Replacing the Founder CEO

TL;DR: When an investor pushes to replace a Founder CEO, there are usually one of two motives behind it: performance or power. By keeping the process open and balanced, investors with strong reputations will demonstrate that the former, and not the latter, is at play.

Background Reading:

Here’s a story about two startups, each with struggling founder CEOs in need of a change, but with very different governance approaches, and very different outcomes. I’ve seen both of these fact patterns multiple times among my own client base, and I’ve made sure to strip any details that could be construed as too specific.

Company A:

Company A raises a small Series A round led by a well-known VC. During that round, no discussion ever occurred about what Company A’s management structure might look like in the next 5 or even 10 years. The VC and Founder CEO “hit it off” and closed the round, with the assumption simply being that the founder CEO would stay in charge of management.

Fast forward 18 months, and the Company is struggling. There’s been revenue growth, but not nearly enough to justify a serious uptick in valuation. One day the VC calls a meeting and informs the founder that they are getting a new CEO, and he’s already been identified. It’s a CEO the VC has worked with before, but whom the founder CEO has never met. His compensation package has already been finalized.

There had been no prior discussion of looking for a new CEO. The founders/common directors were never asked for input on who might be a good fit, or to interview candidates to ensure alignment. So naturally, the founder CEO goes into panic mode. He lashes out at his Board, starts reviewing his company contracts and talking to litigators, and some very lawyerly-sounding e-mails start getting fired off.

In the end, the founder CEO digs his heels and asserts at the next Board meeting that the new CEO candidate is not the right person, that as a Board member the fact that he was not consulted on the process was a violation of appropriate corporate governance, and that he will refuse to step aside at this time.

In order to avoid a full-blown dispute, and knowing that the founder’s threats could credibly create damage, the Board decides to slow down. The founder CEO stays in his position, and they work on a performance improvement plan. With trust being burned, they struggle to get aligned on the recruitment of new management. A year later, the company is still struggling.

Company B:

Company B also closes its Series A round led by an institutional VC. During the Series A negotiation process, however, the founder directly asks the VC about their philosophy on founder management, executive succession, and when they would expect professional management may be needed.  A candid discussion ensues in which the VC acknowledges that there will likely be an appropriate time to bring in more seasoned executives, but that such a process would be open, and the common directors/stockholders would be heavily involved in choosing the candidates.

As part of that discussion, the Founder CEO acknowledges that he himself is not interested in being in control forever, but that he does have a specific vision for how the Company might scale, and what its culture might look like through that scale. He also makes it clear that he expects to receive support in the form of a COO or other C-level support to scale his skillset before any definitive conclusions are drawn as to whether he can lead the company.

The VC makes a few comments about his own philosophy on how to approach management changes, but overall they are aligned. The founder CEO quietly verifies the VC’s answers by speaking with other teams who’ve worked with him before, confirming that is in fact how he operates.

The founders and VC also put in place a board structure that ensures the replacement of the CEO would require support not just from investors, but from an independent director, and they agree on what a fair process for recruiting that independent director would look like. With everything in place, they close the round.

Fast forward 2 years, and the Company has achieved some traction, but it’s stalling. After some hard discussions, the Board determines that it’s time to bring in some outside help. All directors, including the common directors and CEO, are invited to suggest candidates, and to be part of the open interview process. In the end, a CEO is chosen with the assistance of a 3rd-party recruiter, with both the support of the VC and the original management team. The founder CEO moves into the Chief Product Officer position, and remains on the Board. The company is doing much better.

As I’ve mentioned before, I’ve seen both of these fact patterns play out within my own client base. What can we learn from them?

Hard, but respectful conversations up front prevent much harder, and potentially more destructive, conversations later.

Lead investors are heavily incentivized to “sweet talk” a founder team, promising the sun, moon, and stars, in order to close the deal. VCs who overplay their “founder friendliness” are setting themselves up for drama in the future when reality pours cold water on everyone.

Smart founders and good VCs are open and honest about the issues that will inevitably come up in the future, and have candid conversations about them before docs get signed. They set realistic expectations, so that when a change is needed, there is much more alignment on how to effect that change.

And just as importantly, once those conversations occur, smart founders verify the answers they’ve gotten by speaking, off the record, to people who’ve worked before with those VCs. It is one thing to tell founders that you’ll be respectful, open and honest. It’s much more significant to have a portfolio full of teams that will confirm, without you looking over their shoulder, that it’s in fact how you work.

Commit to fair processes, but not specific outcomes. 

Good, litigation-preventing corporate governance always boils down to fair processes. No one ever knows at Series A who will be in the CEO seat at Series B, or Series C, but they can commit to what the process will look like for determining the final outcome.

Save for the very very small number of unicorns in which founders can keep strict control (think Facebook), reputable VCs will never tell a founder CEO that she/he will stay CEO as long as they want to. The job of a Board of Directors is to do what’s best for the all of the Company’s stockholders as a whole, even if that means making a founder CEO unhappy.

What really distinguished Company B from Company A wasn’t the outcome, but the process. By agreeing that executive succession would not be a surprise bomb dropped out of the blue, but a transparent process in which new executives are brought in with the honest support and vetting from all constituencies, Company B kept drama to a minimum.

In many situations where I’ve seen drama occur at the Board level, it’s started from one or two directors on the Board forgetting that there are other directors on that same Board – as well as outside stockholders to whom the Board has to answer – and thinking that they will successfully force through whatever they wish without having to answer to others.

It’s possible that in Company B the founder CEO may have not agreed that it was time to step aside. He may have even contemplated getting a little difficult, in the way that Company A’s founder CEO did. But by ensuring (i) open communication, (ii) a balanced recruiting process, and (iii) a voting procedure that included support not just from the investors, but from disinterested parties, the Board ensured that the founder would have had a much harder time creating drama; at least credible drama.

Excellent, thoughtful governance processes ensure that if anyone ever gets angry and wants to rock the boat, all they can really do is pound sand. Bad governance, however, effectively hands someone else a weapon to use against you.

Contracts enforce good process.

As I’ve written before in Don’t Rush a Term Sheet, anyone who doesn’t take the time to really understand what the material terms of their term sheet mean, not just in terms of economics, but in power structure and how hard decisions will be made, is in for an inevitable rude awakening at some point in the future.

If you have the tough conversations up front, and agree on what good, balanced process will look like, put that process on paper.

I’ve seen some investors sing wonderful songs about their principles and openness, but somehow try to insist that they *need* “simpler” decision-making processes on paper. Don’t worry about what the documents say, they’ll tell you. You can trust me. I’ll treat you right.

Cute.

There are two very different potential motives when investors insist that a startup needs to replace its founder CEO. The first is to improve the performance of the company, which benefits all stockholders and is consistent with the fiduciary duties of Board members. The second is to put in place someone that the investors can more easily control/influence, which is really about power and does not benefit all stockholders. By committing, contractually and reputationally, to balanced processes that include all Board members in executive recruitment, VCs can credibly demonstrate that shareholder value, and not power grabbing, are behind their actions. 

Great governance protects shareholder value.

There are plenty of institutional investors who follow solid corporate governance and still achieve fantastic returns. Yes, it takes more diplomacy and negotiation on the part of investors to build alignment and trust with other members of the Board and the cap table; instead of simply ramming through their agenda. But that is the investment culture and mindset that emerges when startup ecosystems mature from being captive to 1 or 2 funds toward more dynamic, competitive capital markets in which investors have to actually care about their reputation. See: Local v. Out-of-State VCs.   True ecosystems filter out bad actors by funneling deal flow toward those with the best reputations. 

For the most high-stakes decisions a company can make – like whom to raise money from, or whom to have in charge – speed should never be the top priority. Good processes and discussions take time up-front, but in the long-run they can prevent the kinds of disputes that destroy shareholder value, and can even destroy entire companies.


Also published on Medium.