A Theory of Trust-Based Governance in Startups

Abstract

Recent years have seen a remarkable rise in startup funding from traditional public market investors. This Article provides an in-depth analysis of this growing phenomenon and makes three key contributions to the literature. First, we identify a core group of institutional investors—including several of the largest asset managers in the country—that have emerged as prominent players in startup financing. Using hand-collected data, we explore their investment patterns and trends. Our findings show that contrary to prevailing assumptions, these investors tend to venture into startups at earlier stages than previously perceived, often assuming lead or sole investor roles with substantial capital injections.  

Second, we explore how the participation of institutional investors in the startup ecosystem affects the internal corporate governance of these companies. Our analysis reveals a surprising pattern: Despite institutional investors’ significant equity investments and growing early-stage involvement in startups, these titans play a weak monitoring role in startup companies and systematically forego control rights. Specifically, they refrain from appointing directors, a prevalent practice among traditional startup investors such as venture capitalists (VCs). Moreover, we show that these investors are often willing to accept governance arrangements that diverge from the conventional best practices they apply to their public investments, such as unequal voting structures and a lack of board independence.

Third, we develop a theoretical framework that explains institutional investors’ lenient governance approach and underscores the allocation of control rights among startup shareholders. According to our framework, institutional investors deliberately cede control to other corporate constituencies—vertically to founders in managerial roles and horizontally to VCs—that often possess superior information about the company and are thus better positioned to monitor its operation and to ensure its success. Recognizing the advantages of allowing these constituencies to take the helm, institutional investors view the allocation of control rights as a governance approach that may result in efficiency gains for startups and their shareholders.

Our analysis highlights critical policy issues concerning the fiduciary responsibilities of institutional investors with respect to their startup investments, which warrant detailed examination. In establishing these duties, policymakers must consider the unique characteristics of the startup ecosystem and the identity of the involved players. We argue that this analysis may justify a more flexible approach to governance by institutional investors, recognizing that traditional stewardship expectations may not be entirely suitable for startups’ dynamic and innovative nature.

Keywords: Startup Companies, Governance, Control Rights, Institutional Investors, Venture Capital Funds, Fiduciary Duties