Startups’ governance problem

Startups have a governance problem.

Quick first principles, what are boards for? Boards are there to protect investor interest with a remit broadening to wider stewardship.

***

Most startup boards are made up of investor or VC directors, who protect investor interest and keep close involvement with the investee company.

One may ask: if startup boards are made of investor or VC directors, is that not the most efficient form of investor stewardship?

A legitimate question but misses the point a bit.

For many reasons.

VC directors bring a view naturally aligned with the VC’s exit horizon which may or may not be the same as the horizon of the founder’s vision. Unlike listed companies or PLCs, information about whose boards is publicly available, startup boards are less forthcoming about who is serving on their board; this reduces accountability and personal reputation risk for those investor directors, who may be underperforming on their job unlike directors of listed companies.

While the Corporate Governance code — as well as a growing number of powerful institutional investors — frown upon overboarding of listed company directors, there is plenty of overboarding among VC directors on startup boards. Investor director colleagues have told me they have had in excess of 10 board meetings sometimes in a month. Even speaking as someone, who serves on 3 external boards including 2 listed company boards at the time of writing this, I can assure you that is not healthy or conducive to high quality contribution on the board!

VCs themselves are mostly agents of their investors/ LPs so this is a layer cake of governance. Also see agency problem.

***

The scope of the startup governance problem however is larger.

Under pressure to do a lot, startup founders often think, and are encouraged by their VCs and private investors to think, that they need no independent challenge.

As I have written before, startups often do not have time and cannot attract independent directors for a host of reasons, including that many independent director candidates do not have the appetite for the risks, the uncertainty, the entrepreneurial focus, and the emotional rollercoaster that a startup can offer.

My conversations suggest that many first-time startup founders do not know much about corporate governance and even when informed, often feel the corporate governance code or the Wates principles are not for them. This is puzzling since many of them claim to want to create high value businesses.

Of course, when some startups try to bring independent directors on board, they often do it badly. I recently advised a founder who seemed to have found a chair-designate, and subsequently realised they had not given their business’s needs enough thought and were finding that the chair-designate had no relevant skills or experience and did not understand his role at the life stage of the startup. This led to complicated and wrought discussions about asking the said chair-designate to agree to step away from a precious board seat.

***

So why is this a problem?

Simply because most startups actually destroy value (and wealth) through failure.

Too radical a claim?

A reported 20% fail within a year and 60% in under three years. UK numbers are around 57% failure rate within five years. It is also claimed that a majority of startups remain micro-enterprises and never raise external equity investment.

But much investment is raised — a reported £8.27 billion in 2017 and a reported £7 billion in 2018, and a reported £7.4 billion by September 2019. These are not small sums of money. The average deal size in 2018 was £5.4 million but large deals such as £368M raised by Babylon Health skew this metric somewhat.

Framed another way, combined with failure rates, this is potentially a problem of private wealth destruction — happening below the radar and beyond scrutiny. 

As societal expectations shift to climate crisis awareness and ESG and responsible investment, and indeed as investors start to push for governance and business models geared to profitability, privately owned and funded businesses will find they have a lot to change.

Governance structures that support the building of a sustainable business from scratch are a good place to start.

(Disclaimer: These are my own views and do not reflect the views of the boards of JP Morgan US Smaller Co.s Investment Trust or Temple Bar Investment Trust or London Metropolitan University, where I serve as a non-exec director, nor of Ditto AI, where I am an exec director.)

One thought on “Startups’ governance problem

Comments are closed.