Private Equity Governance: Why It Matters

Have you heard of private equity governance?

As Michael Robinson, PhD, CFA, ICD.D, puts it, it is the set of rules and restrictions that are established and enforced by external equity investors in a corporation to reduce their investment risk. It is an additional layer of governance imposed on top of a standard corporate governance framework, which involves the board’s oversight of executives as they build value.

Governance is an essential part of our daily routines. We may not actively acknowledge its role, but it provides the framework for cooperation and coordination in society. Just as we rely on a set of rules in our day-to-day tasks, businesses, small and large, require a robust governance framework. From the boardrooms of start-ups to established corporations, good governance plays a role in guiding effective decision-making, resource allocation, and ensuring there are processes in place to facilitate transparency and accountability. But how important is governance for an early-stage corporation?

In a recent Lunch and Learn session, Michael — angel investor, past venture capitalist and Professor of Entrepreneurial Finance — shed some light on the critical role of governance in addressing common start-up mistakes and steering the success of early-stage corporations.

Rise in Entrepreneurship

There is a growing interest in entrepreneurship among Canadians. Individuals are more interested in starting their own business rather than working their way up the corporate ladder. Emerging technologies have made it easier than ever to start a business, but start-ups often fail, with studies reporting half of all new ventures failing within the first five years. This includes both small businesses, which use a proven business model to cater to their local markets, and start-ups that seek to develop a new business model to scale up quickly.

Reasons for Start-up Failures

Running out of cash is one of the primary reasons behind these failures. This isn’t just a financial issue – it’s often a sign of a more profound problem. It can indicate a failure to communicate the company’s vision effectively, align stakeholders, or secure capital. Effective governance structures can mitigate this risk by ensuring clear communication and alignment of interests among stakeholders. A start-up’s ideas may also not resonate with the market. “The world doesn’t understand why they need your idea,” Michael says. Building a strong governance structure would help communicate your vision more clearly; it can help attract financing, secure talent, and reach potential new customers.

Governance Failure Anecdotes

Michael shared some anecdotes from his 30-year career, highlighting how start-up failures often trace back to governance issues. In one instance, a group of co-founders did not have an appropriate Founders Agreement in place when one of the founders left after a dispute, causing uncertainty over ownership of the intellectual property and making it difficult for the company to continue to develop its product. In another instance, a tech start-up secured funding from angel investors but was not fully transparent on their technology. Family members were also appointed to the board of directors, leading to a lack of independent voices on the board to challenge the founder. The start-up did not evolve as expected and the investors were inclined to take legal action against them and their family. In yet another case, a company that initially raised millions for hardware shifted their focus to software development. They did not receive adequate strategic guidance from the board. As these examples illustrate, an ineffective board is not sustainable for a company’s long-term growth.

Intricacies of Private Equity Governance

“Early on in start-ups, people don’t have a clear understanding of the different hats they’re wearing when they get together to make decisions,” Michael says. A strong independent board of directors fulfills three fundamental roles: oversight by ensuring operations are carried out smoothly; foresight by keeping the organization updated on market trends, technological advancements and its competitors’ tactics; and insight by offering guidance to the management team as they navigate challenges. That said, the governance requirements of a start-up can be more complex and challenging than those of a more established firm. Private companies tend to lack the internal control systems commonly found in public corporations. Likewise, private equity investors often have more flexibility in structuring their investments. They can also find themselves in situations of conflict of interest.

Pre- and Post-Investment Considerations in Private Equity

Prior to investing in a private equity venture, it is important to conduct a thorough assessment of the company, its financial health, management team, and potential risks. Successful private equity investors engage in extensive due diligence to minimize the chances of unexpected setbacks down the road. “As a rule of thumb, take about a month to do due diligence on the corporation and then spend another month getting the governance paperwork done properly," Michael says. More so, decision-making biases can affect the success of a private equity investment. Seeking an outside perspective is crucial for mitigating these biases and making informed decisions. What works for an early-stage start-up may no longer be suitable as time goes on. As companies expand, governance structures must adjust to accommodate changing circumstances, stakeholders and market dynamics.

Enhancing Private Equity Governance

For founders and investors who are interested in actively seeking advice from seasoned business professionals to work through governance and financing issues, consider registering for Haskayne Executive Education’s Enhancing Private Equity Governance: Beyond a Good Idea program. Enhancing Private Equity Governance is an innovative program that unites entrepreneurs and high potential ventures with advisors who have governance expertise and entrepreneurial experience. This pairing creates a mutually beneficial learning environment and fosters long-term relationships that can contribute to the success of start-ups.

Further information about the program, including a program brochure, is available on our website.