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 federal securities regulations.
Times have changed. Successful startups today 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 Securities and Exchange Commission enforcement against large private companies.
This position has also been gaining traction outside the ivory tower. One leader of this intellectual movement was recently appointed director of the SEC’s Division of Corporation Finance. Big changes may be coming soon.
In a new paper titled “Unicorniphobia” (forthcoming in the Harvard Business Law Review), I challenge this suddenly dominant view that unicorns are especially dangerous and should be “tamed” with bold new securities regulations. I raise three main objections.
First, pushing unicorns toward 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.
The dangerous incentives that produce this parade of horrible outcomes 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 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 the cases of Uber and Theranos, in their papers. Yet the authors make few or no attempts 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 my paper.
Take Theranos, whose founder and CEO Elizabeth Holmes is currently facing trial on 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 have plausibly 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 some additional securities disclosures.
As to the proposal to enhance trading of unicorn shares in order to incentivize short sellers and market analysts to sniff out potential frauds, the fact is that these market players already had the ability and incentive to make these plays against 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. They failed to do so. Proposals to expand whistleblower protections and SEC enforcement in this domain seem equally unlikely to have made any difference.
Finally, the proposed reforms risk doing more harm than good. Successful unicorns today benefit not only their investors and managers, but also their employees, consumers and society at large. And they do so precisely because of the features of current regulations that are now up on the regulatory chopping block. Altering this regime as these papers propose would put these benefits in jeopardy and thus may do more harm than good.
Consider one company that recently generated an enormous social benefit: Moderna. Before going public in December 2018, Moderna was a secretive, controversial, overhyped biotech unicorn without a single product 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.
Had these proposed new securities regulations been in place during Moderna’s “corporate adolescence,” it’s quite plausible that they would have significantly disrupted the company’s development. In fact, Moderna might not have been in a position to develop its highly effective COVID-19 vaccine as rapidly as it did. Our response to the coronavirus pandemic has benefited, in part, from our current approach to securities regulation of unicorns.
The lessons from Moderna also bear on 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, varying 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 who press the firm to take risks to achieve astronomical results.
And yet, one or more of these companies may represent an important resource for our society in dealing with disruptions from climate change. As policymakers and scholars work out how securities regulation can be used to address climate change, they should not overlook the potentially important role unicorn regulation can play.