SpaceX employees celebrate during a bell ringing ceremony for the IPO at the Nasdaq MarketSite in New York on June 12. (AP Photo/Frank Franklin II)Frank Franklin II/The Associated Press
Imagine an investor in a state of cryosleep who awoke on June 12 to learn that a money-losing private company with plans “to extend the light of consciousness to the stars” had gone public as the largest stock-market debut in history.
Imagine, also, that its founder, whose average hourly wage is approximately US$3.6-million, assuming an entrepreneurial career of 31 years, has retained almost total control of the company through super-voting shares, and broken many corporate governance norms.
Like OpenAI and Anthropic, which also have public listings planned, Elon Musk’s Space Exploration Technologies Corp., or SpaceX, is a venture capital-backed, founder-led enterprise in which the core leadership retains outsize control. Investors seem unfazed by this arrangement.
Easily overlooked during periods of exuberance, weak governance in VC-backed, founder-led firms has become more prevalent since the mid-2000s, according to a U.S. National Bureau of Economic Research (NBER) working paper by four University of Toronto professors, published in February.
Alexander Dyck, academic director of the Johnston Centre for Corporate Governance Innovation at the University of Toronto’s Rotman School of Management in Toronto, and one of the paper’s co-authors, says we’re going through an AI bubble in which money is chasing deals.
“When that happens, a lot of things we associate with good governance end up being ‘nice to haves,’ not ‘need to haves,’ and can often get neglected in the pursuit of the deal,” he says. “And then there can be buyer’s remorse later.”
VC investing entails the “spray and pray” approach of providing capital to an array of startups with the expectation that only a few will become big winners. Because of these fat-tail return distributions, investors are incentivized to take risks to generate and capture the potential upside.
But ceding control to founders through lenient contracts allows founders to reward themselves disproportionately or to take their companies in directions they fancy but may not reward shareholders.
“We call that a governance problem,” Prof. Dyck says. He gives the example of Mr. Musk merging xAI with SpaceX. Investors who thought they owned a profitable space company suddenly had big exposure to a money-losing AI company.
Carol Hansell, founder and senior partner at Hansell LLP, a Toronto-based corporate law firm specializing in corporate governance and securities law, says when investors expect high returns, they “care less about how decisions are made.”
Priorities can change swiftly when they lose money, there’s a major fraud, or an industry downturn or recession. In such events, there’s renewed interest in understanding how business decisions are made, who’s making them and if there are conflicts of interest, she says.
“Private companies, by definition, don’t have the disclosure requirements imposed on public companies. On the other hand, investors in private companies can often insist on more governance rights as a precondition of their investment, which most public company investors can’t do,” she adds.
Examples of effective governance include clear communication and appropriate transparency with all stakeholders, Ms. Hansell says. But she admits there’s no one-size-fits-all governance structure.
Red flags may include a company making very few changes to the board or management team. That could indicate the board and management have become too close, which may limit the board’s ability “to exercise an appropriate challenge function,” she says.
The trend for startups to stay private for longer entails numerous capital raises in larger amounts and from a broader set of investors.
The NBER working paper found that more complex capitalization structures containing a diverse group of investors with divergent objectives and incentives increase the likelihood of “horizontal conflicts,” or disputes among investors at the same tier. That may result in competition among capital providers that splinters attention and makes it more difficult to monitor founders effectively.
A small number of VC-backed companies have an outsize effect on global innovation and economic growth. According to a recent report by the World Economic Forum, successful VC-backed companies currently account for 42 per cent of total U.S. public market capitalization.
That means poor governance doesn’t only affect direct investors, it can have wide-ranging economic and societal effects. Significant investor losses can make it difficult for the company or industry to raise capital in the future, which can affect its employees, communities and other stakeholders, Ms. Hansell says.
Prof. Dyck says investors who have expectations of big payoffs from a few holdings may have a different perspective on poor governance than does society as a whole.
“The firms we’re dealing with affect so many more people. It’s not three guys in a garage … it’s millions of customers.”