You’ve Lost Control Of Your Startup Even If You Still Own 51% – Here’s Why

Most entrepreneurs’ primary focus during fundraising events is on their dilution. They believe they keep control of their destiny as long as they – solely or with their co-founders – keep a majority of the voting rights of their startup.

It’s simply not true, and here’s why.

Why Entrepreneurs Share Control In The First Place?

As an idea grows into a startup, which itself develops into a company, two external developments dilute the founders’ grip on their venture:

  • Senior executives; and
  • Financial investors 

The transition can be difficult, and it often is. After all, this is often not why most founders chose the entrepreneurial path. 

When things go well, the proverbial “garage entrepreneurs” have to resort to external resources

Sharing Operational Decisions

Many entrepreneurs, when asked why they started on this arduous journey, answer they wanted to have something that was theirs, to be their own boss – and change the world, of course.

These owners usually manage people instinctively. The problem is, entrepreneurs are typically good at one or two things, such as product definition, sales(wo)manship, and market vision, but rarely at managing people.

In many successful ventures, founders hire professional managers to put in place processes, which typically include recruiting and retaining top talent. Think of Eric Schmidt at Google and Sheryl Sandberg at Facebook.

As a result, entrepreneurs have to share the decision-making process with these highly effective achievers.

Even a well-documented control freak such as Steve Jobs recognized that if you didn’t let your top management team make decisions, they would eventually leave the company.

“What do you do all day?”

Sharing Equity Ownership Of The Company

We believe that a parallel can be drawn with the shareholding structure of the company.

Just as founders hire professional managers when the company starts developing, they often call in outside money to keep fueling their growth.

The immediate consequence is that these entrepreneurs lose the sole proprietorship of their company, and must, therefore, share governance with outside investors.

The trade-off is quite clear: the founders’ share of the pie is smaller, but they get a chance to increase the total size of the pie thanks to new funds invested.

Which will it be: the entire small one or a piece of the large one?

Let’s pause for a moment here to clarify two points.

Firstly, we are aware that raising money from venture capitalists is an uncommon path for a company. Very few startups succeed in doing it.

Secondly, not all successful startups are VC-backed. 

How Governance Is Organized In VC-Backed Companies

So now that you had to share ownership with financial investors, let’s see how decisions are made.

In companies backed by financial investors (this is valid outside of venture capital too), the shareholder agreement is the document laying out the prerogatives of each party.

The objective is to make sure things go as smoothly as possible. Like every contract, the shareholder agreement also serves as a reference and negotiation point when things start going awry.

Happy VCs (for now)

Founders and managers retain operational control, i.e., they keep managing the company day-to-day.

They usually present a yearly budget to their financial investors, which is the basis of their action for the coming year. As long as they are within budget, they don’t need to come back to the Board for approval.

However, key decisions must be approved by the financial investors, especially when they impact the value of their stake in the company.

The list of the so-called “veto rights” is quite common across transactions. Here are some of the main items on that list:

  • Change in bylaws, articles of association or the principal business of the company;
  • Dissolution of the company;
  • More debt, capital expenditures or spending than previously budgeted (with preset thresholds);
  • Issuing new stock on parity with, or senior to, the preferred stock;
  • Dividend payment;
  • Changing the composition of the Board.

The list varies depending on the jurisdiction, the stage the company is in, and sometimes bullish or bearish private equity markets.

The cardinal element is that the VC firm is trying to protect its interests in the company.

Why A Majority Shareholding Is Not Bulletproof

It becomes clear that veto rights skew the decision-making process, as VCs have a de facto blocking vote on critical decisions. They can’t vote these provisions alone, but neither can the founders.

In our experiences, retaining 51% means one thing, and one thing only: that founders can’t (theoretically) get fired.

Everybody gets to vote

In theory, a Board needs a majority vote to fire the CEO, CTO, or whatever role the founders are filling.

In practice, it is true as long as entrepreneurs overperform and the company doesn’t need more money; if it does, and new investors are not piling at the door, you will need to cut a new deal with existing ones. It can include a change in the leadership team.

As the recent Uber situation clearly demonstrated, there are other cases in which minority shareholders can get the Founder & CEO removed from executive functions.

These are extreme cases, however. In general, Board members do disagree, but as long as all is going well, investors tend to follow the startup’s founders. If shareholders need to put an item to a vote, it means things are NOT going well.

Guy Kawasaki makes the point that he never saw anything come down to a vote in a Board meeting. He goes further, talking about “a moral, ethical and financial obligation to the outside money.”

There is much truth in that statement, although it might appear naive to outsiders at first glance.

Venture capital is a small world, and VC firms very often invest together in deals. A founding team systematically acting against the advice of its financial investors will, therefore, get “burnt” for future rounds of financing.

Founders have “a moral, ethical and financial obligation to the outside money” (Guy K.)

VC investors put much importance on the fit between them and the teams they back. Moral and ethical conduct is right at the top of the criteria they use to evaluate such groups.

It doesn’t mean that founders should do whatever VCs told them to do.

Most top venture capitalists are proven company builders and have a long experience advising companies, but after all, they get it wrong most of the time.

Entrepreneurs must learn to walk a fine line between listening to their shareholders’ advice and following their gut when it tells them to go in another direction.

Interested in our webinars on startup funding and venture capital? Sign up now!

Conclusion

Entrepreneurs raising funds need to do so with eyes wide open. Too often, negotiations stall on the percentage of ownership – which also drives valuation, another sore point in many a fundraising.

Startup founders should embark on the venture capital adventure only if they are comfortable with a collegial way of making decisions. The fact that they, alone or together, hold a majority position in the company’s shareholding doesn’t mean that they control everything that happens.

On top of VC veto rights, there are moral and financial obligations that entrepreneurs must abide by to ensure their company is adequately financed and their reputation remains strong.

👉 Watch the video where Guy Kawasaki shares his experience on control (and more).

Source: Berkeley Haas

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