It is a well-known story that startup companies that receive venture support aim for an “exit.” In the process of building great companies, entrepreneurs raise venture capital, build teams, and develop innovative products and services that allow them to grow rapidly. Success for a startup is often viewed as reaching a liquidity event, or exit, that provides financial benefits and rewards for investors, founders, and employees. There are mainly two ways he can do this. Either sell the company or go public. Each of the two paths to a successful exit – going public or M&A divestiture – has been the subject of significant academic consideration and public debate in recent years.
However, most venture-backed startups never reach these paths, or if they do, they find themselves in a bind. Approximately 75% of venture-backed startups fail. However, that number is difficult to measure, and some estimates put the number much higher. Generally, a startup has failed if it ultimately fails to reach an exit at a valuation that benefits all stockholders. This can happen for a variety of reasons, including lack of funding, problems within the team, flaws in product development or business model, loss of competition, lack of market need, or changing circumstances. Although participants may not explicitly call this a “failure” and may in fact try hard to find a “soft landing” that could characterize this in other ways, The objective is clearly not an initial public offering transaction or an M&A sale. As a result, all shareholders benefit.
This third and most common path, startup failure, has received little attention in the academic literature but is an important part of the startup and venture capital ecosystem. The ability of startups and their participants to fail efficiently and “honorably” helps sustain the system from which some of the greatest successes in American business history emerge.
my upcoming articles, Startup failureprovides a theory of the laws and culture that foster failure and argues that it plays an important role in the startup and venture capital ecosystems. A wide range of options exist for systems to deal with the large number of failed startups that our venture capital ecosystem produces, but until now they have not been considered at scale.
Although a well-developed bankruptcy system is considered critical to entrepreneurship and the business environment, venture-backed start-ups are unlikely to rely on formal bankruptcy procedures. The article begins by explaining why formal bankruptcy proceedings do not meet the needs of most distressed venture-backed startups, and what can be learned from the rare exceptions.
Specifically, the typical capital structure of a startup company does not include significant commercial debt that must be met. Additionally, venture-backed startups are, by their very nature, like melting ice. The team’s talent, technical know-how, intellectual property and other intangible assets, and network effects of a growing company can quickly disappear once the startup is known. I’m in a predicament. The typical startup is not only a melting ice cube, but also embedded in a network of reputational concerns and constraints in the venture capital ecosystem. Angel investors, venture capitalists, and venture financiers all make repeated venture investments and loans. Venture capitalists invest based on the “power law” principle, in which a few big hits can generate the bulk of a fund’s profits. Venture capitalists often don’t want to be involved in a lengthy bankruptcy process due to the opportunity costs and potential reputational damage. It’s not worth squeezing every last dollar out of a startup, especially in a competitive environment to participate in deals with startups. All of these reasons come in addition to cost and timing issues. Examples of startup bankruptcies, from Solyndra to his FTX, provide studies of rare exceptions that prove the rule. In other words, failed startups typically prefer not to use the formal bankruptcy process.
So what happens to the large number of startups that fail to achieve their founding dreams? There are a wide range of systems available to deal with the large number of failed startups that our venture capital ecosystem produces, but this It had not been considered comprehensively until now. Alternatives to bankruptcy commonly used by venture-backed startups include M&A sales, acquisition transactions, and assignments for the benefit of creditors (ABCs). The low costs, speed, possibility of private ordering, and light level of legal formalities involved in these options allow venture-backed startup participants to “fail fast” and preserve assets and talent without significant reputational damage. can be absorbed or relocated.
Bringing together the strong social and cultural norms of startup networks and venture capital business models reveals the modus operandi of Silicon Valley’s approach to startup failure: normalization and redeployment. Entrepreneurs and employees often benefit from being able to take the plunge and fail. Failure can be caused by lack of luck or other factors beyond the entrepreneur’s control. Knowing that failure will not negatively impact your ability to get a “regular” job or try again as an entrepreneur, as long as you aim to care for others, will encourage you to be innovative. It may help motivate your decision to start a new startup or work for that company. Venture capitalists can often provide implicit insurance that spreads the risk of personal failure by proactively introducing other portfolio companies, early-stage investors, and soft-landing opportunities. More broadly, reinforcing entrepreneurs’ willingness to take on risks is essential for venture capitalists, so fostering a reputation for supporting entrepreneurs in this way, through good times and bad, is essential for VC firms. It is often beneficial for
In particular, several developments are changing the landscape of venture capital investing, suggesting that the system may be under pressure to cope with the scale, type, or number of failures. New entrants to venture-backed startup investing, longer timelines for going private, higher valuations and raisings, and looming increased antitrust scrutiny of technology acquisitions all reflect existing laws. suggests adaptability and changes that may test the culture of startup failure. Regularize and redeploy at low social and financial costs.
The final section of this article therefore highlights regulatory and doctrinal opportunities to advance the law’s approach to startup failure. For example, there have been numerous legislative proposals and discussions in recent years to increase antitrust oversight of acquisitions by large technology companies. Care needs to be taken in coordinating regulatory responses so as not to disrupt the flow of addressing the large number of startup failures that do not pose significant competition issues. Similarly, state law adds doctrinal clarity to difficult but common scenarios faced by startup boards in discharging their fiduciary duties, disseminating insights from California bankruptcy proceedings to growing startup hubs across the country. This may facilitate more efficient handling of failures.
Although the value of supporting failure often receives less regulatory and academic attention than the shiny allure of success, the two are important for funding risky, innovative businesses and for social and intertwined within a larger startup and venture capital ecosystem with significant economic impact.
This article is forthcoming in the Duke Law Journal and is available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4535089.