Post Category → Ethics

Rich v. King: The (Core) Founder’s Dilemma

TL;DR Nutshell: Much of the tension between founders and outside investors lies with one question, highlighted (years ago) by Noam Wasserman (HBS) as the core “founder dilemma”: do you want to be rich, or do you want to be king? When both founders and investors are honest with each other (and themselves) about their feelings about, and approach to, this dilemma, their relationship ends up running far more smoothly.

Background Reading:

Rich or King

In the majority of circumstances (statistically) the wealth accrued by entrepreneurs is inversely correlated with their percentage ownership stake in companies. In other words, founders who give away more equity and control in their companies (to other employees, investors, etc.) end up, on average, building larger, more valuable companies, and therefore become much richer than founders unwilling to give up control. That inverse relationship is the foundation of what Noam Wasserman, a professor at Harvard Business School, calls the “Founder’s Dilemma.”

Obviously, when any particular company (in isolation) is extremely successful, founders are able to maintain more control and ownership relative to companies that are less successful. We all know stories about the (rare) Facebooks of the world in which founders have maintained significant control through many rounds of funding and even IPO.  But overall the types (categories) of businesses in which entrepreneurs give up control in order to attract capital, talent, and other resources will grow much much larger (and enrich the founders) relative to the types of companies in which entrepreneurs maintain a tighter grip.

This is why Mr. Wasserman says that if founders want to avoid significant headache and heartache in the course of building their business, one of the first questions they need to ask themselves, and be honest about, is: do you want to be rich, or do you want to be king? Because very very very rarely can you be both.

Some founders legitimately care less about money than about ensuring that their business stays in alignment with their long-term vision/mission. They certainly want to be successful, but a removal from the leadership position in their company would, in their mind, mean personal failure, no matter how much gold they can expect to line their pockets with.

Other founders want to retain control/influence in their company as long as they feel that doing so will increase their chances of becoming financially successful, but the true, primary end-goal is financial success, and they will willingly step down if they feel someone else can scale the company better and faster.

Kings and VCs Don’t Mix

If you are very heavily a “King” founder, you need to think very very carefully about whether you should take institutional venture capital at all. VCs fall along a spectrum in terms of how much deference/respect they give to founder CEOs. Some (the good ones) will assume a coaching perspective, respecting a founder CEO as the head of the company and pushing her/him to learn and become a great leader. Others (the bad ones) will move as fast as they can to undermine founders and fill management with their handpicked roster of outsiders. The best way to find out who the Coaches and Underminers are is to ask people (privately and off-the-record) who’ve worked with them, particularly other founder CEOs.

However, while the best VCs give founders real opportunities to learn and excel, every-single-one will replace a founder if/when it becomes clear that doing so is required to continue scaling the business. Why? Because VCs are profit-obsessed vultures? No, because they have bosses who hired them to make them money, by achieving big exits. It’s their job.  So even if you have the best, most respectful set of VCs on the planet, the clock is ticking once that money hits the bank. If you can’t handle the thought of not being CEO of your company, no matter how large it gets, don’t take VC money. Ever.

The Jungle, The Dirt Road, and The Highway

What many first-time founders don’t realize, though, is that as many startups scale and become large enterprises, there often comes a time when a founder CEO wants to be replaced. Jeff Bussgang’s three stages of companies: the jungle (earliest stages), the dirt road (early scaling), and the highway (mature company/late-stage growth) help explain why.

To be a successful founder, you usually need a personality that thrives in, or at least is highly capable of handling, chaos (the jungle). Meetings, committees, structure, process, reporting obligations, policies, policies on meetings, meetings on policies, etc. are often the exact kinds of things that founders are avoiding by starting up their own companies instead of taking jobs at BigCo. They thrive in following their intuition/judgments, tackling tough problems, and being on the ground strategizing about product and selling the Company’s vision.

But as companies become full-scale enterprises with hundreds of employees, all of that “structure” becomes necessary. You simply cannot run a 500 employee multi-national company like a Series A startup. Great founders often succeed in the jungle, and thrive on the dirt road (when the company is a startup), but start feeling suffocated, uninspired, and disengaged on the highway. And of course, professional CEOs are the reverse: they are trained to keep the rocketship steady and fueled once its cleared the roughest atmosphere, but their skillset breaks down if required to operate in the iterative, intuitive, grassroots environment of early-stage companies.

“Rich” founders who understand their strengths, and when those strengths are no longer optimal for the stage of their company, are able to actively participate in the executive succession planning of their companies, rather than putting up a fight with their Board.  Some decide to completely step away from the company they’ve built in order to go build something new. Others will take a role in their company that leverages their strengths – removed from the day-to-day processes and bureaucracy of the enterprise, and focused exclusively (as an example) on higher-level product and strategy.  Some founders will (happily) make the transition between jungle, dirt road, and highway without giving up the CEO title, but those are few and far between.

The important thing in all circumstances is that founders not fight the reality of what it means to take on institutional capital and build a large, scaled company. Work within that reality to achieve financial and personal success. Know yourself. 

Start Off With Transparency of Values and Vision

Control-freak founders are not alone to blame for the ‘founder’s dilemma’ dysfunctions of the VC-founder relationship. Certain VCs fail to be upfront with founders about their expectations and style of corporate governance. In order to “get the deal,” they’ll talk up how supportive and founder friendly they are, and once the cash is deposited immediately start running through the playbook described in How Founders Lose Control of Their Companies.  A founder who wants to be King and a VC who pretends (temporarily) to be OK with that is a perfect recipe for dysfunction at the Board level, which usually ends up destroying value.

As trite as it sounds, honesty and transparency go a very long way here. Founders should be open about their vision for the Company, their expectations for how they’ll interact with their Board, and their attitude towards when and how to recruit outside management.  VCs shouldn’t beat around the bush about what the job of a venture capitalist is, and their approach to Board governance and executive recruitment.

The narrative of the founder CEO pushed out by VCs he now hates isn’t the only narrative out there. There are plenty of success stories of founders who built strong, trusting relationships with investors who still did their jobs as VCs and ensured professional management (that the founders can trust) was brought in at the right time. It just depends on the people.  Building and maintaining trust is hard. But so is building and scaling a company. Cut the BS, communicate like adults, and then focus on building something awesome and getting rich, together. 

Burned Relationships Burn Down Companies

TL;DR Nutshell:  Success in building a company most often requires a founder team who can not only find great investors, advisors, employees, and other stakeholders, but build deep relationships with those people in a way that leads them to be emotionally, not just financially, invested in the success of the company.  Short-sighted founders focus on the costs of those relationships, ‘transactionalizing’ them in a way that weakens loyalty. The smarter ones realize that those costs are an investment in an invaluable safety net that will support the company when it hits rough waters.

A brilliant phrase that I learned a while back, and which I’ve often used in suggesting to founder CEOs how they should approach building their “roster” (not just employees, but investors, advisors, lawyers, and other stakeholders) is to never be the person who “knows the cost of everything and the value of nothing.”

If you approach every relationship from the perspective of maximizing your gains and minimizing your costs – get the highest valuation possible, keep as much control as you can, minimize the equity package, minimize the salary, discount the bill –  you may think you are doing what’s best for yourself and your company, but in reality you’re just isolating yourself from the people whom you should most want on your team. 

Talent cares about relationships.

The most successful and talented people in any market/industry – venture capital, angel investing, design, programming, law, sales, PR, etc. – very very rarely get to where they are because they were chasing money. They often do what they do because they, in some sense, enjoy it. It may not be fun in the same way that going fishing or on a great vacation is fun, but work is something much deeper to them than just work. This is not at all, however, to say that money is irrelevant to them, but getting paid well is often more about respect for their talent – a moral acknowledgement of the value they provide – than about their actually needing the dollars themselves.

Put slightly differently, the highly talented people whom you want supporting your company’s success will very often have “F.U. Money” or “F.U. Skills” or both. They’ve already mastered the bottom rungs of Maslow’s hierarchy of needs and are looking for respect, involvement, trust, engagement, etc in their work and investments. They are looking for real relationships. Build and nurture those relationships, and the long-term returns will be massive, either for your company or you individually. Burn those relationships, and you’re fu**ed. 

Don’t Transactionalize People.

Obsessed with maximizing your valuation/control and minimizing dilution? You’re going to end up with shitty VCs; the kind who add no value, are always whining about performance, and will replace you in a heartbeat for not producing the results that they can’t help you achieve. Insisting on keeping equity packages as small as possible? You’ll end up with shitty employees who will drive you insane with the amount of oversight, correction, and overall time sucking they require. Focused on keeping those legal bills to an absolute minimum? You’ll end up with shitty lawyers who are unresponsive, incompetent, and accruing legal technical debt that you’ll pay for later. The examples go on and on.

Watch the bottom line and the cap table intelligently, but let good people make good money. When you push too hard against talent, they will either (i) pass  entirely on you for someone who values them more, or (ii) register in their mind that their relationship with you is purely transactional. The qualitative difference between a transactional relationship and a deeper one sounds small, but in a high-risk, low resource business it can be everything.

If you hit a funding snag and need a bridge to get to your next round, investors with whom you’ve built real relationships may put in some money to keep you going. Investors who view you as just another number in their portfolio will not. Need to cut compensation temporarily, or stretch payments on a bill, to get through that bridge period? You better hope your employees and service providers actually give a damn about your business for reasons beyond their paycheck.

Healthy long-term business relationships are built on a mutual sense of fairness; that it’s OK to take into account leverage and context in negotiations, but that everyone should in the end leave a little on the table as a statement that the relationship is there for something bigger than just money.

Mistrust Burns Money.

Trust – meaning a feeling that you have a solid understanding of a person’s authentic character and that they’ll treat you fairly and respectfully – is not just some teddy bear “kumbayah” lets-all-love-each-other buzz word. It is currency that makes doing business long-term significantly, dramatically, more stable and less costly. If you frame it purely in terms of a risk-reward analysis, if I feel like I can trust someone, I automatically feel like working with them is less risky. And if it’s less risky, the threshold of reward that I need (my compensation) to make the relationship worthwhile goes down significantly. Mistrust is spectacularly expensive.  As a startup, you can’t afford for people to not trust you.

The end-conclusion here is a straightforward one: all of the data on business executives confirms that emotional intelligence – the kind of ‘people skills’ that enable you to connect and build trusting relationships with others – is a foundational trait for successful founders, particularly founder CEOs. People are born with varying degrees of those skills, but everyone should work on improving them.

Very very very few teams succeed purely on the momentum of their business. Study the histories of successful teams, and you’ll see a network of valued relationships being built and nurtured over time, propelling founders forward and often protecting them from hitting rock-bottom.  Don’t be the guy who knows the cost of everything and the value of nothing. He’s lonely, unsuccessful, and poor.

The Fiduciary Duties of Founders

TL;DR Nutshell: The moment someone is added to a startup’s cap table, founders (as majority stockholders, directors, and officers) becomes fiduciaries of that stockholder. This means that, regardless of how much control founders may have over a company, corporate governance law draws a hard line on how that control can be used. Crossing that line can result in a lawsuit.

This is one of those “core concepts” posts that, to lawyers and professional investors, will seem laughably basic; and yet the topic is something that I regularly see first-time founders get very wrong. And like most SHL posts, I’m going to explain things without referencing statutes or complicated terms. Founders need to understand the concept of Fiduciary Duties. The details they can learn from their lawyers or on-the-job.

State Corporate Law

Most Angel/VC-backed startups are Delaware corps. If they are not Delaware corps, they are usually incorporated in their home state and will be required by institutional investors to become Delaware corps if/when they ever are offered a check.  Whether you are a Delaware corp or not, your state certainly has corporate governance rules giving founders (as directors and majority stockholders) varying degrees of fiduciary responsibility to minority holders in their company. The concept is the same.

At the most fundamental level, to say that founders have fiduciary duties to their stockholders means that they cannot, without seriously risking a lawsuit, unfairly enrich themselves at the expense of other people on their cap table. They can certainly get rich by making everyone on the cap table rich; by growing the pie. But they can’t, without some kind of very credible case that it is necessary for the well-being of the entire business, improve their part of the pie at the expense of the rest of it. 

Hypothetical: Founders X and Y hired Employee A and gave her 5% of the Company that, because of some big contributions she made, was 40% fully vested on the date of issuance (meaning 2% of the Company’s equity, of her holdings, is fully vested). After a few months after the issuance, they have a big dispute and the founders fire Employee A, which they are certainly entitled to do. Under the Stock Issuance Agreement terms, 3% worth of the Company gets returned (because it wasn’t vested yet), and Employee A walks away with the 2% she had vested.

But Founders X and Y are pissed off that Employee A has that 2%. “She doesn’t deserve it. She totally ruined the product” they say. Then the light bulb switches on. “We control the Board and the stockholder vote! We’ll just dilute the hell out of her by issuing ourselves more shares!” they say.

Sorry, dudes. If it was that easy to screw minority stockholders, no one would ever invest in a company.

Delaware and other states have rules around “Interested Party Transactions.”  Without getting in the weeds, Interested Party rules boil down to:

  • A Board of Directors has a duty (a fiduciary duty) to do what’s best for the company and all of its stockholders taken as a whole, without unfairly enriching its own members.
  • Any transaction in which the Board members themselves are specific beneficiaries – meaning they are getting something that others are not – is inherently suspect. It is an “Interested Party Transaction” and is open to claims by minority stockholders (the people who didn’t benefit from the transaction) that it was a fiduciary duty violation.
  • In order to “cleanse” (so-to-speak) the transaction and, in some cases, give it a safe harbor protection from lawsuits, extra steps must be followed to ensure the transaction really was fair. Those steps usually are (i) obtaining approval by the disinterested members of the Board (if any) and/or (ii) obtaining approval by the disinterested stockholders of the company. The disinterested people are the ones who aren’t getting the special benefits.

Put the above 3 bullets together, and it’s clear that Founders X and Y (i) are planning an Interested Party Transaction and (ii) without getting a “cleansing” vote of that transaction, are assuming a very serious risk of a lawsuit. If there were 5 people on the Board, and the planned dilutive issuance to X/Y was approved by the rest of the Board, then the risk profile of the transaction would be very different. Similarly, if there are other people on the cap table besides Founders X/Y and Employee A, then if their votes make up a majority of the stock not held by X/Y (the disinterested stockholders) and they approve the dilutive new stock, we’re again in much safer territory.

The key is that, in an interested party transaction, you need to get a majority of the people who aren’t getting the ‘special benefits’ to approve the deal. If you can’t, then you’re asking for pain. 

If the entire cap table is X, Y, and A, then X & Y are just asking for trouble and (frankly) deluding themselves by thinking that they can dilute A (without her consent) in a legally air-tight manner. I’ve seen founders throw out a phrase like “let’s just do a recap” (short for recapitalization) as if recaps are a magical get-out-of-fiduciary-duties card. I think that idea was spread by ‘The Social Network,’ but I’m not entirely sure. Recaps are complicated, and you still have to worry about fiduciary duties to get them done properly.

Corporate Governance is Real

The overarching umbrella of the rules, processes, etc. that govern how corporate directors and officers interact with stockholders is called ‘corporate governance.’ Founders sometimes think it’s all silliness reserved for when they go IPO, but it’s not. From Day 1, corporate governance matters. Yes, it becomes more formalized as you grow as a company and the stakes get higher, but it’s the same rules at Seed v. at Series D, just being applied differently. You better believe it matters the moment a VC is on your cap table.

Fiduciary duties do not mean that you always have to do what your minority stockholders want. That would be impossible. It just means that, as a director/officer, you have to do what’s best for the Company (the whole pie), and not just for yourself. If there’s a financing coming up that some of your stockholders don’t like, you should be safe if disinterested parties approve it as something that is the best move for the entire company. I say should, because the rules, the process, and even the language in your board resolutions matter. They can be (and often are) the difference between moving forward knowing that your decisions can’t be challenged v. handing disgruntled stockholders a loaded gun to use against you when you least want them to.