WeWork fiasco may have startups rethinking their governance structures

Will the WeWork fiasco change the governance structure of upcoming unicorns?

WeWork's IPO implosion centers partly on themes that are at the heart of a hot investment strategy -- Environmental Social & Governance (ESG), which emphasizes relations with employees, customers, and stakeholders, as well as the importance of proper corporate governance--leadership, pay, shareholder rights, and voting rights.

Will any of this make a difference to upcoming IPOs? Some are saying yes.

"[W]e expect the developments at WeWork to positively impact other unicorns, potentially prompting founders to adopt a less centralized governance structure and a more balanced growth/profit profile, easing the transition to the public markets," Pierre Ferragu and a research team from New Street Research said in a recent note to clients.

Others agree. Jon Hale, who covers ESG issues as Head of Sustainable Investing Research at Morningstar, told me ESG has been evolving rapidly in the last few years.

"In the past, companies that have best practices tended to be established companies," he said, "but that is starting to change. Companies are realizing that these ESG issues need to be addressed early on, before you go public, particularly governance issues. Sustainability is not just can you make money over time, but also can you govern yourself with full transparency and manage all your stakeholders."

Others caution that no matter how trendy ESG issues have become, they are not the primary reason companies like WeWork have run into trouble.

"People will tolerate a lot of bad governance if they make money," Kathleen Smith at IPO advisory firm Renaissance Capital told me. "The main problem with WeWork was a business model that could not be proven to investors and a valuation that was too high."

Rolf Bulk, co-author of the New Street research paper, agrees that burning cash with no path to profitability and high valuations were major issues for WeWork, but noted that the intense media interest around governance issues demonstrated that ESG issues had finally become important to investors.

Indeed, media reports around the WeWork IPO often centered on corporate governance issues:

1) Poor executive judgment (no women on board).

2) Insider dealings: (CEO Neumann was privately buying property that he then leased to WeWork).

3) Family ties (wife Rebekah is co-founder and chief brand and impact officer, now reportedly leaving).

4) Multiclass stock structure that gave Neumann far more power than other stockholders.

The multiclass stock structure was particularly troublesome to Bulk.

"Investors are nervous about concentrated voting power," he said.  "The governance structure put the company in a very difficult situation when pitching its IPOs. The predominant issue was Neumann's shares carried 10 times the voting power, and that is a big flag for many public investors, particularly when you are talking about high valuations."

Luke Oliver, Managing Director at DWS, which runs two ESG funds (the Xtrackers ESG Leaders ETF (USSG) and the Xtrackers S&P 500 ESG ETF (SNPE)), said governance mistakes played a part in the lower valuation being assigned to WeWork.

"ESG measures non-financial metrics that can manifest themselves in a very financial way for companies," Oliver said. "WeWork was challenged in the Governance part of ESG, potentially for board independence, accounting and business ethics."

Whether it's high valuations, lack of a path to profitability, or poor corporate governance issues, Smith noted that Renaissance Capital's IPO ETF, formerly one of the big gainers for the year, was down almost 10% in the third quarter.

"The IPO ETF is telling you investors are going to be a lot more cautious going forward," she told me.

For his part, Rolf would welcome less talk of companies fetching sky-high valuations, noting how WeWork had changed once it saw the investor pushback.

"Initially, there was an equity raise of $3 billion and a $6 billion credit line. Now I am hearing about a $3 billion credit line and a much smaller equity raise, which would imply a more toned down growth profile than was initially suggested. This might open up more talk about a more balanced growth-profitability picture, which I think would be welcomed by most IPO investors."

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