Jerry Schlichter Featured in Economist Article
ATTENDING a baby-shower is not an obvious means of contributing to the vigour of American capitalism. But when thrown for one of 24 investors in Julia Jacobson’s small startup, NMRKT, which enables boutiques and small manufacturers to create appealing electronic marketplaces for their products in half an hour, it is vital. Since 2013 the company has amassed 150 clients and is now considering its fourth round of financing. Attending social events helps Ms Jacobson and her equivalent at other startups to take stock of what investors want. This enables them to confront an enduring inefficiency of the market: aligning the interests of investors and owners.
Investors’ opinions matter hugely to young firms like Ms Jacobson’s. Judgments abound and diverge on the value of a startup without the ability to test it in an open market. One investor pushed Ms Jacobson to think about a dreaded “down-round”, basing new fund-raising on a reduced valuation of the company. Others were eager to invest at a higher valuation or buy the company outright. By controlling the purse strings, investors have a great deal to say about the future growth of tiny endeavours like hers.
The personal touch may be useful but it is not the main way that startups stand apart from traditional firms. The most distinctive aspect of America’s vibrant startup sector is the way the ownership of companies is structured. A new breed of firms such as Uber, a taxi-hailing app, or Airbnb, a website that lists properties for short-term rental, is establishing a novel type of corporate arrangement. Investors, founders, managers and, often, employees have stakes that are delineated by carefully drawn contracts, rather than shares of the sort that trade on exchanges.
For people like Ms Jacobson these contractual arrangements provide an experience of ownership that sidesteps the concerns of public companies, by avoiding the contentious regulations and politics that surround big businesses. That should make for better-run firms if managers are fully focused on transforming a concept into a successful company.
Working this way is not easy. Conflicts between the parties arise all the time, over valuations and much else. But it allows such firms to reach pools of capital that an old-fashioned family business would not have got its hands on. Startups typically begin with savings, or money from family and friends, but then tap outside investors for seed funding through a variety of channels, including lawyers, accelerators (in essence, schools for startups) and other “angel” investors with cash to back founders with ideas. These increasingly include entrepreneurs who made money from their own startups and now invest in others. Indeed, the number of small deals has increased substantially in recent years (see chart 1).
Jerry Schlichter’s day-to-day experience untangling questions of ownership is less uplifting. Mr Schlichter is a lawyer who works not on heading off conflicts in small firms but on attempting to get better deals for investors in larger ones. He specializes in suing firms and financial institutions over their management of 401K pension accounts, through which a large number of Americans save for retirement. The money invested is automatically removed from pay cheques by employers, making workers, in the words of Leo Strine, chief justice of the Delaware Supreme Court, “forced capitalists”.
Contract and expand
As in Ms Jacobson’s world, there is a distinction between what it is to be an owner and an investor. But unlike the contract-heavy world of the startup, that distinction is not well defined and indeed in many ways it is denied. The language used, and the law applied, seems to treat such forced capitalists as owners. But they lack almost all the rights and freedoms that privilege might normally afford.
Interests are misaligned along the entire chain. An employer running a 401K selects a committee which selects an investment provider which in turn selects fund managers who select companies whose—selected—board members appoint managers. Each step is swathed in regulation that, even if well-intentioned, is shaped by lobbyists to benefit one or other of the parties rather than the system as a whole.
This layer-cake provides ample scope for mischief, as Mr Schlichter’s business attests. But even if it were to operate without added complications, the different interests of the different layers would impose large and inescapable costs. Fees, such as those charged by mutual funds, are unavoidable at every level. More insidious is the “agency problem” that arises from conflicts of interest between people who provide money and all the parties through which it travels to and from investments.
Agency problems make the idea that a company is actually owned feel almost illusory. The link between the interests of the forced capitalists in 401Ks (and federal-government pension schemes that are broadly similar) and the management of the assets they purportedly own is, at best, compromised. The experience of owning a company no longer accords with what is normally meant by ownership.
The new model of capitalism practised by Ms Jacobson and thousands of other startups is an attempt to get around the inefficiencies and costs imposed by the agency problem. The allocation of rights in a public company is unarticulated and ambiguous. Attempts to fix this through demands for more transparency and regulatory changes, such as the Sarbanes-Oxley reforms introduced in the wake of the Enron scandal, may have helped in some ways but have added to the costs and complications by adding another level of bureaucracy and more red tape.
The fragmentation of ownership is an unintended consequence of the rise and development of the public company. In the 19th century, American limits on banks’ ability to lend restricted credit, but a strong legal system supported contractual agreements, notes Robert Wright of Augustana University in South Dakota. That enabled capital to be raised through direct public offerings, which were instrumental in the early development of American industry.
Over time, mechanisms emerged to trade these direct offerings in regional and national financial markets. Stock markets were not the only source of finance and the joint-stock company not the only model of ownership. But big public companies became the capitalist norm.
A result of this democratisation of ownership was its dilution and the loss of one of its components—control. Shareholders lost their grip on ownership and the collective strength to manage their agents, who ran companies. In 1932 Gardiner Means and Adolf Berle argued in “The Modern Corporation and Private Property” that the outcome was that companies became akin to sovereign entities, divorced from the influence of their “owners” by retained earnings that allowed managers to invest as they chose. As companies became ever larger and more powerful, government felt the need to constrain them.
Laws and regulations have increasingly limited what companies can do, including, most recently, the amount of profits they can return to shareholders. To help owners evaluate whether to buy or sell shares, companies are forced to disclose ever more of what they are up to, but the usefulness of this information is undermined by the layer-cake of agency issues.
Individuals have been net sellers of shares for decades; in their place institutions have expanded relentlessly. Financial institutions now hold in excess of 70% of the value of shares on America’s stock exchanges (see chart 2). The leaders include such familiar names as BlackRock, Vanguard and JPMorgan Chase.
Their size gives the biggest financial firms a great deal of influence. But just as managers of a company may not find their interests aligned with those of shareholders, so the managers of these investment firms may not share the interests of their investors. This creates what John Bogle, founder of Vanguard, calls a “double-agency” society in which the assets nominally owned by millions of individuals are in the hands of a small group of corporate and investment managers whose concerns may differ from those of the masses.
Surprisingly, given America’s litigious nature, few, if any, legal actions emerged in this area until 2006 when Mr Schlichter initiated a string of cases that accuse American companies of not acting in the best interest of their employees who participate in 401K plans. His first court victory came in 2012. This year he has won settlements from Boeing and Lockheed Martin. His extensive briefs provide a window into a complex world with layer upon layer of hidden costs and conflicting interests.
The disparity between the fees some institutions charge and their performance has recently received much attention, in part because, as an issue, it is both understandable and relatively transparent. Less easily quantified bones of contention may matter as much or more. For instance, a disparity between the pressure investment firms place on companies to perform in the short term and the time-horizon of investors, which may be much longer, has given rise to complaints voiced by Mr Bogle and others about a destructive “quarterly capitalism”. And Jamie Dimon, head of JPMorgan Chase, has criticised investment managers as “lazy capitalists” for farming out decision on crucial shareholder votes to consultancies. Those consultancies, working as they do for many investors, are open to conflicts of interest themselves.
No fund to be with
Agency issues are particularly acute in the fastest growing part of the money-management business: the index funds which now represent a third of all the money in mutual funds. They are popular because in an efficiently priced market they are hard to outperform and can be managed at almost no cost. But they do not make their own decisions about when to buy and sell but simply seek to match the holdings of the index, such as the S&P 500, that they track. This low-maintenance approach does not generally include employing stakes to intervene in company decision-making.
Large index managers such as Vanguard, BlackRock and State Street, along with Legal & General in Britain, are acutely aware of this issue. They are responding by trying, in the words of Vanguard’s Glenn Booraem, to be “passive investors but active owners”. Each firm has created a department to consider shareholder motions and management issues, and to interact with activist investors. It is unclear how this will work or what will be considered. As their power grows, so will controversy.
As huge funds ponder the agency problem, New York’s startups are trying to do away with it. In years gone by, entrepreneurs in small businesses would have existed in an informal state. Now the terms of ownership for investors, founders and employees are being defined ever more tightly almost at the time of the creation of new businesses. Clarifying issues of ownership along with innovations in finance is encouraging the availability of capital and expertise, once harder to come by for the small business.
Visit 85 Broad Street in downtown Manhattan to see this in action. Until 2009 it was the headquarters of Goldman Sachs and at the beating heart of American finance. WeWork, a firm that houses young companies, has now taken over six of its 30 floors to house 2,000 of what the firm likes to call its members. The stream of limousines with blacked-out windows that surrounded the building during Goldman’s tenure has thinned, replaced by swarms of people in an array of startup-wear, from tartan shirts to hoodies.
WeWork has 30,000 members in over 8,000 companies in 56 locations in 17 cities. A number of other co-working spaces exist, such as the Projective, which housed early incarnations of Stripe, an online-payment system, and Uber. Demand is booming for the desks that served as launching pads for firms that now flourish. Apartments in Williamsburg, Greenpoint, Bushwick and other newly fashionable neighbourhoods are filled with startups.
In at the startup
Startups with appealing ideas and driven employees but with no contacts, business expertise or capital can receive all those through institutions such as Techstars and Dreamit Ventures, which receive thousands of applications every year. The handful that are selected get money, advice on strategy, marketing, leadership, legal help and access to investors—all functions large firms either provide internally or through pricey consultancies. In return, the nurturers receive small equity stakes and, if they have chosen the right startups and given them the right boost, a reputation that will attract further promising corporate youngsters into their orbit.
New companies have always suffered because commercial banks cannot lend to firms lacking assets and revenues, nor can the firms pay the high fees and retainers demanded by traditional investment banks and law firms. But an elaborate system has begun to emerge for both. Some will be able to get initial capital at effectively no cost from crowdfunding sites like Kickstarter and Indiegogo. An enthusiastic reception can attract bigger investors. This was the route taken by Oculus VR, a virtual-reality startup acquired in 2014 by Facebook for $2 billion.
More common is the creation from the outset of a company that can receive more usual forms of investment, albeit in a novel way. Law firms with experience in the older startup culture of the west coast, such as Cooley and Gunderson Dettmer, do a lot of business setting up such things in New York; so, perhaps unsurprisingly, do a number of law firms that are startups themselves. Spencer Yee left a career at Simpson, Thacher & Bartlett, an established law firm, to work from home on Manhattan’s Lower East Side but has since moved to a co-working space.
Lawyers in the startup world play a vastly different role from those who advise—or sue—large companies. This is in part because of the nature of their clients; often tottering between failure and success they rely more heavily on outside advice. But it is also because lawyers, in the early stages, have replaced banks as the key intermediary for financing. But most importantly they negotiate directly with investors and physically maintain the “cap structure”—the all-important legal contract noting who owns what.
The ambiguities and obfuscation of public companies contrast sharply with the new corporate structures set out by legal contracts that make the rights of both investors and owners more explicit. These legal agreements tackle two fundamental difficulties. The first is the need to mitigate agency problems. This is handled by detailed agreements that include control issues, such as the allocation of board seats. Investors usually insist that management, and often employees, own large stakes to ensure their interests are aligned to the success of the venture.
The second difficulty concerns enabling investment in the absence of an important detail: a plausible valuation. Startups are pioneering a novel answer: an agreement at the early investment stages that enables an investor to buy a proportion of the venture, but at a price determined at a subsequent round of fund-raising, typically a year or two in the future.
The website of Wilson Sonsini, a California-based law firm, offers a 47-step process for generating such contracts; it is free to use as long as you tick a box promising not to claim Wilson Sonsini is your lawyer. The growth of Mr Yee’s tiny firm—he has closed six rounds of financing and two company sales—depends on the need to negotiate each term carefully.
Typically, after initial funding, a founder will retain as much as 60% of the company, with 10-20% reserved for employees and the rest for outside investors. But terms are fluid. Each subsequent round of financing usually dilutes the original stakes by a fifth. That may sound harsh but if the firm’s value is growing fast it can transform a large stake worth nothing into a small one worth a fortune.
The more appealing the idea and the more plausible their record as mangers, the better the terms founders can demand. Annie Lamont, a venture capitalist, points to a management team which, for its first startup, raised an initial $25m and held 10% of the equity by the time the venture was sold. Its most recent startup raised $160m and the team held 18.5% of the company when it was sold. Success lets you raise more money and negotiate a better deal in subsequent rounds of financing. There is no shortage of individuals and institutions straining for a chance to invest in some of the more successful but yet-to-go-public startups like Uber and Airbnb, which have done a series of fund-raising rounds on increasingly attractive terms.
This new way of doing business does not mean there is no role for conventional finance. For all the startups that promise they will never go public—Kickstarter is one—others are keen to do so at some point. Some hope to follow the trajectory of Facebook and Google—vast enterprises, led for a time by their founders, whose shares trade on public markets.
At the moment, however, successful businesses find raising money quick and easy through private means, which gives them no incentive to rush. Using technology to create a secondary market for shares might also means that the biggest no longer need to go public because the ability to extract liquidity from private firms is becoming much simpler. For now, at least, public markets are seen less as a place to raise money and create enterprises than as a mechanism to cash out if and when the time is right.
The flow of money into the startup world is, to some extent, for want of a better alternative. Low interest rates have undermined returns from “safe” investments and encouraged speculation. It would not be surprising if the current upheaval in equity markets curtailed this flow. A similar dampening will be felt if lots of the new firms fail, or if down-rounds become common. Even so, the new structure pioneered by startups is likely to endure as long as it serves as an effective response to the flaws of the public markets. Ms Jacobson is unlikely to have visited the last baby-shower in honour of an investor.