Hello and welcome you are listening to Patrick Boyle on Finance, a podcast exploring ideas from quantitative finance, examining events occurring in markets right now and financial history to see what lessons can be taken away, including interviews with some of the most interesting people in the world of finance. To learn more about the podcast,
visit on finance.org. Sam Altman, the CEO of Open AI, told the Wall Street Journal last year that AI means that a lot of people are going to lose their jobs. So he was probably not awfully surprised to lose his job as the CEO of Open AI last week. There was probably no one better
prepared for such an outcome. I imagine that he kept his personal items in a little box next to his desk at work so that nothing would be accidentally left behind in the office when he eventually got the call from HR, and that he immediately fled to his bunker in New Zealand, probably expecting all of the other Silicon Valley CEOs to be waiting there to greet him. It turns out that all of the drama ad Open AI was a storm in
a teapot. Yesterday morning, we learned that in a dramatic reversal, Altman will be reinstated under the supervision of a new board that contains only one member from the prior board and Open AI's largest investor. Microsoft is expected to have a larger voice in Open AI's governance going forward. A lot of the goings on at Open AI relate to its strange corporate structure, which relate to how it was initially funded.
There are lessons that can be drawn from the chaos at Open AI that apply to the recent trends we've seen towards stakeholder capitalism. Open AI was founded in 2015 by a group of high profile entrepreneurs and researchers. Among them were Sam Altman, Reed Hoffman, Elon Musk, Peter Thiel, Amazon Web Services, and a few others. Its stated mission was to advance artificial intelligence in a way that would benefit society as a whole, unconstrained by a need to generate a financial return.
They announced that they would freely collaborate with other institutions and researchers by making their patents and research open to the public. The founders pledged over $1 billion to the venture, but actually only contributed around $130 million, the majority of which came from Elon Musk.
Open AI was able to hire some of the top researchers in the space early on, despite paying a lot less than Facebook and Google, partially because researchers said that they were excited by the opportunity of working with some of the top people in the field and. Because they believed in the mission of the company. After three years, Elon Musk left his board seat claiming a conflict of interest with Teslas AI R&D endeavors relating to autonomous driving.
Insiders say that Musk pitched that he should be running the company. And when Altman and Open AI's other founders rejected this proposal, Musk walked away, reneging on a massive plant donation, which left a nonprofit with no ability to pay the astronomical fees associated with training AI models on supercomputers.
Unable to balance its research goals with its budget constraints, Open AI made the announcement of creating Open, a ILPA, separate legal entity that operates as a capped profit corporation in 2019, the profits being capped at 100 times any investment. The company explained this decision saying we need to invest billions of dollars in the coming years into large scale cloud compute, attracting and retaining talented people, and building AI supercomputers.
This transition from nonprofit to for profit required Open AI to balance its desire to make money with its stated commitment to ethical AI development. They said that the cap on profits was there to prevent investors from being enticed to try and grab limitless wealth by deploying software that could be very harmful. I'll let you decide whether that was a real concern they had or a good way of marketing and
investment in the firm. This unconventional structure meant that Open AI had a board of directors, which in theory controls the entire corporate structure, which includes the charity and the capped profit company, but which, unlike other boards, is not accountable to shareholders. The directors are in fact not allowed to own any stock to prevent a conflict of interest because they are specifically not supposed to be aligned with shareholders.
The nonprofit's principal beneficiary is humanity, not open AI investors, according to their website. Which may mean that they are accountable to everyone, including you. Or it may mean that they're accountable to no one, the company's operating agreement to investors says in writing. It would be wise to view any investment in Open AI in the spirit of a donation, with the understanding that it may be difficult to know what role money will play in a post AGI world.
Documents like this that were written by an actual lawyer highlight the problems that we're starting to see from the combined popularity of science fiction in Silicon Valley and widespread micro dosing of hallucinogens. OK, so while the Open AI investor documents write about the unknowable role that money will play in a post AGI world,
we haven't gotten there yet. And in the real world, where the role of money is reasonably well defined, Open AI is an unprofitable company and is expected to need to raise a lot more money over time from investors like Microsoft to keep up with the high costs of building more.
Sophisticated chat bots. Despite this lack of profitability, the company is valued by investors at $86 billion, and Bloomberg reported last weekend that some investors were considering writing down the entire value of their Open AI Holdings 20. $86 billion of value evaporated in a weekend, and the reason given by the board was that Altman had not been consistently candid with them. With billions of dollars in jeopardy, some investors started
exploring legal action. But the problem with that is that it's not clear how to sue a board whose legal duty was to the safety of humanity, not to investors. Microsoft may have been willing to sign the wacky documents like they did and pretend that the board, which answers only to humanity, were in charge. But because Open AI requires investors to write large checks to fund the ongoing losses at the company, Microsoft were easily able to exert control,
which is what they did. They pushed for Altman to be reinstated while also offering him a role at Microsoft. Altman quickly confirmed that he and Greg Brockman, another Co founder who left on Friday, would join Microsoft.
Open a is key partner. Former colleagues would have an open door to follow and join a new AI unit, according to Microsoft chief Satya Nadella. As much of A win as this might have appeared for Microsoft, people were saying that they had managed to buy the hottest AI firm for zero. This might not have been the optimal outcome for them, as they would likely have had to deal with antitrust regulators and lawsuits from other Open AI investors.
Now the board doesn't answer to the staff at Open AI either. Other than that, the staff make up some of humanity. But the staff do all of the work while the board attend occasional meetings where they worry about the future of humanity. Not a lot would be going on at Open AI without employees. The majority of Open AI 700 or so employees signed an open letter to the board demanding that the board resign and that they rehire Altman.
The letter stated that the board had told the employee leadership team. That allowing the company to be destroyed would be consistent with the mission. The employees said that unless their demands were met, they would resign from Open AI and join the new subsidiary of Microsoft being headed up by Altman and Brockman.
As a side note to all of this, you have to wonder what the employee contracts at Open AI look like that the entire staff could leave to work for a major investor in the company. Leaving Open AI as an empty shell, typically, executives like Altman would have contracts that prevent them from hiring key staff once they're no longer at the firm, and staff would have signed Ndas, preventing them from taking any technology
with them. The press are reporting that this mass revolt by open AI staff was the primary reason for the boards about face. So while the board on paper only reports to humanity, investors and employees won out.
The Open AI story is a bit of a crazy one, where Microsoft and a number of other sophisticated investors agreed to put billions of dollars in and employees got stock grants all at an $86 billion valuation without the contractual or fiduciary rights that investors might normally expect. Open AI is not the only company with this type of structure
either. Anthropic, A rival company started by a group of former Open AI employees, has set itself up as a public benefit corporation, a legal structure that is meant to insulate it from market pressures. The Open AI case highlights a trend that we've seen in recent years in favour of unusual corporate governance.
I wrote about this issue in my corporate finance textbook as while there's been a general move towards better and better corporate governance over time, bad corporate governance has been a growing issue, particularly in Silicon Valley, where companies like Google, Facebook, and Snap structured their IPOs such that founders were left with unchallenged power to do almost anything that they want.
At these firms, founders were given special shares with special voting powers, meaning that they don't have to listen to investors whatsoever. Investors looked at these companies and felt that the founder CEO had such a great track record that there was little consequence to having poor corporate governance. Berkshire Hathaway, Warren Buffett's company has a similar unusual structure where the A shares get more votes than the B shares do.
The different voting rights were allegedly put in place so the company and its leadership would not be beholden to investors seeking short term profit. This structure at Berkshire Hathaway has kept Warren Buffett in firm control, even as he has given away more and more of his shares to charity. The A shares can be converted to B shares, but B shares can't be converted to A shares. Starting in 2006, Warren Buffett began giving away large amounts of Berkshire Hathaway stock to
charities. But prior to donating them, he converts his A shares to B shares. Since Class B shares have diminished voting rights, this has the effect of preserving his voting control, even as his percentage ownership of Berkshire declined over the years. While investors might feel that there's little consequence to having poor corporate governance, this could be short sighted since you're buying shares of companies in perpetuity.
Leaders who might be doing a great job today but are not accountable to shareholders can take value destructive paths in the future without answering to anyone. Meta's Reality Labs division, which houses its efforts to build the Metaverse, has lost around $46.5 billion since 2019. Would Mark Zuckerberg have been able to waste this much money if
he was accountable to investors? Under a normal corporate governance structure, there's a good chance that he would have been pushed out by shareholders a few years ago. As the losses were mounting, there have been numerous studies on the relationship between corporate governance and investment performance. Gompers ET al. Found that companies with stronger shareholder rights have higher profits and trade at higher multiples than companies
would weak governance. A few years ago, the Business Roundtable and Nonprofit Lobbyist Association, whose members are CEOs of major U.S. companies, put out a press release saying that corporations should be run to protect all corporate stakeholders, defined to include customers, society and employees, rather than following the conventional objective of maximizing shareholder wealth. This is what's become known as stakeholder capitalism.
Critics of shareholder wealth maximization celebrated this announcement as an acceptance of their long term belief that focusing on shareholder wealth had brought about income inequality, the outsourcing of manufacturing jobs, and other societal costs and externalities. Traditionalists viewed this announcement as foolish and caving into the woke mob. Cynics argued that it meant nothing was just PR, and that everything would continue on as
normal. Now, to most people, these arguments might appear to not matter whatsoever, but they do matter because the various stakeholders in a company have very different interests. Actions that benefit one stakeholder group can be reasonably expected to make other stakeholder groups worse off. These conflicts of interest mean that a board that is supposed to represent everyone often represents no one other than themselves and their own specific objectives.
As what the motor And wrote a great blog piece on this topic a few years ago. He looked at the different models of corporatism. Cutthroat corporatism, where the end game is stockholder wealth maximization at almost any cost. Crony corporatism, where companies focus less on efficient operations than on connections to government, with the objective being tilting the scales of competition in the
companies favor. Managerial corporatism Where the interests of executives Dr. the direction of a company and. Investors and other stakeholders are ignored and finally constrained corporatism where companies preserve the primacy of shareholders while constraining how they interact
with other stakeholder groups. Constrained corporatism is what we mostly see where companies are restricted in their actions by the legal and regulatory constraints, self-imposed constraints and market driven constraints. The motor and describes stakeholder capitalism as confused corporatism, which on the surface might look like constrained capitalism, but due to the multiple objectives with no clear ranking of importance, leaves you with a structure
which is destined to fail. The events at Open AI over the last week really highlight this issue. Open A is new board will consist of three people, at least initially, Adam D'Angelo, the chief executive of Quora and the only holdover from the old board, Brett Taylor, a former executive at Facebook and Salesforce, and Larry Summers, the former Treasury Secretary. The board is expected to grow
from there. Open AIS largest investor Microsoft is also expected to have a larger voice in open AIS governance going forward, and this may include a board seat. If we want companies to behave better in their interactions with society. Putting boards in place that are not accountable to anyone other than a vague concept of the greater good is probably not the best approach. The Volkswagen emissions scandal from 2015 highlights that bad corporate behaviour can harm shareholder value.
Volkswagen was hit with huge fines, recall costs and a damaged brand. Because of their illegal behaviour, a board focused on shareholder value is able to make decisions that are good for society as a whole, especially when constrained by the legal system and a reasonable code of ethics. It may be far from perfect, but it does appear to be better than the alternatives. Thanks for tuning into this week's podcast.
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