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OpenAI tumult, FTX blowup help bring VC governance back in vogue

VC investors were willing to forgo board representation during the later years of the bull cycle. That’s changing, thanks in part to some cautionary tales.

Venture capitalists are once again insisting on board seats at their portfolio companies after years of relaxing standards.

FTX‘s implosion and OpenAI‘s recent saga—which caught investors by surprise when OpenAI CEO Sam Altman was suddenly ousted without them being notified—reminded VCs and their limited partners why governance matters.

“Every major investor is now asking for a board seat, versus 2021 when you had maybe 50% [requesting a seat],” said Yash Patel, a general partner at Telstra Ventures, which had a small stake in FTX. “That change is partly driven by LPs who are not happy with what happened in 2021 and its ramifications.”

Many investors, driven by fear of missing out during the last boom cycle, relaxed various aspects of investment criteria, from the thoroughness of their due diligence to governance, even relinquishing certain information rights, including access to detailed financials and business plans.

As valuations rose, investors found themselves taking a smaller stake in each company—another trend that is now reversing. At the same time, founders wanted to maintain more control over their businesses and could get away with refusing a board seat to VCs.

Investors, whose primary concern was getting into competitive rounds, used their smaller ownership in each portfolio company as justification for skimping on governance, according to Theory Ventures founder Tomasz Tunguz. Although in the pre-2018 period, it was customary for investors that led a Series B, for example, to take a directorship role, that became less common during the pandemic era, he said.

Another excuse for forfeiting board seats was investors’ overcommitment to other companies.
Deals were happening so fast and furious that many VCs found themselves on more boards than they could manage well.

Laurie Yoler, a partner at Playground Global, said she has sat on boards where other members had directorship positions on as many as 20 other startups, leaving them little time to monitor the businesses.

“I’ve been on boards where the other people at the table couldn’t remember what the company did,” she said. “At the start of each board meeting, the poor CEO would say, ‘Let me remind you what my company does.’”

For their new investments, overstretched VCs often didn’t request seats or happily obliged when founders denied them board rights.

The prevalence of party rounds, deals where early-stage startups raise capital from as many as 10 or 20 investors, was another reason board representation dropped. In these rounds, none of the investors had a large enough stake to care to take a board seat.

 


But party rounds have been falling out of favor, and the average number of investors in a round has fallen to 3.5, the lowest in a decade.

FTX, which famously didn’t have a board of directors, exemplifies the perils of unbridled investor enthusiasm in that era. When fraud was revealed, many investors realized that a closer oversight of the defunct cryptocurrency exchange could have increased their chances of catching the widespread problems.

As for OpenAI, its nonprofit status limited investor representation on the board. But its investors’ willingness to agree to that unusual structure also coincided with an overall culture of light governance.

Investors may lament their poor corporate oversight during the market exuberance, and many are now vowing not to make the same mistakes again. Microsoft’s success with securing a board observer seat at OpenAI after its recent tumult is an example of the push to fix that problem.

Cautionary tales of poor startup governance—from Theranos to WeWork to Uber—often prompt calls for investors to take oversight more seriously. The difference this time is that the market has become decidedly more investor-friendly, giving VCs the power to act more forcefully.

“Investors have more leverage for demanding a board seat,” Patel said. “The free money has dried up, and entrepreneurs have fewer financing choices.”

Featured image by Klaus Vedfelt/Getty Images

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