Unicorn start-ups are facing increasing scrutiny by the U.S. Securities and Exchange Commission (SEC) for several reasons, including the potential for inflated valuations and misleading statements both of which pose a risk to investors, according to Kim Melvin, a partner with national law firm Wiley Rein.
Unicorns, defined as private companies with a valuation of $1 billion or more, are the focus of the agency’s Silicon Valley Initiative. In a keynote address given on March 31, 2016, Mary Jo White, chair of the SEC, said, “It is essential that the Commission fully engage with Silicon Valley, and participants in this important market across the country, so that we can better understand the unique features of its investors and financings.”
Valuation marks the difference between unicorns and already established private companies, with startup companies relying heavily on the venture capital markets to raise funds and to operate their companies, Melvin said.
The willingness to buy into startup companies has caused a market disruption that needs additional scrutiny, she said.
“Any private company can be held liable under the federal securities laws for false or misleading statements in connection with the sale of their stock to venture capital firms or other private investment companies. It just has not been a historical focus of the SEC,” Melvin said.
Because of the potential for inflated valuations, the agency wants to assess the unicorns’ communications with private investors about their fundraising and stock investments, she said. The agency wants to ensure the companies are not overstating their value and that their internal compliance matches those of public companies with similar valuations.
“The SEC has suggested that these startup companies may not have the internal compliance…the robust practices expected of a publicly held company, for example, perhaps not unexpectedly given that a startup is largely focused on getting its business off the ground more so than…compliance issues around its fundraising,” Melvin said.
In her address, White noted that as the technology sector has evolved so too have the financial markets to support it. New types of investors and funding options have contributed to companies staying private longer.
“Being a private company obviously does not mean that you can disregard the interests of investors. Indeed, being a private company comes with serious obligations to investors and the markets. Whether the source of the obligation is the federal securities laws or the fiduciary duty that is owed to shareholders, the resulting candor and fair dealing should be fundamentally the same,” said White.
She explained that the principles that characterize public companies including transparency with investors, financial reporting controls and strong corporate governance are applicable to private companies, noting the inherent risk in start-ups.
“While the common refrain is that nine out of 10 start-ups fail, an equally interesting statistic from one post-mortem analysis is that 70 percent of failed start-ups die within 20 months after their last financing, having raised an average of $11 million,” White said. “In other words, not only are these investments highly risky, they fail quickly too.”
There are an estimated 150 unicorns worldwide, with many based in Silicon Valley, said White.
According to Melvin, the risk of an inflated company valuation to directors and officers is twofold. First, if information shared with investors by the company in securing the fundraising is based on false or misleading statements that resulted in the valuation being artificially inflated it could lead to an investigation by the SEC.
“That is a quintessential securities claim violation,” explained Melvin.
The second risk is that because of the nature of a start-up – they are typically smaller and privately held — there is a risk to the company’s founders and key officers because there isn’t a requirement to make disclosures with appropriate risk factors or release a registration statement.
“They, in fact, are making oral representation to these hedge funds or other private equity firms and will likely find themselves as defendants in the litigation for specifically making the representation,” said Melvin. “Whereas with a public company, the board will often get named as the parties that signed the registration statements, but there’s a variety of protections in place in the securities laws for those defendants.”
Melvin said there is a greater potential for individual liability in connection with private company claims.
“In fact, you see in Theranos that not only is [Elizabeth] Holmes named, but also the COO and the president of the company,” she said.
According to a Silicon Valley Business Journal article written by Cromwell Schubarth, TechFlash Editor, a San Francisco hedge fund sued Theranos, alleging it lied to obtain a $100 million investment.
The California-based blood-testing startup, once valued at $9 billion, has recently changed its focus to wellness clinics. There is a risk when a start-up suddenly changes focus, like Theranos has.
“There could be an argument, certainly by the plaintiffs’ bar, that the fact that they’re no longer attempting to go down the road that was sold to these investors, as the future and the plans for the firm and the promise by which these funds made their investment, is a suggestion that it was doomed to fail from the beginning. That they knew it all along,” Melvin said. “The shift in focus will be spun, perhaps, by the plaintiffs’ lawyer as an indictment of the whole strategy of the startup in the first place. It will certainly be used, I would assume, by a creative plaintiffs’ bar, as supportive of the fact that they misrepresented to these investors the ability to secure the appropriate governmental FDA approvals and the like.”
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The likelihood of a lawsuit against high-valued start-ups is much higher than for other private companies.
“The more that is at stake, and potentially that was invested in the company based on potential misrepresentations actionable under the securities law, the more likely a lawsuit would be filed,” said Melvin. “There’s more reason to bring the suit. It will garner larger potential damages.”
There are several implications for the private company directors and officers market, Melvin explained.
In the past, Melvin said there was always a clear distinction between public and private D&O insurance. That’s no longer the case for unicorns, she said.
“The D&O insurers have always had a clear line between public company D&O insurance and private company D&O insurance. Historically, claims alleging violations of the federal securities laws have always been among the most significant D&O insurance exposures for public companies,” Melvin said. “Private companies historically have not faced these claims, at least not with nearly the same frequency or severity. At least for these so-called unicorns, this appears to no longer be the case.”
There is the potential for federal securities law liabilities for private companies particularly with large valuations, she said. As a result, there is a need to reassess the risk of insuring these private companies, given the greater potential for securities law liabilities.
“The D&O insurance underwriters are going to have to look to see whether these larger valued private companies really need to be treated like publicly traded companies. The insurance being offered to them needs to be adjusted accordingly,” Melvin explained.
“Frankly, I would expect that these larger private companies and their brokers are going to be carefully reviewing their existing D&O insurance, with an eye towards these potential security law claims, whether by investors, by the SEC or the DOJ.”
She expects that D&O insurers will likely try to match some of the features that are more typical of a public company form in the private company policies. One example is coverage for informal investigations which has broadened over the years. She expects the same coverage to be offered under private company D&O policies.
“One area that pressure was already being brought to bear on the private company form, that this will raise even more acutely, is coverage for informal investigations. The public company form has been broadening over a period of numerous years to extend coverage for investigation costs,” Melvin said. “First, it was to formal investigations. Now oftentimes, at least for individuals, you can get coverage for informal investigations by the SEC, DOJ, or other federal regulatory agency that’s specific to the operative company. That coverage is not typical for a private company, that informal investigation coverage.”
Another example are the defense provisions and choice of counsel within public company D&O policies.
“Public company D&O policies are typically reimbursement policies, not duty to defend policies. An important feature of that is that the insured or the company gets to choose council, subject to the consent of the insurers. They control the defense with duties to cooperate and keep the insurers apprised,” Melvin said. “That control over the selection of council and the defense is sort of a critical and important feature of a public company policy. Private company D&O is more traditionally written as duty to defend policies, which means the primary insurer gets to appoint council, and may have panel council or other firms that it regularly uses.”
Melvin said she anticipates that private companies, particularly those facing federal security law claims, will push to secure the right to choose council and control their defense from their D&O insurers.
“That’s something the insurers are going to have to assess and determine if they’re willing to change their policies in that regard,” Melvin said. “Those were the two most critical features of the public company form that private companies will be looking to import into the private company form.”
She added that brokers will likely be asked to review any securities-related exclusions within the private company form to ensure “they are limited solely to the company offering publicly traded securities, so that it’s clear that the exclusion isn’t intended to apply to securities claims at a time when the company’s still private.”
Limits adequacy is another issue that D&O underwriters and the industry as a whole will have to consider, Melvin said.
“Some of the traditional bench marking for how much insurance private companies should buy may change at least for these companies garnering the largest valuations,” Melvin explained. “Given that the severity that you would typically see in a securities law liability type of claim is greater than and may change the benchmarking, I would envision that would be something that private companies and their brokers would be grappling with in the coming months and year.”
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