Many of our most innovative companies that are household names started as venture capital (VC)-backed companies: Amazon, Google, Facebook, Airbnb, just to name a few. The lucky few startups that were able to raise money from VCs have changed our lives in significant ways—in how we obtain information, communicate with each other, and form relationships. Fifty percent of all IPOs come from VC-backed companies although fewer than 0.25% of startups receive such funding. Those same companies also comprised 44% of all R&D spending of U.S. public companies and created 63% of the total market capitalization of public companies that have formed since 1974.
Understanding the Evolution of Corporate Governance Practices in Startups
In the past decade, VC funding has grown exponentially. In conducting the research for my recent article, I wanted to understand how this growth impacted the corporate governance practices of startups, how they evolved over the life cycle of these companies, and when corporate governance practices were prioritized.
A growth-at-all-costs mindset pervaded startups pre-pandemic; this same mindset reemerged after a brief hiatus even as COVID-19 continued to affect our daily lives. There was a substantial increase in VC investing in 2021 with both investing and fundraising reaching record highs. This increase was characterized by a surge in U.S. deal activity, a new norm of mega rounds and unicorns, and companies continuing to stay private longer with ever increasing valuations.
In order to better understand what has transpired in the realm of startup corporate governance, I used both survey and interview methodologies on a very specific group of individuals: the attorneys who represent VC-backed private companies and their investors.
First, I developed an exploratory survey which was distributed by law firm partners within their emerging companies (or equivalent) practices between November 2019 to February 2020. More than three-fourths of the respondents were partners. They practiced in cities all across the United States: Atlanta, Austin, Boston, Chicago, Los Angeles, Palo Alto, Redwood City, Reston, San Francisco, and Seattle. California had the largest number of respondents at 37% and Washington State respondents came in second at nearly 30%. I used both a Likert scale and ranking system for my corporate governance questions. Although no broad generalizations can be made about the findings in light of the dispersed geographical nature of the respondents and the relatively small number of respondents, the survey yielded some interesting insights that required further consideration and study. To this end, I began interviewing attorneys from April through September 2020 and used the “snowball” sampling technique to determine who I should interview. My 31 interviewees included: law firm attorneys who were partners or senior associates at law firms in the Bay Area and Seattle, attorneys at well-known law firms in the venture capital realm, and a few general counsel of startups. Sixteen of my interviewees were women and fifteen were men; six identified as minorities. The interviews allowed me to study how corporate governance in startups changed during an economic downturn and provided deeper insight on corporate governance during both good and bad economic times.
Four Research Findings from Survey and Interviews
My research yielded four main findings. First, a founder-centric model emerged post-Great Recession which changed the board structure to one in which the founders controlled the board in the seed and early stages. It was not until the Series B round that there would be an even split between founder-management directors and investor directors who were on the board. Although an independent seat was reserved, it was typically left vacant until someone was identified. The most extreme form of the founder-centric model were Adam Neumann of WeWork and Elizabeth Holmes of Theranos. The survey results and interviews confirmed, however, that the Adam Neumann and Elizabeth Holmes-type examples were not the norm despite media depictions that seemed to suggest otherwise.
Second, independent directors are not tie-breakers or swing votes as current scholarship claims. Their value lies in their industry expertise and operations experience. Coming from a number of different backgrounds, they serve as mentors to management. In the early stages of a company, independent directors tend to be friends of the founder or investor so they are not truly independent in the way that they would be in the public company context. The attorneys generally agreed that almost all board votes are unanimous and governance was an exercise in consensus building; there was very little disagreement in board meetings and even if there was, independent directors were not the vocal dissenters.
Third, a best practices framework is used to implement corporate governance infrastructure within startups. Stage of growth and board dynamics influence such implementation. During good economic times, founders direct the pace of implementation of corporate governance measures. If a company meets its metric and management exhibits credibility, the founder-management directors are given a great deal of deference, especially if the founder is a serial entrepreneur with a track record of success. However, in economic downturns, investor directors will instill discipline, similar to how a looming IPO or acquisition would incentivize startups to incorporate corporate governance practices. The focus is on operations and financial oversight. Boards meet more frequently and some board members may meet with management outside of regularly scheduled board meetings as well. This was especially true of startups in determining whether or not to take Paycheck Protection Program loans.
Fourth, startups are not taking the initiative on diversity, equity, and inclusion (“DEI”) measures. The Black Lives Matter Movement and #MeToo Movement did not galvanize startups to advance DEI issues as they did for public companies. The numbers of both women and Black Indigenous People of Color are extremely low, with respect to the startup themselves, their boards of directors, and those who invest in the startups. Working on DEI issues is simply not a priority for private companies. I explore these issues further in an upcoming article, “Startup Biases.”
Normative Recommendations for Startup Corporate Governance
I offer normative recommendations (which I also refer to as a playbook) for improving corporate governance in startups which include the following:
- holding more trainings for directors, especially in the case of first-time directors who serve a DEI purpose;
- forming more board committees, particularly during challenging economic times to ensure that issues, such as compensation or diversifying the board, are given proper consideration;
- identifying culture risk;
- implementing corporate governance measures in a methodical way during good economic times such as IPOs, acquisitions, financings, and dealing with challenges with founders instead of being at the whim of the founder;
- having fewer board observers to ensure that board dynamics are not altered because of the number of people in the boardroom; and
- incorporating DEI measures in the startup ecosystem by employing diversity riders in VC financing documents and recruiting underrepresented groups for key hires, as investors or in the composition of the board.
Ultimately, my empirical analysis reveals that a number of factors impact the extent to which startup corporate governance measures are implemented and prioritized, including the power dynamics among the board members; the emergence of a founder-centric model after the Great Recession; startups staying private longer; the pervasiveness of the growth-at-all-costs mantra; and the economic climate.
Jennifer Fan is the Associate Dean for Research & Faculty Development and Associate Professor of Law at the University of Washington School of Law.
This post is adapted from her paper, “The Landscape of Startup Corporate Governance in the Founder-Friendly Era,” available on SSRN.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.