We need to rein in Silicon Valley unicorns, says law prof

Episode Notes

Transcript

Lee Rawles:

Welcome to the Modern Law Library. I’m your host, Lee Rawls, and today I’m joined by Renee M. Jones, author of the new book, Untamed Unicorns: Why Startup Finance is Broken and How to Fix It. Renee, thanks so much for joining us.

Renée M. Jones:

Thank you so much for having me. I’m so excited to be here.

Lee Rawles:

Well, when I got approached for a book about unicorns, I was extremely excited. It turned out to be a little different than I thought it was, but I learned a lot. What I want to do for our audience who may not be financial wizards is right up top, let’s talk a little bit about startups and the startup financing model and what it means. So when I first think of, oh, I’m launching a business, the thought in my head is a small business like, okay, I’m going to open a shopping market with my family and here it is. That’s not what we’re talking about. So what counts as a startup in the way that we’re talking about it today?

Renée M. Jones:

I would say a typical startup company that’s going to end up seeking to attract venture capital financing is a situation where an entrepreneur has an idea that they think they can get started on their own, kind of prove concept, but then they can quickly scale and quickly grow into becoming a massive and significant enterprise. So these tend to be today mostly tech-based startups. So if you think about Uber, Apple, Amazon, those are some examples of some of the very successful startups, some of those huge startups that are part of our everyday life, but they started off as startups that were first founded by a founder who starts the business, maybe attracts a couple of people to work with them as co-founders. They might start off financing that company on their own. We call that bootstrapping. So they might have some resources of their own or they might quote unquote work out of the garage until they can reach out to maybe friends and families who can kick in a little bit more money.

But eventually the goal is to attract investments from a venture capital firm, which are professional investors who focus mainly on entrepreneurship. And then when the venture capitalists come in, the founder will go through multiple financing rounds. When the venture capitalists come in, that’s where they bring in significant amounts of money and they work very closely with the founder to help them develop the product and develop the business, hoping that it will, again, grow very rapidly and become a significant massive enterprise. And then at some point, the idea is that the venture capitalists want to exit or get out of that investment. And they’ll do that by either selling the startup to a larger company, typically a public company, or the gold standard once was they would enter the public financing markets through an IPO. And that’s when the company’s shares would begin to trade on the public trading markets like the New York Stock Exchange or NASDAQ.

And then everybody, regular retail investors could invest in that company. So that’s the typical path of a startup company, or at least it has been until very recently.

Lee Rawles:

And now we need to talk about unicorns, which I would love to do. Let’s talk about unicorns. What are the unicorns in this world?

Renée M. Jones:

So a unicorn is a startup company, as I just described, that’s typically financed by venture capitalists, but it’s a startup, but it’s an enormous startup with a valuation of a billion dollars or more. So it once was the case that you would never see a startup company that’s financed outside of the public markets grow that large. And that’s why they were called unicorns because they used to be so rare. But now they’re fairly ubiquitous. So when the term was first coined in 2013, there were only about 40 unicorns. Now there are more than 1500. And they’re playing a very significant role in our economy and the way that they’re financed and managed has changed significantly. And that’s the topic of my book on tamed unicorns.

Lee Rawles:

So growth from 40 to 1500, that sounds insane and like a huge leap. Is the change due to a whole lot more new money has entered the arena or have other things changed that have led to companies being able to build up those kinds of $1 billion reserves?

Renée M. Jones:

So a number of things have changed. So some of it’s economic, some of it’s I would say cultural, but a lot of it has been at least facilitated by legal changes. So from the economic perspective, a lot of the startups that we talked about that are internet-based or platform based, they don’t require a lot of capital. So they’re able to grow pretty efficiently without necessarily raising a lot of money. That’s part of it. But I think the most important part of it is that there’s much more money available in private markets compared to the past. And that change, that shift in the ability to raise money in private markets can really be attributed to significant changes in the law that have really been implemented over 40 years. But there are two major statutes that I think have contributed to this the most. And the first would be a 1996 statute called NSMEA.

I know that’s a mouthful. It’s the National Securities Markets Improvement Act. And that rule lifted the cap on the size of private investment funds. So think about private equity, venture capital and hedge funds. There used to be a cap on how large they could grow, but then NSMEA eliminated that cap. And that’s where money started to sort of flow into the private markets from the public markets. So since NSMEA was adopted, the assets under management, that is the amount of money that’s managed by these private funds has grown from about 200 billion when NSMEA was adopted in 1996 to more than nine trillion at the end of 2024. So again, massive exponential growth in private markets, a lot more money chasing attractive deals. So then there’s a lot more competition among these private funds for the opportunities to invest in the most attractive startups.

Lee Rawles:

So you said 1996, and I am about to date myself, but I was graduating high school just a couple years after that. And I remember the dot-com burst. I remember the recession as I was entering the job market. There have been a number of financial busts since this legislation put a lot more private money, private equity in play. Do you think that there is a connection to removing the limits for this private investment and increasing the risk of these busts that have happened several times since?

Renée M. Jones:

Right. So the timeframe that you mentioned, 1996 is really an important timeframe, at least in the discussion about the growth of private markets at the expense of the growth in public markets because 1996, you could say, is the heyday for the number of public companies. And it’s also sort of the heyday for the number of IPOs per year. But soon after that bump or that bubble, we saw what we call the popping of the dot-com bubble where companies like a lot of dot-com companies failed and there were major frauds revealed at companies like Enron and WorldCom. And that was in 2001 and 2002. And the response to that in Congress was the Soybanes-Oxley Act of 2002, which sought to improve financial reporting and oversight in public markets. So up until around that time, a lot of the concern for lawyers and securities lawyers like me was ensuring appropriate accountability and appropriate oversight and appropriate controls over financial reporting because of the frauds at public companies.

But what my book shows is a lot of those concerns that we had about public companies after 2002, we started to see similar problems developing at private companies like startups. And examples of that of course are Uber, Theranos, which was a blood testing startup that turned out to be a fake. And WeWork, which as you know, was office sharing startup that ended up kind of imploding. And so a lot of the governance problems, a lot of the oversight problems, a lot of the concerns about the accuracy of financial reports, which sort of ballooned in public markets and were addressed by Sarbanes-Oxley are now starting to plague the private securities markets.

Lee Rawles:

And another thing that might be giving us more unicorns is you described the life cycle that a startup ordinarily goes through. And in the past, I believe about four years was the time period that you said was most common between the launching and then the VCs, like you said, sell the company or there’s an IPO. But that has changed. And these startups are now spending longer in this period of time where they are not subject to the kinds of reporting and oversight that we do expect of them once they do the IPO. Am I saying that correctly?

Renée M. Jones:

That’s absolutely correct. So sort of in the past, in this 1996, 2000 timeframe, the typical timeframe from a startup being founded, that is the founder comes up with an idea and starts to raise money from venture capital list to its IPO was about four to seven years. And really there was a race to get to that finish line to the IPO because that was the time when the founders, the VC investors and the startup employees would be able to convert their equity holdings, which were basically just paper holdings into cash. So everybody really worked very hard to rush to the IPO. And then that started to change when the law started to change. So we talked about more money being available so you can get the money that you need in private markets and not have to go to public markets. So that’s one thing that changed.

And the other thing that changed is there was a longstanding rule under the securities laws that any private company that would include a startup that had 500 shareholders or more would be required to register with the SEC. So they’d be required to start providing that public disclosure and required to comply with federal corporate governance rules. But that law was changed in 2012 with the Jobs Act of 2012. And what the Jobs Act did is it took what had been this 500 shareholder rule, which was the threshold for public registration to a 2,000 shareholder rule. But when they adopted the 2,000 shareholder rule, Congress also said that employee-held shares wouldn’t count. So that was a point in time where startups could stay private for as long as they wanted. So up until 2012, when Facebook, for example, reached that 500 shareholder threshold, it was basically forced to become a public reporting company.

And that’s when it decided to pursue its IPO. But then when the law was changed, companies didn’t have that pressure to prepare for the IPO. So we started to see that timeline stretch from about four to seven years to as long as 20 years. So for example, SpaceX, which just went public recently, had been a private company, a startup for over 20 years.

Lee Rawles:

And we haven’t brought this up yet, but you are the former director of the SEC’s division of corporation finance from 2021 to 2023. Was this a major concern as you talked around the water cooler that the public does not have a good window into these companies? And as you said, SpaceX could operate for 20 years doing contracts with the government. We are trusting them with a lot of public safety decisions, and yet we did not have a window into the company’s internal records.

Renée M. Jones:

Yeah, I would say for a long time, it’s been a concern or an issue at the SEC about the growth in the number of private companies, about the sort of fall off in the number of IPOs and the general drop in the number of public companies from about 8,000 in 1996 to about 4,000 today. So it was an issue that as the director of the division of corporation finance, I was responsible for overseeing the SEC’s policy initiatives. And then one of the items on our policy agenda while I was there was looking at private markets and making recommendations for reform. So we were looking at some of the causes that sort of had contributed to those shifts and what we could do to address them, but we didn’t end up actually releasing any rules that would address the problems that I talk about in my book.

Lee Rawles:

And we will get to some of your suggestions for ways to rewrite those rules. But first, we’re going to take a break and hear from our advertisers. When we return, we’ll still be speaking with Renee M. Jones about untamed unicorns. Why startup finance is broken and how to fix it. Welcome back to the Modern Law Library. I am here with Renee M. Jones to talk about her book, Untamed Unicorns: Why Startup Finance Is Broken and How to Fix It. So Renee, I want to get to your suggestions for how policymakers can fix the system. But first I think we need to talk a little bit about why is this dangerous? If this was only extremely deep pocketed private firms risking their own money, then it would be like someone else going to the casino doesn’t necessarily impact me financially. I don’t quite understand the choice, but I’m fine with it.

All right. If that’s how you want to spend your hard-earned money, well, okay. But we can’t be so laissez-faire about this because there are ripples that can affect the regular people. Can you talk a little bit about why this is dangerous and how it can cause societal harm when we allow all of these things to be taking place in the private market?

Renée M. Jones:

Sure. So I think just to start at a very high level, I think it’s an issue of transparency and accountability. So with private companies, startups that are private companies that aren’t subject to the SEC’s disclosure rules, we don’t have a lot of transparency. That means that the companies aren’t required to provide disclosure to their investors, to the SEC or the public. So we don’t have a lot of insight into their operations. And that gives them the opportunity to grow, to develop market share while they’re being shielded from the eyes of, or the observation of their competitors, their employees, regulators in the public. So they can amass significant market power while they’re engaged in anti-competitive behaviors or where they’re violating or at least skirting the laws. So one of the big concerns is that startups are taking advantage of the secrecy to engage in, we could call it antisocial or unsocial behavior, but there are not really any mechanisms for the public to really see what’s going on.

So they acquire this massive market power. They’re using the VC’s money, the hundreds of millions or billions of dollars that VCs are investing in them. And then they’re able to use that market power and the money from the investors to work to change the law, to evade the law and outmaneuver regulators. So what we’ve seen is in many instances, startups at the very early stage and while they grow, they’re engaging in non-compliant behavior. So one example would be Theranos. So Theranos claimed that they had developed technology that would allow dozens of blood tests to be conducted on a single drop of blood, but the company was able to operate in secrecy. So even though the product didn’t work and some employees knew that and tried to blow the whistle, the company led by Elizabeth Holmes grew to unicorn status. She was at one point the most wealthy, I think, self-made woman entrepreneur, but it turned out that the product never worked.

So again, if Theranos’ investors and directors understood that they were going to have to go public and prove that the product worked, they would’ve been more demanding on Elizabeth Holmes most likely, and they wouldn’t have been able to get away with all of those lies. Another example I think is Uber, which when they started off, they weren’t complying with taxi rules. They weren’t complying with the rules for background checks. And so –

Lee Rawles:

Or labor laws or there’s a whole lot of – Or labor

Renée M. Jones:

Laws,

Lee Rawles:

Yes.

Renée M. Jones:

Classification.

Lee Rawles:

In various cities, there are taxi laws and they just went, but we’re different.

Renée M. Jones:

Yeah. Classification of employees, all of those issues. And so their laxity or their carelessness with respect to background checks, for example, subjects their riders to risks of violence or sexual assault. And that’s a problem that has continued to unplague Uber and even Lyft to this day.

Lee Rawles:

A phrase that you used in the book that really struck me was domination via predation. And it sent a little chill through my spine. Can you talk about this particular way that startups are operating and what the danger is then to society?

Renée M. Jones:

Again, they have a lot of money. They’re raising tens of millions, hundreds of millions, billions of dollars from venture capitalist investors. So that gives them a lot of leeway to offer their products and services at below cost and seek to drive their competitors out of the market. So of course we’ve seen this with Uber and Lyft where they’re able to drive more traditional taxi cabs out of the market. It’s much more difficult now to hail a cab, for example, on the street than it would’ve been 10 or maybe 20 years ago. That’s one example. Another example would be WeWork. It grew massively, grew massively around the world, but mainly the way that they did that is that they were offering the office sharing spaces at a below cost to drive other competitors out of the market. So WeWork was never able to really develop a sustainable, profitable business model, but still it grew to be one of the largest unicorns and almost went public, again, by pursuing the strategy of what some of my colleagues have called venture predation.

Lee Rawles:

And the ultimate idea here behind doing this is once you drive the competitors out of the market, then you raise your prices and you have a captive audience that can’t go anywhere. So then all of us end up paying more. So that’s one way that society can be placed in danger. I would love for you to get into something that I think most of us just try not to think about on a daily basis. Just set it aside, say that’s future me’s problem, and that is all of our retirement funds. So what are the big private investor firms doing that could actually impact those of us who hope to one day retire, even if that may be 30 years away?

Renée M. Jones:

So I’ll start with venture capital. So most of us who are saving in our 401ks or other retirement plans are investing in mutual funds that are managed by companies that are well-known. I could guess Fidelity would be one and Vanguard would be another. That’s pretty typical to be in someone’s 401k plans. And when we put our money into these 401k plans, generally speaking, we’re thinking, well, we know we’re taking risks because we’re investing in stock. And of course investing in equity is risky. The value of our equity can go up or down. But generally we think we’re investing in kind of blue chip, well-known public companies that are providing disclosure where investors have significant rights. They can sue. If there’s fraud, they have voting rights and they can potentially vote out. Poor managers, they can sell their shares and that would put pressure on the existing board to replace underperforming managers.

And that’s where most of us think, well, that’s where our money is. But as startups started to stay private for longer, again, we’ve talked about this maybe 10 or even 20 years, some of the managers of these mutual funds thought, “Well, we want to get in on the opportunity of these fast-growing startups. There are not as many of them going public and they started investing in startups in the late stage financing rounds. So some of us who are investing in some well-known mutual funds may, without knowing it, be investors in a lot of startup companies. So Fidelity was a big investor in Uber. It was a big investor in WeWork. And when those companies started to flounder or when WeWork failed, they lost a lot of that money. So that would be one example. But a bigger concern that I have these days is that venture capitalists, the money that’s been invested in these venture capital firms and the money that in another type of private fund called private equity, the money that’s invested in those private equity private companies, the ability to achieve an exit, which of course is the goal, is being challenged.

So we’re seeing startups stay private. We’re seeing private equity companies, they buy companies, they run them for a short period of time, and then they want to flip them or sell them and put them back into the public market. And both venture capital firms and private equity firms are having a lot of difficulty achieving these exits. That is, they can’t sell the companies that they’ve invested in or the companies that they’ve bought at the valuations that they’re holding them at in the private markets. So what we’re seeing is a lot of efforts to sort of work around that problem. And one of the ideas, at least that private equity has come up with is that regular retail investors, people like you and me, saving in our retirement plans should be allowed to invest in private equity without disclosure, without actually making that choice because the choices of course are made by the mutual fund managers, not by us.

So we’re seeing a big effort by private equity and private asset managers working with the Trump administration to open up 401 plans to these private risky assets that are generally illiquid, that don’t have to provide disclosure. And the goal or the plan is to use what’s called target date funds, which are a default fund, a default option for most 401 plans that automatically enroll their employees in a plan. So imagine you join a company, you’re offered a chance to invest in a 401k plan, you get busy, you get confused, you don’t know what that means. You don’t know what to do. In many instances, you’ll be automatically enrolled. And the idea of automatic enrollment is that by failing to make a choice, by failing to invest, you’re giving up an opportunity and you might reach retirement without enough money. So if you’re automatically enrolled, you’re going to start saving automatically.

You don’t have to think about it. And when you leave your job or when you retire, you’ll have money because it’s automatically being taken out of your paycheck.

Lee Rawles:

And from your perspective, you’re like, “Well, I put 7% of every single paycheck goes straight into my 401k. So that money is safe, that money will grow, and it’ll be there for me when I’m ready to retire.”

Renée M. Jones:

Right. So it used to be you had to sign up. Now you’ll be automatically enrolled unless you opt out. And again, that’s because people weren’t taking the step that they really ought to take in order to start saving for their retirement. So if you’re automatically enrolled, your money has to go somewhere. And there’s going to be a default option that the 401k plan chooses. And typically that default option is what’s called a target date fund. And a target date fund is set up so that, again, the employee or the worker doesn’t have to spend a lot of time thinking about what’s in their 401 plan. So we’ll start off, if you’re very young, they’ll start off with a pretty aggressive investment portfolio that consists of a lot of stock. And then as you get older and you approach retirement, that investment mix is going to shift over time to be a little bit more safer.

So probably more bonds and less stock. But the idea is you invest in it, it’s safe, and they’re making adjustments as you age to reflect the appropriate level of risk. Okay. So that was a long explanation as to what a target date fund is, but it’s important because the idea that private equity managers have is that everybody’s target date funds should have a little bit of private equity in it. So the people who are not paying attention, who didn’t choose to be in a 401k or didn’t make an active choice, I should say, and who didn’t make an active choice about how they wanted to invest their funds are the ones who are most likely to end up if they’re in a target date fund with private assets. That includes private equity, it includes infrastructure. It could even include crypto. Again, these are illiquid assets.

There’s no ready market for those shares. And they’re high risk assets and there’s not a lot of information to even know what am I actually invested in? Those are the people who are most likely to end up with private equity. And you’re going to have to work really hard if you are a 401k investor. If the Department of Labor’s plans are adopted, you’re going to have to really work hard to avoid having any private equity in your 401k plans.

Lee Rawles:

And now I would never suggest that a private equity manager would make anything but the most moral decisions that are ethically good for society. That being said, they have invested lots and lots of money into this company that at the moment is still private and then found out there’s not a market for it. People don’t want to buy it. Maybe the initial promise it showed never panned out. Maybe there are other risky things about it that no one’s willing to take on this company. So one way that they get their money back is to say, “Hey, suckers.

Small time people who maybe aren’t used to this kind of financial system, you want to own part of a startup, right? Do you remember Apple? Do you remember what happened with those shares? You could be part of this without the targeted private people or 401k investors understanding that this company hasn’t met its promise. It’s not that it’s necessarily worthless or it’s going to go out of business, but the value that we say it has, we don’t actually have backing for that. There’s no way for them to check it out when it’s a private company. Is that correct?

Renée M. Jones:

The valuations in the private markets are fairly subjective. There’s no active trading market in those shares. And so the investors decide what the company is worth. They put in their money, they say we’re putting in this money at X valuation. That gets announced to the public and that’s deemed to be the value of the company, even though it hasn’t really been checked by any other standard financial valuation tools. So that’s one problem. So if these private equity interests or venture capital interests are transferred into people’s 401k plans or into funds that are going to be going into these people’s 401k plans, who’s doing the valuations? It’s going to be the private asset managers. And you’re just going to have to take it at their word that the value that they assign to those interests is what they’re worth. So one thing I would add is that private equity is a sort of private investment vehicle.

It’s a little bit different than venture capital. In venture capital, the venture capitalists generally take a minority stake in the firm. So they might own up to 30% of the firm, but they don’t have control. Whereas private equity, they will usually acquire 100% stake in the firm. They’ll have complete control. They’ll take it over. They’ll try to achieve efficiencies. They’ll try to make it run better. And then they think, well, we fixed this company up. We’re showing that it’s run better. It’s making better profits. Now we can go ahead and sell it because we’ve improved its value. So in private equity and also in venture capital, what we’re seeing is that their traditional investors, which are large public pension funds and also university endowments, they’re getting impatient because they’re not getting their money back when they expected it because of this liquidity problem that I’ve described.

So they’re getting impatient. The universities are facing trouble. They’re sort of getting a lot of hassle, I would say, from the Trump administration and they’re running out of cash and they’re trying to get out of some of their private equity investments. So at the same time that these traditional VC and private equity investors are seeking exits, that’s the same time that the Trump administration is trying to accommodate their desire to get into our 401 plan. So there’s a risk that these overvalued assets are going to be transferred from professional investors who can act to protect their interest to sort of your average unsophisticated 401k saver.

Lee Rawles:

The other group that I think about, and maybe they’re not top of mind, but as you told us at the very start of our show, the IPO, when that happened, that was the target that a lot of these startup employees were working towards, the founders and the employees. That was the payoff. For many Silicon Valley workers, the first few years in that company were very lean. You may be taking home no money and you hope you have a spouse that has a steady job with health insurance. And the IPO was what was at the end of the tunnel. If instead of that happening in A four to seven year time span. We’re now 20 years out. The payoff for those employees was supposed to happen at the IPO. How is this impacting tech workers? Because the traditional payoffs are not happening at the traditional timeline.

What’s happening in Silicon Valley now that this startup financing system has changed?

Renée M. Jones:

So definitely the risk that employees are taking on has changed when the sort of timeline to the IPO has expanded. As you mentioned, typical part of the startup financing model is that employees are going to be compensated with equity. Either stock options or restricted stock, some form of equity in the company, that equity doesn’t vest immediately, meaning they have to stay for significant number of years. It’s usually four years before they’re fully vested in any grant. But even when they’re fully invested, there’s no market for their shares. So they might exercise their options. They might own the shares outright, but it’s going to be very hard for them to sell them. So we did see the development in about 2010 of what’s called private trading markets for startup shares. And that’s where employees can go on these private trading platforms, their electronic platforms and seek out buyers for their shares.

So that’s a little bit of liquidity available to investors, but it’s kind of hit or miss. There’s not a lot of information either for the sellers or the purchasers about the value of the shares. And you don’t know who you’re selling to. They may have more information than you do. You don’t necessarily know exactly what the shares are worth, but you might say, “Well, I want to buy a house or a car, so I’m willing to take some of this off the table.” So there have been mechanisms developed to provide some liquidity for startup investors. Another mechanism is that the company, when it’s going through a later financing round, will say, “Hey employees, you can sell a part of your portion of your shares to these new investors.” So there is this new mechanism for liquidity for employees, but nonetheless, they’re taking on significant investment risk.

And if they don’t get information, the securities laws don’t require the startup to provide sufficient information to employees that would really enable them to value their shares. And one of the concerns I have about this system is, again, you have to remain an employee at the time of the exit event to really benefit from that exit when it occurs. So people are kind of hanging on for dear life thinking next year’s going to be the IPO and that’s when I’m going to get rich. And that works out. It’s worked out maybe for the SpaceX employees. I think there are about a thousand of them that became millionaires, but for every SpaceX that mints a thousand or thousands of millionaires, there are plenty of other startups that go bust or sold well below their private valuations. And in some of those instances, at least I write about some in my book, Good Technologies in Airbnb.

The investors lose out. They don’t get the benefit of their equity. Some of them have actually spent a lot of money exercising their options, paying the taxes due on options, and then the IPO fails. I think this happened with WeWork and they’ve put all in all this money thinking, “Wow, this is a good time. I can exercise early, reduce my taxes.” And then the IPO falls apart and they’ve lost all of that money.

Lee Rawles:

Well, it sounds like a real mess. We’re going to take a break to hear from our advertisers. And when we come back, Renee is going to offer some suggestions for how we can increase transparency and clean up some of this really scary risk. Welcome back to the Modern Law Library. I am here with Renee M. Jones talking about untamed unicorns, why startup finance is broken and how to fix it. We’ve done it. We’ve reached the portion of the show where we talk about how to fix it. And just for listeners who are interested in picking up the book, Renee has so many really great anecdotes in here about specific companies, some kind of chilling case studies. And I really do encourage you to pick it up and dive into those because there’s some really eyebrow raising examples in there. So if you like a good economic horror story, there are definitely some in there.

But Renee, how do we fix this? What’s the roadmap for reform?

Renée M. Jones:

So yes, so there are a lot of problems that I address throughout my book and there are a lot of, like you said, hairy, I would call them hairy anecdotes, but there are ways to address the problems. I think overall my argument in my book is that the securities laws have basically been sort of turned into Swiss cheese with all the loopholes that have been opened up to the registration requirements, which were basically adopted to that ensure that investors are fully informed when they make investment decisions. That is, the government doesn’t tell you what companies you can buy or who can raise money from investors, but it does require, at least the law ostensibly requires if you want to raise money for investors, you have to tell them the truth and you have to give them sufficient information so that they can make good decisions.

And that will help ensure that capital is allocated efficiently. That is that the money that we invest is put to its best and highest uses. So that’s the idea, that’s sort of the underlying theory that undergirds all of our securities laws.

Lee Rawles:

And just a reminder, every investor dollar that goes to a company that there’s not even a chance it can succeed, it’s still on its last gaps, that’s money that didn’t go to a company that maybe could have produced some really groundbreaking technology and made a lot of money for that investor and done a societal good for the rest of us.

Renée M. Jones:

Very well said. I think that’s a good way of putting it. It’s another way of saying allocational efficiency, probably a little easier for your listeners to understand.

Lee Rawles:

Yes, I don’t think I’ve ever said allocational efficiency.

Renée M. Jones:

Okay. So the idea is investors need information to make good decisions. So all of my reforms are basically based on that basic philosophy, ensuring that investors are adequately informed whether they’re investing in public markets where we have a good disclosure regime or in private markets where we’ve basically weakened significantly to the disclosure regime. So I focus on four key areas. One is the main exemption that startups and all private funds rely on when they raise capital from investors. And it’s called Regulation D. It was adopted back in 1982. And I really look at very closely at Regulation D, what it has accomplished, what it hasn’t accomplished. And I basically argue we need to ensure that investors who are buying securities that are issued under Regulation D are adequately informed and that the SEC has adequate insights into what’s going on in that market. So improving the disclosure, not just to investors, but the kind of information that these companies provide to the SEC when they sell securities in these exempt transactions.

Next, I look at employees. We’ve talked about how employees are largely in the dark when they make decisions about whether to stay in their jobs, whether to leave their jobs. If they do leave their jobs, should they exercise their options or leave all that sort of paper wealth on the table? So they’re making these decisions in the dark. There’s an exemption that startups rely on when they issue securities to their employees. That’s called rule 701. And I look at rule 701 and I try to ensure that, okay, you don’t have to register with the SEC if you’re selling, maybe you’re selling these securities to your investors. Maybe that’s okay. But you do have to give those investors, those employees, adequate information so that when they decide to take a job, to leave a job, to exercise their options, et cetera, they’re making that decision with a better understanding than they now have about the company’s prospects, about its financial situation, and about the best likely valuation for their shares.

I look at what’s going on in private trading markets. So that’s where employees and early investors and founders are selling shares to other investors on these private trading markets. There’s a number of them that exist. Equities in, Forge Global are a few. But people who are going onto those markets to buy those shares, invest in those companies don’t necessarily have sufficient information. So there’s no standard disclosure that’s required when a shareholder or a company or a platform says, “Are you interested in buying Stripe or Sheen or whatever is the other hot startup company?” So you can buy those shares, but the question is, are you buying at the right price? And there’s not enough information available about these companies to really, again, make sure that you’re paying the right price. And there are concerns about insider trading because some of the people in these markets are well-informed and some of the people in the market have no access to inside information.

So there’s a securities law provision that says not only are companies raising money required to register their securities, anyone who wants to sell securities has to register their sale unless they have an exemption. And the exemption most of us rely on is called the trading exemption. If we’re buying or selling shares, for example, on the stock market. But that exemption doesn’t apply if you acquire your shares in a private offering that wasn’t registered with the SEC. So it used to be that you had to hold your shares that were acquired in a private placement or a private offering for three years under SEC Rule 144. That three-year holding period was shortened over time, first to two years, and now to one year. So now when a startup employee exercises their option, they can resell their shares as long as they’ve held those shares for at least one year.

And again, that’s facilitated the development of these private trading markets. And then finally, I look at the 500 shareholder rule. I think we talked about this at the beginning. The 500 shareholder rule that’s called Section 12G. And it used to require, again, if a company got large at 500 shareholders, by that point in time, they knew they’re approaching that limit. They’re going to have to prepare for an IPO. So when Congress changed that 500 shareholder limit to 2000 shareholders, that’s what allowed not only startups to grow large, but to continue to grow and to remain private even when they’re much larger than so many of the public companies that are required to make disclosure and comply with federal corporate governance rules. So I argue we should restore the 500 shareholder rule that would take an act of Congress. But even if the Congress doesn’t act, the SEC has rules interpreting Section 12G, and I argue they should look at those rules and close the loopholes that investors and startups are using to evade what is now a 2,000 shareholder registration threshold.

Lee Rawles:

You also mentioned that current Supreme Court doctrine does not have a very consumer protective stance on predatory pricing claims, that it’s hard to get that through the Supreme Court. So I think many or maybe most of my listeners are attorneys and they may be saying, okay, well, this all sounds like it’s going to take policymakers specifically in Washington, specifically the federal government. What do I do? And well, maybe you aren’t going to be able to take a predatory pricing claim case to the Supreme Court, but I would love to hear from you what your advice would be to lawyers and then to the general public when it comes to addressing this or who should we be putting pressure on? Who can you be calling? Well, what can you be pushing for and who should you talk to about it? I

Renée M. Jones:

Think the first thing I would say is to pay attention to what’s going on. A lot of the changes that I’ve mentioned, the deregulation or the expansion of these exemptions are happening under the radar. There are a lot of little changes that most of us never notice, have never heard about. So one thing I would say is to pay attention to what’s going on. So when the Department of Labor says we’re going to open up 401 plans to these illiquid, opaque, risky assets, I think the public needs to pay attention. The public is paying attention. The comments that have gone to the Department of Labor on this proposal, there are tens of thousands of comments. Most of them saying, “Hey, please don’t wreck our 401k plans.” The SEC has proposed shifting. This is talking about public companies, but shifting from a system of quarterly reporting, mandatory quarterly financial reporting, to a system where companies can choose instead of reporting quarterly to their investors just to report to them on a semi-annual basis.

That proposal went up for public comment. The public rang in resoundingly, I think 99% of the public said, “Don’t make this change. We want to continue to get access to information.” So pay attention, speak up. A lot of these rules are put out for public comment. The more people comment, giving sober, thoughtful reason comments, the more difficult it is for these changes to be adopted and the easier it is to challenge them in court. With respect to your 401k plan, ask questions, do your own research. It’s really hard to find independent investment advice. A lot of the investment advice that you’re going to get is going to come from a Fidelity or a Vanguard, and it might not be at the level of detail that you need, and they may have significant conflicts of interest. So listen to what they say, but do your own research and look at not just what mutual fund I’m invested in, but what securities is a mutual fund investing in?

What does my portfolio really look like when I get past just the name of the mutual fund to the companies that they’re investing in? And if they’re investments in companies that you don’t understand or in securities that are illiquid, I mean, you have to really think about, are you comfortable with that level of risk?

Lee Rawles:

Is this something where if you worked for a sufficiently large business, you could approach the finance department and say, “Hey, I’ve been hearing these scary things about our 401ks and being exposed to startup finances. Could we as a company look into that and say, we’re not interested in our employees having that?” Or is a 401k more individual? Is that something you would have to do on an individual level?

Renée M. Jones:

So I am not an ERISA expert, but I do understand enough to say that every 401k plan has trustees and the trustees are the ones who are in charge of choosing the funds that employees are permitted to invest in. So theoretically, at least, employees can try to identify who those trustees are or communicate with their employers and say, “We’re concerned about this.” What’s happening is that there’s lots of pressure from the industry to convince these trustees that this is what’s best for investors. Again, they’re not talking directly to investors, but they’re talking to the people who have the responsibility to put together their plan menus and saying, “Everybody should be in private equity. This is what public pension funds are doing. You have this, maybe not this obligation, but it would be good for your employees to have this.” And then the trustees have to make that choice.

To the extent that those trustees, whoever they are, if you can figure out who they are, hear from their employees that this is not what they want. I mean, I think the DOL comments file reflects that. That might give them pause or at least cause them to ask questions. But again, they’re outgunned, they’re outwitted, they’re being outspent. So I don’t have a lot of confidence in them holding the line.

Lee Rawles:

Oh, everybody’s forgotten about NFTs and that just happened.

Renée M. Jones:

Yes. And FTX and the crypto winter and all these other disasters that were just a few years ago.

Lee Rawles:

I would say a rising concern I have had is with AI companies and the lack of transparency, but massive amounts of the available money out there is going into the AI companies. And I have no crystal ball, but they have not turned a profit yet. They’re still very reliant upon venture capital funds to continue operating. And you don’t have a crystal ball either, but you have more of a sense than I do. Do you have concerns about the lack of transparency specifically when it comes to AI companies? We are putting a lot behind this. A lot of businesses are making decisions based on the idea that it’ll always be here and it’ll always be pretty cheap to access.

Renée M. Jones:

Yeah. I mean, we talked about below cost pricing and then all of a sudden that changes. I think some corporations are now seeing that with how much they’re spending actually on AI when it’s not free anymore. But what I would say generally with respect to the venture capital market and the unicorn problem, so many of these AI companies, OpenAI, I guess XAI, which is now public, it’s part of SpaceX. It went public as part of SpaceX. And Anthropic, these are the Centicorns, the $100 billion private companies. Again, it’s

Lee Rawles:

Unheard of. Say that again. What

Renée M. Jones:

Is it? $100 billion companies. Yeah. SpaceX when it went public. Centicorn.

Yeah, Centicorns went public at I think $1.7 trillion valuation. So there’s a lot going on. A lot of assets, a lot of employees, a lot of the economy is sort of encompassed within these companies. So they obviously aren’t providing the kind of disclosure that a public company would provide. I mean, SpaceX through XAI did disclose a lot of information. So these are unlike the other unicorns that I talked about that were asset-like because they were just platforms and they just didn’t require that much cloud space. AI is very different. It’s very capital intensive. They’re raising billions of dollars at a time. They’re borrowing, I would assume, billions. SpaceX just borrowed billions. And it looks to me like they can’t continue to grow in private markets. They’re going to have to turn to the public markets. Both OpenAI and Anthropic are preparing at least for their IPOs.

SpaceX didn’t do so well, so we’ll see if they turn around and try to follow in their footsteps. But my biggest concern, it goes back to the question, I think you raised this of if all this money is going to AI, what’s not getting funded? 50% of the money raised in the venture capital market last year went to AI companies. So that means people working on all other ideas, other forms of innovation are going to have a lot more trouble raising money. And there’s a lot of concern that we have an overinvestment in AI with respect to chips, data centers, et cetera. So a lot of that money is probably, it’s very duplicative. We don’t know who the winners and losers are going to be, who’s going to have a dominant model. Once a winner emerges, some of that other investment is probably going to become worthless.

But again, I can’t predict, but I think that’s just kind of what I see happening potentially.

Lee Rawles:

Well, Renee, if your subsequent book is on, what would it be? Milicorns?

Renée M. Jones:

I don’t know. We haven’t come up with a term yet.

Lee Rawles:

We haven’t come up with a term yet, then please come back and talk to us about it. And if listeners are interested in picking up Untamed Unicorns, where can they do that?

Renée M. Jones:

So Untamed Unicorns is available for pre-order on Amazon, on Barnes & Noble, and on bookshop.org, which connects to your local bookstores and also available anywhere you buy your books.

Lee Rawles:

And if you are listening to our conversation after August 4th, it is in those bookstores. You can walk right in and pick it off the shelf. All right. Well, Renee, thank you so much for joining us for this episode. If our listeners wanted to reach out, learn more, contact you, is there anywhere that you would point them to? Could be your Boston College Law School page, anywhere that they could connect with you.

Renée M. Jones:

Sure. I’m on LinkedIn, so under my name, LinkedIn. And I’m also on my Boston College Law School website, and my contact information is available there as well. And I post information about my work, my publications, my press coverage, and also events that I’m planning around this book.

Lee Rawles:

Wonderful. Well, again, thank you, Renee, and thank you listeners of the Modern Law Library. If you enjoyed this episode, please rate, review, and subscribe in your favorite podcast listening service. And if you have a suggestion for a book you’d like me to cover in a future episode, you can always reach us at [email protected]. Thanks for listening.

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