How to implement strong corporate governance pre-IPO
Going public offers a host of benefits, including access to capital and increased public awareness. However, the benefits also come with heightened expectations and increased scrutiny from regulators and investors. Early-stage companies and startups looking to go public (even if years down the road) must establish a strong system of corporate governance capable of meeting new regulatory requirements safeguarding shareholder and stakeholder interests.
Even for privately held and early-stage companies, the consequences of not having good governance practices in place can be reputationally or financially damaging. The recent, very public drama that ensued when OpenAI’s board fired its CEO, Sam Altman – and then hastily rehired him after he was recruited by Microsoft and 700 OpenAI employees threatened to follow him there – demonstrates the perils of an inexperienced board, unconventional governance structures and not having the data-backed clarity to make the best decisions.
Implementing strong corporate governance practices as a startup or early-stage company requires fostering an organizational culture that understands and supports the changes associated with being publicly listed. These will include putting in place an effective and experienced board that can challenge management's assumptions and act in the best interests of stakeholders, changes to internal and external audit practices, and the ability to withstand exposure to higher degrees of public scrutiny.
The importance of strong corporate governance before an IPO
Ideally, leadership will have positioned the company to meet expectations of publicly traded companies at least a year or more before the actual IPO. The company will likely retain external expertise as it builds an internal and external IPO team or teams.
Ensuring the company has strong governance practices is just one aspect of IPO preparation, but it's critical. The Stanford Graduate School of Business published the results of its Stanford Closer Look Series study, Scaling Up the Implementation of Corporate Governance in Pre-IPO Companies. The paper reflected studies of 47 companies that completed IPOs in American markets between 2010 and 2018.
Authors David Larcker and Brian Tayan reported that, despite variabilities among the 47 companies, there were some commonalities. The following averages may prove informative should you find your board and company on the IPO journey.
Implementing strong corporate governance practices can be incremental, and often begins with leadership. The study found that, on average, those companies that relied on CEOs other than their founders to take their businesses public brought those CEOs on board five years prior to the IPO.
When it came to implementing SEC-friendly accounting and financial systems and retaining the external auditors required for IPOs, companies involved in the study did so, on average, four years in advance of their respective IPOs. Audit and finance practices are critical in building confidence in a company's statements, so a company needs to ensure its statements are prepared in accordance with generally accepted accounting principles (GAAP). In the US, financial reporting systems need to reflect controls required for SOX (Sarbanes-Oxley) compliance. Larcker and Tayan found that 77% of the study's pre-IPO companies had retained one of the Big Four accounting firms prior to their IPO. On average, corporate governance undertakings escalated three years in advance of the IPO.
That's when companies became “serious” about developing their corporate governance systems. That's the same point, on average, when companies in this study recruited the CFOs who would be charged with taking their respective companies public.
Preparing for an IPO
While a startup company's board of directors is unlikely to have independent directors, a company preparing for its IPO must recruit directors who meet regulatory bodies' independence standards. Independence is not, of course, the sole criteria for director recruitment. The board must also be competent, and membership should possess diverse skills the company needs to be successful.
Consider that compliance and disclosure requirements may drive changes to practice. Your board can be charged with providing executive compensation disclosures that include presentation of the company's compensation philosophy, pay objectives or peer group analysis. Since the board will establish an independent compensation committee to establish compensation processes, the board will need to recruit compensation expertise.
Boards have traditionally recruited on the basis of senior management and industry or sector expertise as well as prior governance experience and financial literacy. Audit and risk management experience have been reflected on board matrices for some time now, and they've been joined by needs for risk management, technology and cybersecurity expertise. A company approaching its IPO may also benefit from recruiting for one or more directors with experience taking companies public.
Increasingly, diversity expectations extend beyond gender to include age, ethnicity, board tenure and more. Your board recruitment is likely to reflect the need to provide effective oversight of environmental, social and governance (ESG) issues, and the importance of being prepared for shareholder activism. Recruiting directors with technological, ESG or social media qualifications may contribute to greater age diversity on the board.
Independence is also a criterion when it comes to committee composition. The audit committees of companies listed on the Toronto Stock Exchange (TSX), for example, are required to consist of at least three directors, all of whom are required to be both independent and financially literate.
Your board and each committee should establish and regularly review their respective charters or terms of reference (TOR) as well as the board's policies. To ensure strong corporate governance pre-IPO, the board can benefit from legal consultation. That will help ensure these documents (and the board's performance) reflect duties, authorities and limitations as required.
Before an IPO is also the time to ensure your board is adopting best security practices right now. Public companies have various reporting requirements and stringent guidelines on how they prepare and distribute materials. A 2023 rule passed by the SEC also requires public companies’ boards to be more literate in cybersecurity than ever before – something leadership needs to begin preparing for well before an IPO. By adopting best practices early on, directors and leadership teams are better prepared for a smoother transition from a private to a public company.
More companies are turning to board portals as a way to improve security. For a pre-IPO company, the use of board management software can provide board members with a dedicated platform throughout the IPO process that minimizes risks associated with going public.
Just as management will adjust and elevate aspects of corporate performance in preparing to go public, the board will also need to commit to acquiring and developing the expertise associated with effective oversight, and with the compliance and disclosure requirements of a listed company. From a governance perspective, it's critical that individual directors and the board as a whole understand and are prepared to undertake the responsibilities and hold up to the scrutiny associated with leadership of a public company.
To learn more about establishing governance best practices before an IPO, download our free checklist that details the seven steps early-stage and pre-IPO companies can begin taking today.
