Startup Governance by Elizabeth Pollman

Sections: The distinctiveness of startups and their life cycle

A framework of startup governance

Startups have a unique governance structure deriving from the fact that each stakeholder group has different interests. These diverging interests can cause conflicts and tensions that only in some cases are addressed by existing regulation.

  • How helpful? Scale of 1 to 5

5.

  • Topic Tags

Fiduciary duties, shareholder conflicts, VC-founder conflicts, VC interests, founder-executives

  • Relevant questions addressed

What are some typical conflicts that arise within a startup?

What leads to these conflicts?

  • Summary bullet points
  • Startups have a different focus than publicly owned companies and traditional closely held corporations, and they present different risks. This leads them to have different governance
  • The different shareholders have overlapping roles and conflicting interests which create more and more tension as the company grows, driven by more complex capital structures
  • Shareholders can have shifting roles or dual and conflicting roles, acting as role A in one context, but role B in another
  • Shareholders in a startup are not a homogeneous group with the same interests and rights.
  • The uniqueness of startups is driven by their goal of eventually being acquired or going public. The objective is for the startup to cease being a startup at some point
  • Startups have two main areas of evolution determining issues in governance
    • The business
      • Many startups fail, and those that do not evolve in “recognizable patterns”
        • Early-stage, highly entrepreneurial and innovative
        • Mid-stage, refining product/service development, scale-up, revenues
        • Late-stage, manage more complexity, find exit opps to return liquidity
    • The capital structure, driven by the business
      • At founding, the company generally issues all stock to founders
        • Founders provide capital to the company through their funds and their personal networks
        • As the company needs more capital to grow, Angel Investors, and then VCs enter the scene
        • Angel Investors typically will get common stock or basic debt, leaving the capital structure simple in the early stages
        • VCs tend to require more complex debt or equity instruments and board seats. Employee compensation through stock options further complicates the capital structure
        • The more financing rounds a startup entertains, the more complex its cap structure
  • Issues in governance are mostly derived from principal-agent conflicts and agency costs. They can be horizontal or vertical
    • Vertical issues
      • Shareholder vs. board
        • The board is constituted at the first investment round or earlier with amendments to the articles of incorporation.
        • VCs seek board seats and will have them outlined in the term sheet
          • Having board seats allows them to help grow the company, as well as monitor the founders and protect their investment
          • Boards can be founder, investor, or shared control
          • They usually evolve from founder-friendly to one of the others within the first few rounds of VC involvement
        • Board and voting control are negotiated and separated from rights to cash flows.
          • Because of this, they are the site for conflict resolution. If conflicts are not well resolved new conflicts can arise.
          • They are usually caused by founders and investors with different interests
      • Board vs. founders or executives
        • As the startup grows and its needs change, the board can change the role of founders drastically, as well as that of non-founder executives.
        • VCs on the startup board must act in the best interests of both the fund and the company. Sometimes these interests won’t align and investors will have opportunities to serve themselves first
        • Founder-executives can sometimes be ousted for these reasons, instead of legitimate changes driven by company interests
      • Shareholders vs. founders or executives
        • Startup shareholders usually lack quick exit opportunities to take if they disagree with management
        • Staged financing eliminates some of the tensions between the groups by setting milestones for management
        • Mechanisms such as this are less effective if there is a lot of competition among investors to provide capital
        • Misaligned interests can have huge impacts on these conflicts, making them worse
    • Horizontal issues
      • Different groups with different equity interests can cause friction
      • Preferred vs. common
        • Both will gain from growth and profitable exits
        • But they conflict on liquidity needs, risk-taking, exit timing and acceptable exit mode, etc.
        • Fiduciary duties address these conflicts by providing that the board and the executives must protect the interests of the company and its shareholders, but different shareholders have different interests
        • There are three main legal views
          • Common maximization: in the presence of a conflict, BoD and executives must protect common shareholders (Delaware)
          • Enterprise value maximization: BoD and execs must act to increase the value of all equity classes (scholars)
          • Contractual Approach: the common gave up control to preferred or vice versa and this allows for favoring the class in control (scholars) or the company as a whole
      • Preferred vs. preferred
        • Preferred stockholders have different interests depending on what round they invested in, or their fund’s goals
        • Conflicts can arise in regards to future financing rounds or exit opportunities
      • Common vs. common
        • There are different types of large common shareholder in startups
        • Employee participation in startup governance tends to be indirect if they have stock options, whereas it is direct for executives and founders
        • This type of conflict arises during exit opportunities, secondary sales, and other corporate decisions,
          • especially if there are many different equity arrangements or if investors give different incentives to different groups
    • Governance issues arise overtime throughout the stages of the startup and tend to increase with corporate structure complexity
      • As a company expands and grows, it becomes more articulated and more possibilities for conflict are created
  • Follow-up links

Venture Capital on the Downside: Preferred Stock and Corporate Control - https://repository.law.umich.edu/mlr/vol100/iss5/2/

Engineering a Venture Capital Market: Lessons from the American Experience - https://scholarship.law.columbia.edu/faculty_scholarship/993/

The Exit Structure of Venture Capital - https://digitalcommons.law.byu.edu/faculty_scholarship/36/