Venture Capital and Financial Stability

Ann Lipton

The last decade has seen a transformation in patterns of corporate organization. Enabled by loosened restrictions on private capital raising, venture capital firms have fueled the creation of a new ecosystem of large, privately held “unicorn” companies that are so well capitalized that they have not sought to access the public markets. That shift has been accompanied by a host of new questions about optimal governance arrangements,¹ fiduciary obligations,² the positive externalities of securities disclosure,³ fraud prevention,⁴ the role of shareholder agreements,⁵ and the disciplining effect of the capital markets.⁶

 In her new paper, Interest Rates, Venture Capital, and Financial Stability, forthcoming in the Illinois Law Review, Professor Hilary Allen adds a new question: what are the risks to financial stability? Allen claims that low interest rates fueled the growth of venture capital, which is itself prone to inflating bubbles and exacerbating panics. She ultimately argues that financial regulators need to be more attuned to unexpected places where funding tends to flow during periods of accommodative monetary policy.

Allen begins by tracing how an especially prolonged low interest rate environment—first in the wake of the great financial crisis, then again in the wake of covid—encouraged investors to reach for yield, resulting in a veritable geyser of venture capital funding. Venture capital, Allen next explains, is prone to inflating asset bubbles, in large part because the close social ties between VC firms and founders encourage “herding” toward similar businesses. Additionally, VC firms operate on a “power law,” whereby they expect most investments will fail but a few will become outsized hits. The model structurally encourages inflated optimism and a lack of vetting, and—due to the inability to short private company stocks—the absence of mechanisms to express pessimism. The upshot is, VC funds, flush with cash, created a bubble in startup firms concentrated in a small number of industries: ultrafast delivery companies and fin tech—particularly crypto.

From there, Allen explores the systemic implications. Most obviously, VC herding and the startup bubble resulted in a concentration of funds at Silicon Valley Bank—which in turn led to a run on Silicon Valley Bank when it suffered from a sudden rise in interest rates. Nearly simultaneously, two banks heavily exposed to crypto, which was also adversely affected by rising interest rates, also failed. The resulting loss of confidence in small and regional banks forced the FDIC to guarantee even uninsured deposits in order to protect the larger banking system. Allen recognizes, of course, that there were other factors at play, but she attributes the three bank failures at least in part to VC and crypto concentration.

 Allen also warns of the potentially destabilizing effects of crypto itself, which thus far have only been avoided because crypto has not (yet) been fully integrated with traditional finance. Crypto is an ideal investment for VC funding, Allen explains, because of its minimal startup costs, rapid growth based on sentiment and—so long as crypto is not treated as a security—ease of exit through sale of tokens rather than the traditional route of an IPO or a merger. These factors encouraged VC firms to make large crypto bets, and, now that they are committed to the technology, they have turned to political lobbying to erode the guardrails that have thus far prevented crypto from contaminating the broader financial system. That possibility, Allen maintains, continues to pose a threat to stability.

Allen ultimately concludes that, for the specific case of crypto, the best protection is enforcement of the existing securities laws to prevent the quick buildup and exit on which VC depends. More generally, however, Allen argues that financial stability regulators should set their sights on VC funds, due to their general opacity, and their unique ability to “magnify bubbles on the upswing, and panics on the downswing.”

Interest Rates, Venture Capital, and Financial Stability is thus a strong addition to existing literature on the unintended consequences of a trend that began in the 1980s and has accelerated since then, namely, the increasing ease with which operating companies (and investment funds) can raise capital outside of the federal securities disclosure system. Those changes shaped today’s VC industry, and the consequences that follow.

1. Elizabeth Pollman, Startup Governance, 168 U. Pa. L. Rev. 155 (2019).
2. Sarath Sanga & Eric Talley, “Don’t Go Chasing Waterfalls”: Fiduciary Duties in Venture-Capital-Backed Start-Ups, 53 J. Legal Studies 21 (2024).
3. Elisabeth de Fontenay, The Deregulation of Private Capital and the Decline of the Public Company, 68 Hastings L.J. 445 (2017).
4. Verity Winship, Private Company Fraud, 54 U.C. Davis L. Rev. 663 (2020).
5. Jill E. Fisch, Stealth Governance: Shareholder Agreements and Private Ordering, 99 Wash. U. L. Rev. 913 (2022).
6. Renee M. Jones, The Unicorn Governance Trap, 166 U. Pa. L. Rev. Online 165 (2017).