Where ignorance isn't bliss start-ups and corporate governance

Research any of the high-profile start-up scandals and collapses that made headlines in recent years and it’s clear that fundamental corporate governance failings were a key component. Take the infamous case of Theranos, the once-heralded health technology company led by Elizabeth Holmes. The U.S. House of Representatives Committee on Energy and Commerce 2016 Report concluded Theranos’ spectacular downfall was “largely attributed to serious corporate governance failures”, including a lack of transparency, inadequate oversight and a board filled with close allies rather than independent voices.

In a similar vein, Bloomberg’s exposé on the well-publicized unravelling of WeWork highlighted  “..corporate governance failures … were evident in a multitude of areas, from conflicts of interest … to weak internal controls and a lavish spending culture”. Ultimately this exposed the start-up’s fragility, undermined its valuation, and forced the cancellation of its planned IPO and the lay-off of thousands of employees.

Most recently, FTX’s multi-billion-dollar bankruptcy disclosed that for much of its three-year life, the company had no Board of Directors and almost non-existent record-keeping. Critical business decisions were documented solely on informal ephemeral messaging systems such as Slack, Signal, and Telegram. According to John Ray III, the CEO appointed as part of the bankruptcy proceedings, FTX’s dramatic implosion uncovered “a complete failure of any internal controls or governance whatsoever.”

Of course, these are extreme cases of corporate governance failings contributing to so-called “Unicorns” crashing and burning and are not typical of all start-ups. Theranos, for example, involved actors who were subsequently convicted of fraud, and fraud is also alleged in the case of FTX. Nevertheless, when it comes to corporate governance, even perfectly law-abiding start-ups regularly act like ostriches, hiding their heads in the sand in the vain hope that either corporate governance will go away if they ignore it for long enough, or that they can successfully “fake it ‘til they make it”. In the typical start-up pressure-cooker environment—scrambling to achieve ambitious growth targets while tightly constrained on time, team, and budget—corporate governance is frequently seen as a luxury, a distraction from the ‘real’ business, and not the best use of the organization’s finite resources.

In fact, nothing could be further from the truth. Even for relatively small start-ups (seed and Pre-Series A), ignoring corporate governance inevitably proves to be a false economy.

The Practical Benefits of Prioritizing Corporate Governance

While over-enthusiasm – often borne out of the corporate inexperience of a youthful culture – can tempt fledgling businesses to prioritize innovation and agility over formalized structures, the lack of at least a baseline corporate governance framework can expose start-ups to a myriad of risks and hinder their long-term success.

Some key reasons why start-ups should prioritize corporate governance as a means of helping secure their future growth and long-term sustainability are highlighted below. As fund-raising is always a critical concern in the start-up world, the focus is on the practical benefits a start-up can gain in an investment context if it puts fundamental corporate governance building blocks in place from the outset.

1. Attracting investors

As part of a fund-raising due diligence process potential investors typically require the start-up to establish a data room and populate it with key business documents. Quality investors will expect the data room to include basic corporate governance documents (board minutes, resolutions, constitutional documents etc.). Failing to provide these risks undermining investor confidence in the founding team’s professionalism and management skills and may affect their decision-making about the potential investment opportunity.

By having robust data rooms with baseline corporate governance documents and other key business records collected, organized, stored and actively managed from the outset, a start-up can increase its value and attractiveness to quality investors.

2. Expediting fund-raising

The absence of some or all key corporate governance documents and records from the data room will likely (and should) prompt queries from potential investors. The founding team will need to spend time responding to and/or remediating these. This risks prolonging the due diligence process and the eventual investment decision.

A start-up that includes appropriate corporate governance documents and other key records in its data room from the outset reduces the scope for investor queries, saves itself time and accelerates investor decision making.

3. Mitigating risk

Where corporate governance documents are missing or non-existent, the founding team may be tempted to replicate them or prepare documents retrospectively. At best, this again consumes precious management time and prolongs the due diligence and investment process. Also, as memories inevitably fade with the passing of time, documents created ‘after the event’ may be incomplete or inaccurate, risking potential confusion or lack of clarity. At worst (e.g., backdating of documents), creating documents retrospectively can amount to fraud and expose individuals to the risk of criminal liability.

Start-ups that prepare and store corporate governance documents at the time of the relevant events, so they are already in place and available when an investment round occurs, can avoid these risks.

Note also that in highly regulated sectors such as financial services, or in special economic zones, in some markets regulators may impose mandatory minimum corporate governance requirements. Non-compliance with any mandatory corporate governance rules will significantly amplify the risks associated with corporate governance failures.

4. Building long-term sustainability and scalability

Start-ups frequently have ambitious growth plans, aiming to scale their business to IPO and beyond. While in the very early days it may be feasible for a start-up to operate effectively without a solid ‘’best practice’’ baseline corporate governance framework in place, a more structured approach will be required to support the organization scale into a long-term sustainable business. Otherwise, the business risks becoming unmanageable during periods of rapid growth. FTX is a clear example of this. It scaled rapidly to operate in 250 jurisdictions and control tens of billions of dollars of assets for millions of users. However, according to the debtors’ report filed in FTX’s bankruptcy, the company’s fundamental corporate governance gaps contributed to it being unable to proceed with a planned IPO or subsequent trade sale rescue before it ultimately spiralled into bankruptcy.

Implementing a baseline corporate governance framework gives start-ups a solid foundation for sustainable business practices, and also makes it easier for them to quickly seize unexpected opportunities when they arise.

Conclusion

For start-ups, ignorance of corporate governance isn’t bliss; it’s a recipe for investment round delays, increased risk, barriers to growth and barriers to long-term sustainable business. The lessons from high-profile failures underscore that solid governance from the outset is not an optional luxury but a critical necessity for survival and success. Directors of start-ups have a responsibility to champion robust governance practices and guide their new ventures towards a prosperous and enduring future. The good news is that as IoD members, we have the benefit of access to the IoD’s best-in-class resources, materials, and professional development training to equip us for this task. Let’s harness the power of corporate governance and together, help our start-ups thrive.

This is a guest blog which contains the views of the author and does not necessarily represent the views of the IoD.