A Theory of Trust-Based Governance in Startups

Recent years have seen a remarkable rise in startup investments by traditional public market investors, namely institutional investors. As public markets have gradually regressed, their private counterparts have seen immense growth and demand from sophisticated asset managers (Gözlügöl, Greth, & Troeger, 2023). As a result, these investors have begun crossing over into the private domain, increasing their exposure to private markets (Kwon, Lowry, & Qian, 2020). In a recent paper, we provide an in-depth analysis of this growing phenomenon and explore the investment patterns of institutional investors in startups and their corporate governance approach in the private sphere.

Using hand-collected data spanning 2009-2023, we identify three giant institutional investors—BlackRock, Fidelity, and T. Rowe Price—that have emerged as prominent players in startup financing. Over our sample period, these institutions have substantially increased their holdings in the private market both in terms of the number of investments and average investment amount. In addition, they have gradually begun venturing into startups at earlier stages than in the past, sometimes as early as the seed round stage. Another interesting finding is that these investors increasingly assume lead or sole investor roles with substantial capital injections.

Our analysis of institutional investors’ corporate governance preferences in their startup companies reveals a surprising pattern. Given that these sophisticated institutional investors are known as juggernauts of corporate stewardship in the public sphere, one might expect their governance approach to be similarly adopted among their private portfolio companies. In this Article, we reveal that this is not the case.

Despite institutional investors’ significant equity investments and growing early-stage involvement in startups, these investors play a weak monitoring role in startups and systematically forego control rights. Our empirical analysis shows that they rarely demand meaningful control rights such as board representation, even in their capacity as lead investors. While BlackRock, Fidelity, and T. Rowe Price led nearly two hundred investment rounds over our sample period, they only appointed seven board members and four board observers, deviating from the conventional practice of lead investors to designate board members.  These findings align with previous studies suggesting that mutual funds, despite having significant cash-flow rights, tend to abstain from demanding effective control rights in their startups (Chernenko, Lerner, & Zeng, 2020), and rarely demand board representation (Adams, Hermalin, & Weisbach, 2010).

In our paper, we also explore how the participation of institutional investors in the startup ecosystem affects the internal corporate governance of startups and expose a significant governance gap between public and private portfolio firms. We find that institutional investors are often willing to accept governance structures that diverge significantly from the conventional best practices they apply when investing in public companies and provide relatively weak shareholder protection. This includes accepting unequal voting rights, lackluster board independence, and CEO duality.

      Why do institutional investors, practitioners of strong governance in public firms, depart from their traditional principles when investing in startup companies? We argue that institutional investors’ deviation from their traditional governance approach reflects a deliberate choice to cede control to other corporate constituencies better positioned to increase firm value and yield efficient gains. This approach comprises a two-dimensional allocation of control rights: vertical allocation between institutional investors and startup founders and horizontal allocation between institutional investors and traditional startup investors (VCs).

Vertically, institutional investors cede control rights to startup founders, whose visionary leadership and merits are synonymous with the companies they create (Hamdani & Kastiel, 2023). These investors intentionally enhance the control rights of founders in hopes that their unique virtues will generate above-market returns (Goshen & Hamdani, 2016). The inherent tradeoff between increased agency costs and the founders’ pursuit of their idiosyncratic vision can benefit institutional investors, primarily owing to startups’ distinctive characteristics.

Horizontally, institutional investors relinquish control to traditional startup investors, mostly VCs, who are more knowledgeable and active in monitoring and engagement (Lerner, 1995). Institutional investors, relatively new to the private domain, enhance the relational control of VCs, allowing them to exert influence with greater efficiency. This strategic approach can optimize firm value by relinquishing control to more diligent monitors, mitigating potential managerial agency costs.

We argue that this two-dimensional approach can align with institutional investors’ fiduciary duties towards their beneficiaries. Vertical allocation to founders encourages creativity and innovation, which can facilitate the attainment of mutual goals and increase firm value. Similarly, horizontal allocation to traditional startup investors delegates control to more experienced, knowledgeable players who can potentially add value and yield efficient returns.

Understanding this allocation of control rights approach can assist policymakers in delineating the fiduciary responsibilities of institutional investors in their capacity as startup investors.  In establishing these duties, policymakers must consider the unique characteristics of the startup ecosystem and the identity of the involved players. Our analysis, we believe, justifies a more flexible approach to governance by institutional investors. Traditional stewardship expectations may not be entirely compatible with startups' dynamic and innovative nature.

Danielle A. Chaim is Assistant Professor at the Faculty of Law, Bar-Ilan University.

Asaf Eckstein is Associate Professor at the Faculty of Law, The Hebrew University of Jerusalem.

The paper is available here.

This post is published as part of the special series ‘The Law and Finance of Private and Venture Capital’.