The Institute’s annual Corporate Governance Paper Competition and Presentation Awards, launched in 2006, promotes awareness of corporate governance among local undergraduates. In part one of this two-part article, the authors of this year’s Best Paper argue that traditional agency theory has neglected the unique characteristics of startups, and identify the distinctive vertical and horizontal challenges of startup governance.

Introduction

Entrepreneurs establish startups – companies or ventures focused on pursuing, building and testing scalable business models. These enterprises are typically supported by external funding, notably through venture capitalists (VCs), driving them towards creating novel products or services, achieving rapid expansion and pursuing exits via strategic acquisitions or initial public offerings (IPOs). Moving beyond the initial seed phase, startup ownership usually expands significantly from the founding group. This growth occurs as capital is raised from investor syndicates and as employees receive restricted stock or options that vest gradually during their tenure.

The role of startups in propelling both economic advancement and societal progress is fundamental. Elizabeth Pollman highlights this significance, stating that the leading companies by market value in 2019 – Apple, Alphabet, Microsoft and Amazon – ‘all began as venture-backed startups’. Indeed, businesses originating in modest settings like garages or dorm rooms increasingly shape our economy and society, often operating under VC-influenced ownership and governance structures during their formative years. Following the public listings of giants such as Apple and Alphabet, unprecedented levels of capital flowed into emerging private companies.

However, the current geopolitical landscape is by no means easy for startups to thrive. Under the global background of fragmented multilateralism and resurgent protectionism, the ‘funding winter’ for startups persists. VC funding has now contracted by 35% from the 2021 peak, with early stage investments in emerging economies plummeting 40% since 2023. In addition to difficulties in fundraising, political instability in technological hubs has triggered brain drain, leading to a loss of technical expertise for local startups. All of this has resulted in the low survival rate of startups – a recent study has indicated that 90% of startups fail within five years.

Struggling for startup survival and the place of corporate governance

Under the generally tough geopolitical landscape for startups, a common trend has been to focus solely on financial survival, neglecting the construction of corporate governance for the long term. Indeed, the survivalist mindset stems from legitimate concerns, given that startups must achieve product– market fit before funding is exhausted and that operational speed often determines competitive viability.

However, empirical evidence increasingly contradicts the false opposition between governance and growth. A quantitative study of 174 Indian IT startups demonstrates that integrating governance early correlates strongly with accelerated growth trajectories, with governance emerging as the strongest predictor of sustainable success, which outpaces even environmental or social factors. Companies embedding governance fundamentals from inception achieved better stakeholder alignment, operational resilience and strategic decision-making. Similarly, a systematic review of sustainable startups revealed that those formalising governance structures secured competitive advantages in four key areas – attracting ESG-focused investment, mitigating regulatory risks, enhancing innovation capacity and improving operational efficiency through circular design principles. These startups outperformed peers in scalability and adaptability precisely because governance provided frameworks for managing rapid change without sacrificing accountability.

The lack of corporate governance, conversely, heightens vulnerability for startups. Those without transparent decision rights, ethical safeguards or board oversight risk internal conflicts, regulatory penalties and reputational damage that disproportionately impact young ventures with limited buffers.

Rethinking the role of corporate governance

This paper highlights corporate governance issues through the unique lens of startups and argues that corporate governance is not mere compliance, but serves instead as a fundamental driver of sustainable growth for startups. We examine the traditional agency theory framework, analysing its core features, and argue that conventional corporate governance theories have neglected the unique characteristics of startups. We then analyse distinctive startup governance challenges through vertical (hierarchical) and horizontal (intra-stakeholder) dimensions, proposing a modified agency framework tailored for startups.

In part two of this paper, we will present two case studies that illustrate vertical and horizontal governance challenges, respectively, and build on those to offer practical recommendations for effective startup governance. Finally, we conclude by reaffirming the central thesis – that adopting a robust, dynamic and flexible governance framework specifically adapted to startup features is essential for achieving sustainable growth, even under challenging geopolitical and economic conditions.

General framework – corporate governance through the lens of traditional agency theory

Defining corporate governance

The term ‘corporate governance’, as a broad global topic, is defined in diverse ways depending on the author’s purpose. Building on the Cadbury Report, where ‘governance’ was first defined, a meta-definition provided by The Chartered Governance Institute describes corporate governance as ‘a mechanism and framework in which firms will be directed and controlled’. Scholars have pointed out the coordination of responsibility between multiple stakeholders of a company, such as capital sources, employers and employees. Those who focus on more selective research under the general topic of corporate governance define corporate governance on a more purpose-specific basis. For instance, academics focusing on company regulations may narrowly define corporate governance as ‘a system of law and sound approaches through which the company is directed’. Thus, for the purposes of meta-analysis of the role of corporate governance in fostering growth among startup companies, we have adopted the meta definition of corporate governance.

Models of corporate governance

Over the past few decades, various models – including agency theory, stewardship theory and resource dependency theory – have been proposed to characterise the connection between corporate governance and company performance over time. Agency theory, described as ‘arguably the most endemic theoretical perspective’, is a traditional yet widely discussed model of corporate governance. First advanced by Jensen and Meckling, it defines the agency’s relationship between two parties – the principal (owner) and the agent (manager) – from a behavioural and a structural standpoint.

Structure of the traditional agency model

Jensen and Meckling define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision-making authority to the agent. In the corporate governance scenario, the shareholders are the principals while the directors are the agents. However, if the agent and the principal are both maximum utilisers, the agent is inclined to shirk and prioritise self-interest at the expense of shareholder interests, known as ‘managerial opportunism’. Due to the separated ownership and managerial control, agency costs therefore arise as part of promoting the alignment of interests between agents and principals in a corporation.

Under this general framework, three types of agency cost were summarised by Jensen and Meckling: 1) monitoring costs borne by the principal, 2) bonding costs borne by the agent and 3) residual loss. Further scholarship advancements have sought to reduce shareholder– manager agency costs, thereby improving corporate efficiency.

Features of the traditional agency model

The agency model has been enormously influential in corporate governance development. However, it operates as a static model, overlooking differences between phases of a company’s life cycle, as well as institutional differences between different types of corporation. For example, public and closely held companies demonstrate different institutional structures in corporate governance. For closely held companies, shares are often held by a limited number of people – often those who share close family ties – while shares of public companies are generally traded on a public stock exchange. In addition, for closely held companies, stakeholders are sometimes also the managers of the corporation. The agency theory therefore ceases to apply in that case.

Furthermore, the traditional agency model typically features a standard vertical, hierarchical corporate structure. Jensen and Meckling define the relationship between stockholders and managers as ‘a pure agency relationship’, but, while this outlines the basic stockholder–manager relationship, it also reduces their complex interactions – whether overlapping, conflicting or cooperative – into a rigid dichotomy. In the modern geopolitical context, characterised by political uncertainties, economic fluctuations and diversified corporate structures, the principal–agent relationship demands more nuanced insights into its inherent dynamics.

In addition, the traditional agency model overlooks horizontal conflicts by treating agents and principals as homogeneous entities, implicitly assuming all members within each group share identical interests. Consequently, internal conflicts within these groups remain unresolved within this framework. This limitation suggests that the model struggles to accommodate the increasingly complex managerial and financial structures of modern corporations – particularly evident in the divergent interests associated with varied stock types (for example, preferred versus common shares) and diverse corporate staffing arrangements (for example, employees versus independent contractors).

Thus, as corporations evolve, while agency theory continues to offer foundational governance guidance, a gap has emerged between its rigid, dichotomous framework and the nuanced realities of modern corporate governance. Consequently, contemporary corporations increasingly encounter challenges beyond the scope of traditional theoretical models, calling for the development of more adaptable theoretical frameworks.

Modified framework – why startups are structurally prone to governance challenges

The unique business nature of startups results in additional governance challenges beyond the traditional agency theory framework, incorporating both horizontal and vertical governance issues.

Vertical governance issues: systemic oversight failure

Traditional corporate governance theory relies on a clear principal– agent dichotomy, where shareholders (principals) oversee managers (agents). However, the effectiveness of this oversight is challenged by startups’ structural features arising from their high demand for financing, which can give rise to a hotbed of corruption.

Capital plays a significant role in startup development at different stages. Whether for early stage research and development, or laterstage expansion and production, substantial funding is essential. However, in view of long periods of illiquidity and high failure rates, traditional banks are often reluctant to finance startups. Consequently, founders frequently resort to alternative sources of funding, from personal savings and contributions from family and friends in the early stages, to angel investors and venture capitalists during the expansion phase. These diverse parties collectively form the shareholder base.

Yet it is precisely this complex composition of shareholders that often results in oversight gaps between shareholders and managers, particularly when founders take on multiple roles or collude with close connections, or when institutional investors like VCs fall short of effective monitoring.

From the CEO-founder’s perspective, the overlapping role as both owner and manager can blur the boundaries of accountability and reduce the effectiveness of shareholder oversight. At the inception of a startup, it is common for founders to retain ownership of the company by issuing themselves common equity in the form of founders’ stock. Empirical research shows that approximately 77% of the founding teams witnessed at least one founder personally providing the initial funding. Having ownership, the CEO-founder possesses a dual identity as both the monitor and the subject, hindering the checks and balances under the traditional agency theory framework.

Moreover, the involvement of family and friends as shareholders often reinforces the founder-CEO’s dominance and therefore undermines effective decision-making. In early stage startups, founding teams often include close personal connections, with studies indicating that 40% are founded with friends and 17.3% with family members. While such ties can ease fundraising, recruitment and collaboration, they also pose governance challenges. Internally, these close relationships discourage open discussion of sensitive issues and reduce the likelihood of critical oversight, as individuals may prioritise personal bonds over professional judgement. This tight-knit group often holds a substantial portion of the voting rights or occupies key executive roles, enabling them to control major decisions. This concentration of power limits the influence of outsiders, making it difficult to challenge or correct potentially self-serving actions by the founder and their inner circle.

From the perspective of shareholders, particularly VCs, vertical governance issues also stem from monitoring failures. While traditional academics assume that VCs actively monitor management on account of their financial stakes, they overlook how VCs often perceive themselves not as supervisors but as investors who prioritise scaling the company for a profitable exit. Unlike founders, who generally aim for sustainable growth of the company, VCs aim to secure returns on startups through exit strategies, such as IPOs or acquisitions. In this sense, the oversight is often conditional on the startup’s ability to attract subsequent funding rounds and to grow to a valuation sufficient to justify exit. As long as the startup demonstrates market traction and fundraising potential, VCs may overlook deeper governance concerns – such as internal corruption, discrimination or harassment – if these do not immediately threaten the valuation or disrupt the funding trajectory. This growth-oriented approach can inadvertently accumulate governance risks beneath the surface, posing a threat to sustainable growth.

Horizontal governance issues: inefficient decision-making from conflicting shareholders

Traditional agency theory also proves inadequate when addressing horizontal governance issues within startups, as it rests on the assumption that shareholders have a common interest in maximising the organisation’s value.

However, in startups, significant tensions often arise among shareholders themselves, particularly between preferred shareholders, such as VCs, and common shareholders, including the founders and employees. These internal conflicts among equity holders can lead to inefficient decision-making and further complicate governance dynamics.

The root of this conflict lies in the differentiated objectives and rights associated with each type of stock. Unlike the founders, VCs prioritise a profitable exit over long-term sustainable growth. To safeguard their interests during exit, they often negotiate for convertible preferred stock with voting rights, as well as board representation. These contractual tools not only vest VCs with the right to influence company decisions, but also provide for liquidation preferences over common shareholders in the face of downside risk.

Thus, VCs and common shareholders often diverge in terms of risk appetite, fundraising strategies and the timing of exit, especially in scenarios such as down rounds or acquisition offers. For example, when a startup is running out of capital and falls below a VC’s expectations of a large-profit exit, VCs may prefer an immediate sale, due to their preferred liquidation rights that entitle them to recover their investment before the common shareholders. Common shareholders, on the other hand, may oppose such a sale if the price is below the overall liquidation threshold, as they would receive nothing. Instead, they may push for another financing round or resort to debt to preserve the possible longterm upside, which may put preferred shareholders at risk. These conflicting incentives can paralyse decisionmaking and even lead to long-lasting litigation, hindering the sustainable growth of the company.

Elizabeth Huang, Yuki Liu and Cici Zhao

The University of Hong Kong

This two-part article is extracted from the winning paper of the Institute’s annual Corporate Governance Paper Competition for 2025, titled ‘Governance as a growth driver: rethinking corporate governance in startups’, under the theme ‘Is governance a driver for growth?’ Part two will be published in next month’s edition of CGj. More information on the competition and the full version of the Best Paper, along with those from the First Runner-up and Second Runnerup, are available on the Institute’s dedicated Corporate Governance Paper Competition minisite.