Ep.283 - Renee Jones on Untamed Unicorns

Speaker A: Welcome to M. The Business Scholarship Podcast, a place for interdisciplinary conversations in the broad world of business research. My name is Andrew Jennings, and it's my pleasure to be your host. If you like what you hear today, please subscribe to the podcast on Apple, Spotify, or wherever you get your podcast, plus leave a rating and let other people know about the show, too. And if you have ideas for the show, please let me know. My email address is andrewdrewkginnings.com and I look forward to hearing from you. All right, time for the episode. Our guest today is Renee Jones, professor of Law at Boston College. We'll be discussing her new book, Untamed why Startup Finance is Broken and how to Fix it. I'll, uh, add a link to the book's webpage in the show notes for the episode. Renee, welcome to the Business Scholarship Podcast.

Speaker B: Hi, Andrew. Thanks so much for having me.

Speaker A: Renee, um, I'm really excited to have you on to talk about this book. I really enjoyed the early read and I think this episode is going to be coming out about the time that it will be published for the broader market. You, I think, are uniquely qualified and positioned to write a book about what's happening in the startup finance system. What might be wrong with it? Before we get into the book, could you just introduce yourself to the listeners? What's your professional background and what experience has motivated you to write this book? Who are you trying to reach with this book? Sure.

Speaker B: So I guess I would say there are about three phases to my career which contributed to the perspective that really helped to inform the book, which, as you mentioned, analyzes some of the major startup scandals and then tries to connect those scandals to some of the flaws that have emerged in the startup financing system over recent decades. So I guess I'd start off with my eight years of private practice as a corporate insecurities lawyer, representing both private and public companies before I became a law professor. And then, of course, I'd been a law professor at Boston College Law Law School for the past 25 years. And my research has focused largely on the federal state relationship in corporate regulation. And in particular, I focus on trying to improve the accountability mechanisms for corporate officers and directors. And then finally, and then maybe most importantly, I served as a director of the SEC's Division of Corporation Finance during the first two years of the Biden administration. And in that role, I was responsible for overseeing the SEC's disclosure review program. And in that part of our division, we focused on review corporate filings to ensure that they complied with the SEC's disclosure rules. And then another important part of my job was managing the SEC's policy initiatives, that is handling the proposal and adoption of new rules to provide better protection for investors. In the policy side, part of my remit was conducting a comprehensive assessment of the private offering regime, um, under the securities laws. And that work was really invaluable to me as I wrote this book, especially the last chapter of the book, which lays out a roadmap for reform.

Speaker A: In your career as a securities lawyer, as a securities teacher, as a securities regulator, you have been working under a system that we've inherited from the 1930s that's been heavily amended over the years. And there's maybe a platonic ideal of how startup small business financing is supposed to happen. When you teach your securities regulation class to students, obviously there are a lot of in theories and in practice, but distinctions. But when you're teaching this class to your students, what is the platonic ideal of how that financing is supposed to happen for the smaller businesses or the new businesses? And how is financing of, uh, maybe bigger businesses supposed to happen?

Speaker B: That's a pretty big question. So I think I'll break my answer down into smaller parts. First, I'll describe the, uh, traditional startup financing model, and then I'll get into the ways that this model has changed. So just starting with the classic paradigm for financing startups, the whole process is often divided up into financing rounds. So we'll, we'll clear the term financing rounds a lot through this description. First, a founder will come up with an idea for a new product or a new service, and they'll often finance the earliest phases of the operation using his or her own funds. And we call that bootstrapping sometimes. And then the founder might turn to family and friends to finance the next stage of the company's growth. But once they have a solid business plan, they might reach out to angel investors. And angels are wealthy individuals. Typically, they're successful entrepreneurs. And they'll provide what we call seed financing. And there are incubators and accelerators that also operate in this space. Y Combinator is one example of an accelerator. But the holy grail in the financing system for startups is a venture capital deal. And that's when one of the big firms that dominates the space will come in with the traditional VC financing rounds. So firms like Sequoia, Benchmark, Anderson, Horowitz, and then these VC rounds are often divided into series, which would be labeled Series A, series B, series C, et cetera. Again, in the classic model, the traditional model, a startup will go through three or four financing rounds before it's developed a product or a service that's ready to go to market. And then it will begin to bring in revenues, begin to bring in profits, hopefully. And that is a point in the traditional model that a successful startup would pursue an IPO and turn to the public markets to finance the next stages of its growth. So while that's the classic or the traditional model, things are changing. And what we're seeing is that companies aren't making that natural transition from private markets to public markets. They're just lingering in this VC space for years, maybe even a decade on end. And that sort of lingering in that space. Sometimes we refer to it as a, uh, stunted adolescence has led to a lot of the problems that I write about. In my book.

Speaker A: In securities regulation, we teach students about the two or three key goals of securities regulation. One is to facilitate capital formation. Another is to protect investors, and also to ensure fair and orderly markets. But we'll set that last one aside for maybe our conversation with this competing set, uh, of policy goals of facilitating promoting capital formation, but also protecting investors. How is the model that you just described designed to protect investors? And maybe what has changed in the markets in the last decade or two?

Speaker B: You describe the securities regulatory system as having a major goal of protecting investors. And in the public offering space, we really rely on disclosure as basic building block for providing that investor protection. And in the public market space, that disclosure system is covered by mandatory rules that all of the companies have to comply with. When we're in the private space, we're still looking for disclosure to protect investors. But a lot of the assumption behind the rules that govern private markets is that investors will be able to protect themselves. And so I think that was true in the classic model that I described, because in the traditional model, VCs really exercised significant control over a startup and its founders, and they work closely with the founders to guide them through the various stages of growth. And they did have access to good information because they had the standard financing documents that had built in mechanisms. And those mechanisms, Those protections allowed VCs to exert control over the startup's operations and its personnel. So some of these terms include staged investments, board representation, that is a seat on the board of directors, or multiple seats on the board of directors, veto rights over significant transactions, redemption rights and registration rights. And these would empower investors to either pull the plug when things weren't going well or to compel a public offering after a set period of time. So investors were really in These classic documents were able to protect themselves. But these days that script has largely been flipped. And now it's increasingly common that the startup's founders are going to gain control over the board of uh, directors at a fairly early stage in the startup's life. Because many startups now have what we call dual class structures. And in a dual class structure, the startup's founder gets special shares that have super voting powers. Typically it's 10 votes per share. And with their super voting powers, they have the right or the ability to elect a majority of the board of directors. So they basically have the power to choose the directors who are essentially their bosses, like Google and Facebook. They did adopt dual class structures, but they adopted them right on the eves of their IPOs. And that was to ensure that the founders would have continued control after the company hit the public markets. But what we're seeing today is that it's very common for startups to adopt this dual class structure at an early stage in the startup's life. Typically we might see this when the, uh, startup acquires or attains what's called unicorn status, where they have a valuation of a billion dollars or more. So in the classic model, yes, investors could protect themselves. In the current model, investors are finding it very hard to exercise oversight or very hard to direct or rein in the conduct of reckless or wayward founders.

Speaker A: In the book, you note that there's been a lot of change in this system, that it's broken down that the platonic ideal of how startups small business financing works versus financing of large mature companies works is broken down. We've seen this public private divide that you and other scholars have noted is not such a clear divide anymore. Are the changes that you're seeing in the market, are they being driven by law and regulation? Is it something that you and counterparties in the regulatory space or in Congress are driving? Is it the result of maybe secular industrial or economic trends, or is it a bit of both? Or are there other factors that are driving these changes in the market?

Speaker B: I see it as a combination of economic factors, social factors, and legal factors. And I try to address all of those in the book, but I'm a lawyer and a law professor, so I'll just focus on the legal side of things. And I would say on the legal side, these changes were facilitated by two major statutes that most people have never heard of. So the first is a 1996 statute, we call it NSM, that stands for the National Securities Markets Improvement Act. And that statute lifted the cap on the number of clients a private fund could have before it had to register with the SEC as a public investment company, what we normally refer to as mutual funds. So after NSM passed, private funds, including VC funds, could grow to formidable sizes and avoid the regulations that apply to mutual funds. So after this change in the law, the assets under management in private markets soared. And then the second change was the jobs act of 2012. And the, the JOBS act removed what were long standing limits on the number of shareholders that a startup could have before it was required to register with the SEC and become a public reporting company. So before the JOBS act, uh, any startup or any private company that had 500 or more shareholders had to register with the SEC and then provide ongoing disclosure to investors and the public. The JOBS act changed that 500 shareholder limit to 2,000 shareholders, but it excluded any employee held shares from that count. So together these changes removed pressure on startup founders to prepare for an ipo. And that meant that founders then gained the upper hand with VCs who found themselves competing with other non traditional investors. So that included hedge funds, so for wealth funds and mutual funds. And so VCs were competing with these other large funds for attractive opportunities. And that's where we started to move to this, what I call a founder friendly model of VC financing.

Speaker A: We've talked about how unicorns have challenged the old model of startup financing. I'd like to talk a little bit about their role in society. What makes them special apart from the financial side of things? What's different about how they're governed and what's different about them, um, with their place in the American economy and society?

Speaker B: Sure, that's another big question. We'll start off with a simple definition. A, uh, unicorn is a private startup that's valued at a billion dollars or more. And they're called unicorns because they used to be so rare, but now they're ubiquitous. So there were only about 40 unicorns in 2013 when the term was first coined, and now there are more than 1500, by some counts more than 1600. And then there are 75 decacorns, and those are private startups that are valued at $10 billion or more and 5 centicorns which have stated valuations of $100 billion or more. And of course there was a SpaceX IPO recently that's a former center corn and it went public with a valuation of almost $2 trillion. So these unicorns are playing a very significant role in our economy. Many of them, um, employ thousands of people, some tens of thousands of people. They're producing products and services that have changed how we live and how we work. And they include some huge retail outlets like Shein, AI developers like OpenAI and Anthropic, and also a lot of the crypto firms and a lot of the fintech firms that manage our money, which unfortunately sometimes disappears. So they're playing a huge role in our economy, but we don't have a lot of insight into their operations and how they're being run.

Speaker A: Oftentimes stories of failure can be more instructive than stories of success. And you've got quite a few stories of failure in the book and obviously we don't have time to catalog all of them and people should get the book and, and read some of the failure stories. But could you give us a little bit of a taste of uh, the types of failures that you cover in the book? In what ways do these unicorns fail, whether in business terms or in terms of living up to what we might expect of them as a society, as consumers? What might be causing these failures other than just the fact that the business is a generally fraught thing, whether I'm starting a restaurant or whether I'm starting the next big software or AI, uh, company. Tell me a little bit about failure in this book as you see it.

Speaker B: In my book I really focus on oversight failures of VC investors because we really, when again, in the traditional model we really relied on VC investors to keep founders on the straight narrow. So in that traditional model, the VCs control the purse strings and they controlled the board of directors so they could easily replace any underperforming or any unethical founders. And founders understood in the classic model that they really had to get their house in order. If a startup was succeeding and growing really quickly, they had to get their house in order to prepare for an eventual IPO, which would be required when it hit 500 shareholders or more. And that's a milestone which is often reached when a company's employees begin to exercise their stock options. But because of the JOBS act now, a startup can stay private indefinitely unless it has 2,000 shareholders. And we're not including any employee held shares in that count. That just basically means a startup doesn't have to go public unless the investors have discovered it's time for them to cash out their shares. So it's eliminated the organic pressure for startups to professionalize as they grow, to bring in experienced managers to create a more bureaucratic structure. And this has created an environment where mismanagement and misconduct and unfortunately even Fraud can take hold at startups and not only take hold, but it can persist undetected or unaddressed for an extended period of time. Some of the failures that I emphasize in my book are things that I think most of your listeners have heard about. WeWork Theranos are some of the big ones. Uber's another example that I use. Uber ended up succeeding and going public, but it experienced a lot of problems when it was in its startup phase. So those are the well known startup failures. But my book also addresses a lot of lesser known failures, including companies like Ozy Media or Outcome Health or Frank, or the hydrogen powered battery truck company Nikola. So these are all companies that either lied about their products or lied about their revenues or lied about their performance, but were able to grow with venture capital financing and really have a big influence on the economy before the sort of the house of cards began to fall down.

Speaker A: In thinking about these governance failures, these oversight failures at, uh, unicorns, in what ways is this country's system of securities regulation as it exists today, maybe partly to blame for these fillings? And perhaps on a more positive note, are there instances of our securities regulation system preventing worse failings? So I like to teach in, uh, my unit on IPOs, the WeWork IPO that never happened, and the students and I look at the S1 and some of the more galling things in the S1 and of course that didn't really get off the ground because the disclosure was so unattractive to investors that the IPO didn't happen. For all the failures that we work. Perhaps on a more positive note, the securities regulation system might have prevented further harm there. How are you thinking about the influence of our security system on the failures and maybe on the failures averted?

Speaker B: So I think maybe we can step back and just think about the structure of our securities laws, how they're supposed to work, just the theory behind and undergirding the system. And then what happens when we steadily chip away at those basic elements? As mandatory disclosure is the bedrock of our US Security system, and required disclosures are what empower investors and directors to provide oversight and also to provide discipline for managers. And there are also corporate governance rules which are also part of the securities laws, and those give investors additional rights, including information rights and voting rights, and the ability to weigh in on important corporate decisions. Those rules generally apply to public companies, but these disclosure and governance rules do not apply to private companies like startups. So that makes it very difficult for investors to exercise oversight to police or detect fraud to the Extent that a company in the traditional model raises two or three rounds or four or five rounds of financing, proves its product is viable, starts to bring in revenue, and then goes public, I agree with you. That process works pretty well because in the first stages, we have the investors who are in control, the VC investors who are in control. And then when we move to the public markets, we have full and fair disclosure. And then the public and the market is in control, and public shareholders and the market itself, stock market trading is disciplining the conduct of the managers. But when companies are staying private for seven, eight, nine or 10 years, that disciplinary system has really broken down. And that's where we see, like I've mentioned, significant instances of misconduct. And even when investors know about it, they might try to keep it under wraps. They might cover it up, they might see, maybe we can benefit from this misconduct without public scrutiny, without disclosure. Maybe we can engage for a short period of time, or even an extended period of time in illegal or other forms of unsavory behavior. Maybe we can use our market power to influence a law, to change the law. And I know you've written about this, Andrew, that startup investors sometimes benefit from startup misconduct, even including legal violations, as long as they can keep them under wrap. What I'm seeing is that incentives, both for investors and founders, are skewed. So it's not really surprising that we're seeing so many instances of startup misconduct and fraud. And I guess to add one more thing, we there was an orderly process to a private acquisition or an ipo, I think we'd see a lot less of this misconduct. But without the iPodOS, startups are growing so strong and so powerful that they're actually changing our legal system. And then when they do go public, a lot of the bad behavior, the misbehavior, is continuing. And again, that's also warping public company governance.

Speaker A: Your book does a lot of work, and, um, we've done some of that work in this conversation too, to lay out the problem in what ways the startup financing system is broken. But it's not just a diagnosis. You also offer some prescription for reform. Could you talk about the reforms that you propose in this book? There are a number. But could you give us a thrust of what you think we need to do to maybe fix this system? Obviously, you have a great advantage to make these proposals, given your role as a regulator and as a scholar in this area. What should we be thinking about doing going forward?

Speaker B: It's a great question. It's a question I've put a lot of thought into pretty complicated question, but I tried really hard to come up with some workable solutions. The last chapter of Untamed Unicorns lays out a roadmap for reforms that would help to restore proper boundaries between public and private markets. And just to speak really generally, the goal of the reforms is to ensure that all investors have access to information when they're making investment decisions, whether they're investing in public markets or investing in private markets. So I'm a big believer in the idea that transparency helps to deter misconduct. And as Brandeis famously said, or paraphrase, sunlight is the greatest of disinfectants. My proposals fall into three large buckets, and I'll just give you a very high level overview here. First, I start with Regulation D. As Regulation D is the primary exemption that startups rely on when they're raising capital, and almost all of the $4 trillion in capital raised each year is an exempt transaction is raised under Rule 506 of Regulation D. And under Rule 506, if all of the investors are accredited, meaning that they meet certain wealth and income standards, then no disclosure is required at all. So what I'm recommending is reforms that would ensure investors have adequate information when they're purchasing securities that are being issued under Regulation D, and also to ensure that the SEC has better insights in how this exemption is being used. So next I look at Rule 701, which is the exemption that startups use when they're offering stock options or other forms of equity compensation to their employees. And I recommend expanding the disclosure that's required under Rule 701, because that would assist employees when they're making important investment and employment decisions. And then finally, I look at section 12G, which I've already mentioned. That's the 500 shareholder rule. It once was a 500 shareholder rule, now it's a 2000 shareholder rule. And section 12G really helped to ensure that all large companies that had a broad shareholder base provided ongoing disclosure to investors and the public. And now, without Section 12G, without that 500 shareholder rule, we're not getting that disclosure from these huge impactful companies. So I argue that Congress should look at Section 12 and perhaps go back to that 500 shareholder rule that seemed to work really well for 30, 40 years. And I also argue that the SEC, even short of congressional action, really needs to take a close look at its rules under section 12G to close loopholes that investors and startups are using to evade Section 12G's registration requirements. So those are the Recommendations in a, uh, nutshell. And of course I go into much more detail in the final chapter of the book.

Speaker A: This book is going to be published in August 2026. I think this episode will also be coming out around the same time. If your editor were to come to you 10 years from now, the2030s will have celebrated the 100 year anniversaries of the securities and the Exchange Acts. If your editors were to come to you and say, we'd like you to do a new edition of this book or to do a follow up book on it, reflecting on what's happened in the interim, what do you think that book might look like? Obviously it's hard to make predictions, but are you maybe willing to offer a guess as to what that book might look like?

Speaker B: Oh, that's a great question. It's a really thoughtful question. I think I'll take an optimistic perspective. So ideally, without the US investors and the public having to go through a major crisis, we can accomplish some of the reforms that I've recommended in my book. We would be able to achieve a better balance between public and private markets. And when I say achieve a better balance, I say we would have a system that would continue to work well in financing new businesses and financing entrepreneurship and connecting people who have great ideas with potential investors. I think that's really important. And we would do that in a way that's not too onerous, that's not too burdensome, but does ensure that there's an effective system of oversight. So I would try, really try to preserve what's left of that traditional VC financing system. But the reforms that I would adopt would provide a regulatory backstop. So when that system starts to break down and investors aren't getting information that the traditional financing model says that they would receive, there'll be compelled disclosure so that you can raise money in private markets without registering with the sec. And that's okay because registration an IPO was very expensive. It costs millions and millions of dollars. But just because you're not registering with the SEC and providing all of the public disclosure doesn't mean you shouldn't be providing important, material, relevant financial information to your investors, to your owners. And so to the extent that the VC financing system or the private financing system has gotten out of whack, you would correct that by ensuring that even when you're in a private company, you are required to provide some minimum disclosures to your investors. And so I think that would fix some of the problems in the private market. And then again, in the ideal situation we would have a natural transition when a company became very large, when it had significant revenues, when it was able to hire the top notch lawyers, we would see a company move to the public markets and that would solve a lot of the problems that we're hearing about when we're talking about putting private assets, for example in investors 401ks. Because these companies, yes they would grow rapidly in the private markets, but they would transition at a, ah, relatively young stage to the public markets. And that would provide those investment opportunities, that's those high tech, those emerging market opportunities for the regular public investors. And to the extent that public money is being poured into these private companies, that would also protect retail investors like mutual fund investors or pension funds that are putting money, lots of money, billions or trillions of dollars into these companies but are not getting adequate disclosure about the company's operations and aren't able to influence their conduct in any way. I guess the ideal that I would see is we functioning private markets, effective oversight, effective disclosure regime, whether it's through private ordering or private ordering with a backstop, with mandatory minimum disclosure rules and then well functioning public markets for those companies that are big, that are influential, that have revenues, have money, he can afford to make the public disclosures because the exemptions were really put in place to eliminate disclosure requirements where they weren't justified, the cost didn't justify them. But when we're talking about huge, multi billion, even multi trillion dollar companies, it's really hard to argue that they can't afford to make those disclosures that public companies are making because they're bigger than most public companies.

Speaker A: In fact, our guest today has been Renee Jones, professor of Law at Boston College. We've discussed her new book, Untamed why Startup Finance is Broken and how to Fix It. I'll add a link to the book's webpage in the show notes for the episode. Rene, thank you for joining the Business Scholarship Podcast.

Speaker B: Thank you so much Andrew for having me. I've really enjoyed this conversation and anybody who's interested in learning more about the history or my recommendations can purchase Untamed Unicorns at ah, Amazon, Barnes and nobles, bookshop.org or wherever they usually buy their books. Thanks.

Speaker A: Thank you for listening to another episode of the Business Scholarship Podcast. If you like what you heard today, be sure to subscribe to the podcast on Apple, Spotify or wherever you get your podcasts. Rate the show and let other people know about it too. If you have ideas for future episodes, let me know. My email address is andrewdrewkjennings.com and I look forward to hearing from you. Until the next time, I'm your host, Andrew Jennings.