After yesterday’s post on Raising Money as Forcing Function to Drive Towards an Exit, an entrepreneur brought up another point to me: raising money also starts the track towards the founders no longer owning the majority of the business, and, often, losing control. Many entrepreneurs start companies to be their own boss as they have a high internal locus of control. Only, after two, sometimes even one, round(s) of financing, the founders no longer have control.
Here’s how the math might look:
- Start – Founders own 90% with a 10% employee option pool
- Series Seed – Sell 15% of the company and add another 10% to the option pool for 25% dilution taking the 90% for the founders down to 67.5%
- Series A – Sell 25% of the company and add another 10% to the option pool for 35% dilution taking the 67.5% for the founders down to 43.9%
So, in a “normal” scenario, after the second round of funding, the entrepreneurs no longer own the majority of the business. But, now the startup has the desired capital to execute against the plan and hopefully build a large, successful business.
Entrepreneurs need to understand the trade-offs and determine how far they can go on their own vs going faster with outside capital. The long-time question investors like to offer up to entrepreneurs: would you rather own a slice of a big watermelon or the entirety of a small grape.
What else? What are some more thoughts on the founders reaching the stage where they no longer own the business?
David Cummings on Startups 
Hi David – one important concept to also bring up (and it may be more of a management decision issue vs. founder/ownership issue). Once founders lose control and the start-up grows, there is often pressure to embrace more traditional corporate practices which involves bringing on high-salaried executives/professionals – people that by definition are likely more concerned with their bi-weekly salary rather than accelerating the company – they simply do not own stock. Options, maybe? And the incentives remains keeping the status quo along with modest growth as an acquisition will likely mean job loss for the hired executives.
There are many investor-backed start-ups that exist that have taken on funding to grow and have grown, but never to a shareholder-enriching event. Most will never achieve an exit or achieve enough internal cash flow to produce meaningful distributions. And if there is excess cash available, often investors, especially institutional, will prefer to reinvest the cash in an acquisition or more hires – the VCs want 10x returns not a 2% dividend-yielding holding.
The employees make up less than 10% of ownership stake; the founders are often employed in other positions rather than CEO if they are even at the company. The motivation for management and employees becomes sustain, get paid every 2 weeks and obtain bonus targets (usually driven by EBITDA which discourages continued, expense-high investment and growth and mathematically, no EBITDA means less cash to pay out cash bonuses and merit pay increases).
You can argue the board and VCs needs to provide a better landscape for success. It becomes a chicken and egg situation. Company is sustaining and has some phantom market value; if it goes to 0 or takes a huge hit, that looks bad. Yet, the investors are not too keen to fuel with bigger investments to grow or do not wish to give up more stock to executives. At some point, the company fizzles or maybe gets sold for a fraction of its former asking price (further penalizing the founders/shareholders while the non-owner employees enrich themselves further via salary and bonuses).
What are your thoughts on the above scenario? Their commonplace in the start-up environment? VC tolerance for such (not all VCs are super-heroes)? Advice for founders, investors and hired executives/employees to create and sustain a fast-growing enterprise that can reward the shareholders as well as employees that come on that will not have the luxury of substantial, if any, ownership stakes?
To reference the ‘smaller slice of the bigger pie’ analogy, there are many, many shareholders could have had several full grapes but are told to hold out for a slice of a bigger, juicier, richer slice of watermelon. Makes sense, except there are many employees at the table eating the grapes (and more) along the way and sometimes, the watermelon seeds themselves. At some point, a grape for a shareholder/founder is not all that bad especially considering a huge majority will never get the larger watermelon slice.
P.S. – Back button is a savior.
Why the presumption that Founders will/should lose control? It harkens back to a time when investors knew how to “play the game” and entrepreneurs didn’t…or it’s indicative of a weak startup, or weak product, and needs the risk shift in favor of the capital at stake. For that matter, Founders can issue their own term sheets to investors to begin negotiations. There’s plenty of ways to structure so that founders can retain voting control on a minority equity position.
What intelligent investor, knowing the leadership had strong enough psychological drive to found their own company, would WANT the founders out? What manager would put key talent in a psychologically unfavorable and stressful position?
HBS/HBR is turning out quite a literature on founder-first startups succeeding, firms like a16z are proving founders can lead. Time to challenge this nonsense. It amazes me that for as disruptive a bunch of entrepreneurs are…they rarely challenge the assumptions in entrepreneurialism.
Followup on that comment and challenge you with…Investors are the one’s who need to understand the trade-offs. The world is a big place, with plenty of incubators, accelerators, angels, VC’s, crowdfunds, mico-VC’s to sell shares too. Entrepreneurs need to learn how to walk from bad deals.