Founder Control

By October 14, 2019Financing

Many founders dream of becoming the next Jeff Bezos—they want to start a company, grow it, take it public, and lead it for years. While some founders accomplish this goal, they are the exception rather than the rule. For every Jeff Bezos, there are hundreds or thousands of founders who chose (or are forced) to relinquish control of their company long before an IPO. While it may be painful to consider handing over the reins of your company to someone else, founders should be prepared for the possibility. One study of startups found that after three years, 50 percent of founders were no longer the CEO, and less than 25 percent were the CEO during the company’s IPO1. This article will help you understand the strategies and tradeoffs involved in maintaining or ceding control of both the majority ownership and management control of your company.

Ownership Control

Although a handful of founders choose to bootstrap their companies (discussed in more detail later in the article), almost all startups receive outside funding at some point. While receiving outside funding means that founders’ ownership will be diluted—they will own less of the overall company—accepting outside funding can help the company grow more quickly. Additionally, angel investors and venture capital firms can provide mentoring, networks, and other non-financial resources to help startups succeed. Ultimately, many founders choose to receive outside investment based on the logic that they would rather have 20 percent of $1 billion than 100 percent of $100 million.

Management Control

Although it has clear benefits, one of the main reasons that founders are hesitant to accept outside investment is the fear that they will lose control of their company. Even if a founder remains the CEO, accepting outside investment means that other investors will have some influence over the direction of the company. After putting in so much time, effort, and personal resources into a company, it can be difficult, even painful, to give up any amount of control. The difficulty and pain for a founder can be compounded if he or she is replaced as CEO. When a founder is replaced, the company could deviate from its founding vision and the founder could potentially be forced out of the company entirely.

Still, while many founders fight for management control of their companies, others choose to relinquish control and focus on a company project or role that they are passionate about and that is well aligned with their skills. For example, in comparison to Steve Jobs, Steve Wozniak was content with leaving Apple’s management to others while he worked in the research and design department, engineering computers. Whether founders willingly take on a new role or are pressured to step down, understanding why investors often prefer to bring in an outside CEO can be beneficial.

Reasons for Replacing Founders

Although founders are often resistant to the idea of being replaced with new management, investors are often compelled to make the change because they want someone with particular skills and experience. As the company enters different stages of growth and maturity, a different skillset is often required to meet new challenges. Even though the founder has many abilities that have been critical in starting and growing the company up to this point, those same skills may become a detriment to the company going forward. For example, a founder may have been able to manage the few dozen employees that were necessary as the company was getting off the ground; however, managing hundreds of employees with different functions and backgrounds may prove to be more difficult. Additionally, the CEO will need to understand and analyze finance and accounting issues, foster relationships with investors and analysts, know how to navigate regulatory and governance matters, and create operational efficiencies. While some founders may excel in all these roles at any stage of company development, investors understand that those individuals are rare exceptions.

The Founder Control Matrix

The following matrix identifies what most commonly happens based on the founder’s levels of equity ownership and management control.

Founder Control Matrix

Most Common

Although there are exceptions, founders do not usually maintain majority ownership of the company and are often replaced by an outside CEO. When this occurs, the founder must decide whether they will leave the company or take on another role within the company. Research shows that around 40 percent of founders stay as directors and 23 percent take positions that report directly to the CEO, while 37 percent leave the company2.

Although the founder will no longer have total control over every decision in the company, if he or she chooses to stay then a founder can continue to influence the company’s direction, keeping it more in line with her founding vision. Additionally, the founder can pass on important knowledge to the new CEO which can help increase the company’s chances of success. A founder’s continued contributions and innovations can help increase the value and impact of the company.

Absentee Owner

An absentee owner—someone who owns a startup but leaves management duties to someone else—is rare for venture capital backed startups. Founders need to be fully engaged and dedicated to their company for it to grow and succeed, and outside investors want to invest in a company with founders that are all-in. While it is possible for a company to function with an absentee owner, such as a family-owned business or real estate company, the types of companies that are attractive to venture capitalists and that will eventually become public always necessitate engaged founders.

Bootstrapping

Founding and developing a company with very little outside financing is known as bootstrapping. Founders often bootstrap their company initially because they are unable to obtain outside investment or because they do not want to lose equity in their company. The benefits of bootstrapping include maintaining full control over management of the company and a greater portion of equity ownership. By giving up less equity, founders can capture a greater portion of any increase in company value. On the other hand, refusing to accept outside investment could hamper growth and cut the company off from the expertise and resources of angel investors or venture capitalist firms. Eventually, most bootstrapped startups accept venture capital funds; however, accepting outside funding after the company has already achieved significant growth can help founders maintain ownership and control of their company. For more information on bootstrapping, see our article The Stages of Startup Financing.

Dual-class Stock

An increasingly popular way to leverage the advantages of outside investment while also maintaining management control over a company is dual-class stock structures. Dual-class stock structures are created when a company issues a class of shares to founders and other insiders that has superior voting rights. Consider the following example:

Hawk Company issues 8,000 Class A shares in exchange for 80 percent ownership in the company. The founders receive 2,000 Class B shares, leaving them with 20 percent ownership in the company. However, Class A shareholders are entitled to one vote per share, while Class B shareholders are entitled to ten votes per share. The ownership and voting rights of this stock structure are represented in the graphs below.

Class A Ownership - 80%; Class B Ownership - 20%; Class A Voting Rights - 28.57%; Class B Voting Rights - 71.42%

Under this arrangement, Class B shareholders own only 20 percent of the company, but possess over 70 percent of the voting rights, giving them complete management control over the company. By utilizing a dual-class stock structure, founders get the best of both worlds—the ability to utilize investor’s capital to grow their company and the ability to control the company’s vision, strategy, and overall management.

In other scenarios, companies can take the dual-class stock structure to the extreme. For example, Snapchat only issued non-voting shares in its IPO. These non-voting shares give shareholders no control over the direction of the company while still giving them a percentage of ownership.

Proponents of dual-class stock structures argue that this arrangement allows companies to quickly respond to rapid changes, which can be especially useful for technology companies. On the other hand, some investors argue that dual-class stock structures are damaging to corporate governance and could allow founders to make decisions that are not in the best interest of all shareholders. Because of these concerns many investors have begun pushing back against dual-class stock structures. For example, because the NYSE’s listing requirements do not allow companies to alter voting rights after listing on the exchange, any dual-class stock structures need to be created before the company goes public. Additionally, dual-class shares generally have sunset clauses that require stocks with superior voting rights to be converted to regular, single-vote shares after a certain number of years.

Other Methods of Maintaining Management Control

In addition to dual-class stock structures, founders can keep control of their companies by exerting influence over board composition or convincing the board to hire a malleable CEO.

Case Studies

Decisions and consequences of maintaining or relinquishing control vary between founders. Steve Jobs, Mark Zuckerberg, Evan Spiegel, and Travis Kalanick provide contrasting experiences that highlight the importance of founder control.

Steve Jobs—Apple

Steve Jobs founded Apple Computers in 1976, and today is known as the visionary and driving force behind his company. However, before he was the famous CEO of Apple, the company’s earliest investors believed that neither he nor co-founder Steve Wozniak had the skills necessary to lead and manage the company. Job’s and Wozniak’s differing responses to this decision illustrates the different paths that founders can choose when management control of their company is taken out of their hands. As mentioned earlier, Wozniak willingly allowed others to manage the company while he focused on engineering new products. Jobs, on the other hand, would go on to fight for management control of the company. Michael Scott, an experienced CEO, was selected to lead the company and was replaced by Mike Markkula following Apple’s IPO in 1981.

Later, unable to convince the board to make him CEO, Jobs handpicked John Sculley, CEO of Pepsi-Co to lead Apple. Jobs likely hoped that he would have greater influence over the company by choosing a potentially loyal CEO. However, when Sculley and Jobs had a disagreement that was brought to the board, the board sided with Sculley. After this incident, Jobs claims he was fired, while others say he chose to leave the company. Either way, Jobs lost the battle for control of the company he founded, and although he would later return and become the CEO of Apple, his experience highlights why management control is such an important issue for founders.

Mark Zuckerberg—Facebook

Mark Zuckerberg founded Facebook in 2004 and has remained the company’s CEO. Zuckerberg’s success in maintaining control of Facebook is rare but provides a roadmap for other founders who hope to stay on as the CEO of their companies. Zuckerberg gained investor confidence in his abilities as CEO, brought in experienced outsiders, and used a dual-class stock structure to maintain management control of Facebook.

Although investors often doubt the long-term success of founders as CEOs, the success of Mark Zuckerberg, Steve Jobs, Bill Gates, Jeff Bezos and others has persuaded investors that some founders are indeed capable of maintaining control of their companies. In Zuckerberg’s case, investors were further pacified when he assembled an experienced executive team, including Sheryl Sandberg, to help lead the company. By taking this approach, Zuckerberg eased investors’ concerns about his inexperience and allowed him to continue as CEO.

Even without investor support, Zuckerberg would likely still have been able to maintain control over Facebook because of its dual-stock structure. Under this structure, Zuckerberg owns around 16 percent of Facebook but controls almost 60 percent of the votes, effectively giving him total control of the company. Because of this control, Zuckerberg famously negotiated a deal to purchase Instagram for $1 billion and only notified the board of directors after the agreement had been reached3. The purchase of Instagram has proven to be successful and shows how allowing a founder to have complete control enables quick decisions that can be beneficial for the company. On the other hand, it also raises concerns about corporate governance, and some opponents of dual-class shares argue that giving too much control to founders can allow them to make decisions that may hurt the company. For example, Facebook’s involvement in the Cambridge Analytica scandal and its inappropriate use of personal data has eroded investors’ confidence in Zuckerberg’s management team and caused some concern about the level of control that he has over Facebook’s decisions.

Evan Spiegel—Snapchat

Evan Spiegel founded Snapchat in 2011 and grew it to a height of 190 million daily active users. Spiegel and co-founder Robert Murphy have also utilized a dual-class stock structure to maintain control of their company. Together they control over 80 percent of votes while having only around a 45 percent equity stake in the company. In an unprecedented move, Snapchat was the first company to IPO by offering shares with no voting rights, allowing the founders to maintain their high level of control over the company. A higher level of control also comes with a greater share of the blame when company performance does not meet expectations. Despite warnings, Spiegel pushed an app redesign that failed; this failure combined with slowing user growth has led to a decrease in Snapchat’s market cap from a high of $31 billion to a low of $6.5 billion. While Snapchat’s prospects are unclear, this chain of events is one of the reasons that investors are increasingly opposed to dual-class shares.

Travis Kalanick—Uber

Travis Kalanick founded Uber in 2009 and helped pioneer the gig economy. He grew the company to around $70 billion before he stepped down as CEO in June 2017. Sexual harassment allegations and coverups within the company, negative company culture, a video of Kalanick berating an Uber driver, and other poor behavior shook investor confidence in his ability to lead. Additionally, the battle for company control between Kalanick and other investors became even more contentious and public, which has damaged Uber’s reputation.

Adam Neumann—WeWork

Adam Neumann co-founded WeWork in 2010 and served as its CEO for nine years. In August of this year, WeWork filed to go public with a private valuation of $47 billion. Soon after WeWork’s private valuation, however, investors began to worry about WeWork’s potential for profitability and corporate governance structure. Reports emerged that Neumann owned many of the buildings leased by WeWork, profited greatly from selling the trademark for the word “We,” and received millions in loans from the company. Furthermore, Neumann was guaranteed stock with twice the voting power of other CEOs, and Neumann’s wife was given the right to name his successor should he become unable to run the company. These facts, combined with reports that Neumann created a culture of partying and drug use, caused Neumann to step down as CEO in September and WeWork to withdraw from its IPO. These problems highlight some of the reasons that investors are hesitant to allow founders to maintain extensive control over company management.

Conclusion

Control of a company is a passionate and at times contentious issue for founders. Giving up any measure of control can be difficult, and being forced out of the company you started can be devastating. However, every founder needs to make decisions about the level of equity ownership and management control that he or she will give up to outside investors. Whether a founder chooses to bootstrap, to use a dual-class stock structure, or to take the traditional route, founders should understand the benefits and drawbacks of each option.



 

Resources Consulted

 


 

Footnotes

  1. Wasserman, Noam. “The Founder’s Dilemma.” Harvard Business Review, February 1, 2008.
  2. Wasserman, Noam. “The Founder’s Dilemma.” Harvard Business Review, February 1, 2008.
  3. Wall Street Journal. In Facebook Deal, Board Was All But Out of the Picture
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Author Rand Hawk

Rand is from Gilbert, AZ and will graduate with a MAcc from BYU in April 2019. He is currently studying to become a CMA and CPA. Rand is a huge Cubs fan and enjoys spending time with his wife and son.

More posts by Rand Hawk

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