (CalSTRS) targeting Apple to consider how their technology is affecting children’s well-being.
- Short term pressures: Another challenge of public markets is the pressure from investors who hold stocks in time frames of days and months, not years and decades. As stated by Marc Andreessen, a leading Silicon Valley VC: “In the modern era, public market time horizons have never been shorter, and private market time horizons have never been longer.”
Because of some of these public company governance features, many successful private venture-backed companies have decided to “stay private”. In 2000, the median age of companies at listing was five years; in 2016, it was ten years and six months. Moreover, the decrease in IPOs and number of U.S. publicly listed companies, which have gone from 8,491 companies in 1997 to 4,496 in 2017, have also been attributed to the more demanding, and costlier, compliance and regulatory frameworks required in public markets. This has generated an interesting “stay private/go public” debate both on business and regulatory grounds.
There are at least three governance issues to consider when dealing with private venture-backed companies: 1) the late stage “unicorn” phenomenon and its governance consequences, 2) conflicts of interests and “dual fiduciary conflicts” and 3) multi-class share structures.
1The Late Stage “Unicorn” Phenomenon and its Governance Consequences
Corporate governance has become one of the most important topics in business management, but most of the governance research and attention has been focused on public companies, not so much on private startups. However, the evolution of the private tech market, particularly in Silicon Valley, with the rise of the “unicorns” -private tech companies valued at over $1 billion dollars- has refocused some of the governance attention to private venture-backed companies. As per CB Insights, as of April 12, 2018, there were 233 unicorns, cumulatively valued at around $777 billion.
In this context, there have been many governance failures in some of the most prominent private venture-backed companies, such as with Uber, Theranos, Zenefits and SoFi, where founders engaged in illegal and/or bad behavior that led to serious failures of culture, ethics and compliance.
Theranos is a particularly important case to highlight since the U.S. Securities Exchange Commission settled fraud charges against its founder, Elizabeth Holmes, who agreed to pay a $500,000 penalty, return millions of her shares and relinquish her voting control in the company, in addition to being barred from serving as an officer or director of any public company for 10 years.
These situations have forced companies and boards of directors to take a closer look at their overall governance practices, which have been seemingly overlooked by Silicon Valley’s long held mantra: growth at all costs. Recent media attention has focused on some poor governance features such as lack of independent directors, diversity, shareholder rights and disclosures in addition to the common practice of “overboarding”(sitting on an excessive number of board seats) by investors in the tech industry.
The late stage unicorn phenomenon has arguably created a new form of “quasi-public” company, in terms of the size, relevance and importance of companies such as Uber, Airbnb, SpaceX and WeWork. In almost any other era, these companies would have had to go public to reach such scale. But the late stage tech ecosystem has evolved, facilitated by some of the following trends:
- Private Market Financing: Private companies have been able to raise billions of dollars not only from traditional venture capital firms (whose funds have become larger over time), but also from larger pools of money such as private equity funds, public mutual funds (i.e. T. Rowe Price, BlackRock, Fidelity, Vanguard, etc.), strategic investors, public corporations and sovereign wealth funds. The epitome of this trend may be represented by the emergence of Softbank’s Vision Fund, the massive $93 billion fund raised in May of 2017 “for technology investments in need of patient long-term capital and visionary strategic investment partners.”
- Private Secondary Transactions: The creation of secondary markets for shares of private companies have been critical to provide liquidity for employees and/or early investors without the need to go public. New alternatives such as Nasdaq Private Market (NPM) have made this change possible (Nasdaq acquired SharesPost in 2013 and SecondMarket in 2015). In its 2017 annual report, NPM stated that “2017 was a defining year for the private market and solidified that companies choosing to stay private longer is not a trend but today’s new reality.” (…) “It was the biggest year yet for NPM with $3.2 billion in private transactions, a 3x increase from 2016.”
- The 2012 JOBS Act: This Obama era regulation extended the 500-shareholder rule for public registration to 2000 shareholders, making it easier for companies to stay private for longer.
- Favorable Investment Terms for Public Investors in Private Companies: Late stage investments have included favorable liquidation preferences, ratchets and IPO veto or blocking rights.
- Public Market Pressures: The shorter term pressures of public market investors, coupled with the threat of activist investors and stricter and more onerous regulatory and compliance requirements, have spooked some founders, many of whom given the choice to stay private and in control of their corporations, prefer to remain private. This phenomenon has also led to some new initiatives such as the Long Term Stock Exchange to provide an alternative solution.
In March of 2016, Mary Joe White (at the time Chair of the Securities and Exchange Commission) gave a speech at the Stanford Rock Center touching precisely on some of the governance implications for the longer pre-IPO lifecycle of private companies. Many of her questions have still not been adequately answered: a) Have boards of directors expanded beyond entrepreneurs and original investors? b) Does the board have sufficient regulatory expertise? c) Does leadership include outsiders with relevant industry experience or experience in public companies? d) Do board members understand their fiduciary duties, and that they extend to common shareholders? e) Have these companies bolstered internal controls over financial reporting to avoid errors or misconceptions in valuation?
It could be argued that with the ability and will to “stay private”, many of the unicorns have opted to side step the stricter public company governance standards, keeping minimum (and often insufficient) startup governance standards. This puts unicorns in an awkward position, a bit like teenagers not wanting to grow up and embrace adulthood. But with their increasing investor base, including public mutual funds and other non-traditional investors, plus larger number of employees and other stakeholders, not everyone is represented in the boardroom anymore. The company and investor makeup starts to look increasingly like a public company, carrying more agency costs that require more accountability and oversight.
There has been a call to add more engaged, qualified and independent directors to these boards. This would help provide better oversight and bring outside expertise, avoid conflict situations, and in the process, it could help on the diversity front due to the simple fact that the pool of directors for these companies have been traditionally drawn from a very small group of VCs and entrepreneurs (who are mostly white and male). It has been reported that only 9% of decision-makers at US-based venture capital firms are women (“that’s a grand total of only 170 female investing partners at US VC firms managing over $25M”), 74% of US-based venture capital firms have zero women investors, and 15% of US venture dollars in 2017 went to teams with a female founder. Another report on diversity in venture capital firms found similar deficiencies. There is no such thing as a pipeline problem, and there are many talented diverse candidates that would be willing to fill these independent director spots. The case of Uber, which expanded its board to 17 members, a staggering number even by public company standards, seems like a step too far in this direction, but that resulted from a bitter and very public battle for control with ousted CEO Travis Kalanick.
2Conflicts of Interests and the “Dual Fiduciary Conflict” in Venture-Backed Boards.
Silicon Valley has long been accused of rampant conflicts of interests, to the point where the phrase “no conflict, no interest” has been attributed to one of its leading VCs. One of the areas where conflicts can arise is in the case of transactions where the interests of the investors (who hold preferred shares) diverges from the interests of founders and employees (who hold common shares), such as in acquisitions, down round financings or recapitalizations. In such contexts, VCs that sit on venture-backed company boards have “dual fiduciary duties” because they wear two hats: they owe a duty both to the VC fund (to maximize return on investment) and to the portfolio company (to maximize the value of the corporation and its common shareholders). There have been several cases litigated recently dealing precisely with this conflict.
The most important lesson from Delaware, stressed by Vice-Chancellor Travis Laster in the Trados case (2013), followed by Vice-Chancellor John W. Noble in the Nine Systems case (2014), and continuing with an increasing case load from Delaware, is that fiduciary duties of directors from venture-backed companies are owed to the corporation and its common shareholders, not to the preferred shareholders (who benefit from contractual rights instead). Courts have also noted that boards in Silicon Valley tend to be conflicted and lack independence (recent cases have involved eye opening fact patterns such as co-ownership of private planes and properties in private islands), in which case they cannot benefit from the business judgment rule (a deferential standard of review expressed as a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company). Instead, the conduct of conflicted directors must be evaluated under the more stringent entire fairness standard. Such review, which is very fact intensive, will analyze whether the process and the price of the transaction was fair (exposing directors and VC funds that fail to manage the process correctly, to extensive litigation and personal liability).
There are preventable measures that a board should consider depending upon the context and specific facts surrounding a conflicted transaction. Some of these measures could include creating a record showing fairness (rights offerings, market checks, fairness opinions, better board minutes), forming independent committees (requiring more independent directors) or using “majority-of-the-minority” stockholder votes in conflicted transactions, among other structural protections.
3 Multi-Class Share Structures in Silicon Valley and in the Technology Industry.
Starting with Google’s IPO in 2004, founders of many of the leading Silicon Valley companies began implementing dual-class share structures, giving founders greater voting rights. This structure provides founders with control and more political power vis-à-vis investors and outsiders. Typically, founders and insiders will have Class B shares with 10 votes per share, while the rest will have Class A shares with 1 vote per share. This is not a new legal tool (dual class shares have a long history in corporate America, dating back at least since the early 20th century) but it has been fully embraced by the tech industry. Although there has been a long tradition of strong founder-led companies in Silicon Valley (some would even call it a “cult of the founder”), previous generations of tech entrepreneurs did not use this legal control structure (where famously even iconic founders such as Steve Jobs got fired).
But in this era, with increasing competition from investors to get into “hot” deals, investors have been quick to engage in “founder-friendly” strategies, including ceding control via dual class shares to leading founders (as was the case with Airbnb, Facebook, LinkedIn, Square, Uber, Yelp, Zynga, among others). Prominent VC firms advocated for this practice, and a new chapter of Silicon Valley power sharing began. But some unicorns have gone to the extreme of granting insiders extra-powerful super-voting shares carrying 30x to 10,000x as many votes as ordinary stock, while others have decided to strip away all voting power to other shareholders.
Snapchat last year was the first tech company to have an IPO with a triple-class share structure (10:1:0), providing no voting power to public shareholders. Institutional investors have been pushing back against tech companies that go public with multiple-class share structures (56 companies went public with dual class share structures between 2010 and 2016) and have argued that these structures should be abolished by the regulators or stock markets in favor of the “one-share-one-vote” principle. Two of the world’s largest index providers, S&P DJI and FTSE Russell announced decisions to partially or fully exclude companies with multiple-class share structures from their indices, while others have advocated implementing sunrise (initial) and/or sunset (terminal) provisions establishing a set of limits to this practice. One of the most recently appointed SEC Commissioners has also advocated against the practice of “perpetual dual class shares” in his first public speech.
Some have explained this structure as a fundamental trade-off between entrepreneurs’ freedom to pursue their idiosyncratic visions for value creation, and investors’ need to ensure management accountability. Whatever control sharing standard is preferred (there are myriad different ways to set up these structures), the debate will not end anytime soon and there is certainly no one-size-fits-all solution. But it seems that implementing reasonable sunrise and/or sunset provisions (that could be time-based, performance-based, or as a result of dilution, death or incapacity, transfers, or others) would strike the right balance of power distribution between founders and investors, rather than ending all talk of “founder friendly” terms.
We should also note that the debate over dual class shares is certainly not solely a U.S. governance concern. It has also been heavily debated internationally. In fact, the Hong Kong and Singapore stock exchanges (who have traditionally adhered to the “one-share-one-vote” principle), are about to allow dual class shares in an effort to attract new listings from China and not risk “loosing another Alibaba” to U.S. stock exchanges.
Founders, investors and all participants in venture-backed companies should not overlook the importance of corporate governance. It is critical to understand the role of each of the players in the startup ecosystem, where relationships and dynamics between founders, employees, investors and other stakeholders can make or break a company. As companies have stayed private for longer, with many now reaching unicorn valuations (despite some contested valuation metrics), there has been a shift regarding governance practices. There has also been an uptick in private company lawsuits, particularly in Delaware, targeting poor governance practices in these companies. “Growth at all costs” should no longer be the sole driving mantra of Silicon Valley and the tech startup industry. Boards of directors of venture-backed companies should take notice.
Author: Evan M. Epstein
Founder & Managing Partner
Pacifica Global Corporate Governance
Pacifica Global was founded in San Francisco to serve as a leading corporate governance advisory firm. The mission of Pacifica Global is to help public and private companies solve some of their most complex corporate governance conflicts and challenges.