Sustainable Startups - How Can Founders and Entrepreneurs Protect Themselves?
In the past article series I discussed how founders in venture backed companies lose control and find and themselves thrown out of their companies. If you haven’t read it yet click here. In this article, I am going to discuss how founders and entrepreneurs can and should protect themselves.
1. Focus on Goal Alignment
Selling a portion of your company comes at a heavy cost and while funding partners (Venture Capitalists and Angel Investors) may have brilliant visions for your company there’s no guarantee that it aligns YOUR vision of success. When a venture firm invests in in your company, they are also investing in a dozen other companies and expects most of them to fail. Step one is to analyze your vision and goals for the company and make sure that they line up with the vision and goals of your funding partners.
2. Realize You Might Get Fired
Entrepreneurs generally believe when signing a deal she will not be fired by the venture capitalist. However, venture capitalists regularly assume that entrepreneurs will be unable to make the transition to capable managers and often terminate founding entrepreneurs and replace them with
professional managers—see e.g. Steve Jobs. For example, at time of an IPO (successful exit) 43% of CEOs are non-founders. The inability of founders and entrepreneurs to handle the challenges associated with growth is referred to as the “founder's disease.”
Indeed, some founders are content with living dead status and are relieved that their company is not going to grow so large that they have to be replaced by a more professional manager. If you want to oversee your company for the long haul it is important to maintain this as a goal from the outset.
3. Learn from the Pros (Snapchat, Facebook, etc.)
For any founder who has put their time, sweat, and money into a company the prospect of giving up control and retreating into the shadows is understandably hard to swallow. You can learn from entrepreneurs that have successfully navigated the funding industry all the while maintaining a large percent of ownership and control over their companies.
Take for example Larry Ellison (25% stake in Oracle), Mark Zuckerberg (maintains control of Facebook through “supervoting” shares), and Evan Spiegel (he and cofounder Bobby Murphy each own 22.4% of Snap Inc). These CEOs maintained control of the board and retained a large percentage of ownership of their company.
Options Available to an Informed Founder
1. Don’t Take Venture Capital Money
You can choose not to enter a venture capital transaction and instead pursue the innovation using non-venture funds. The growth rate may be slower, but you can maintain a lifestyle business without fear of venture reprisal.
Another option is to license your intellectual property (patents, copyrights, and trademarks) to a third party.
2. Take a Demotion
If you do take venture capital you can choose to hedge the founder's disease risks by giving up the position of CEO and taking a position such as chief engineer, CTO, or lead scientist. It is much more difficult to wrestle these positions away because you know your product or processes best.
3. Secure More Control of Your Company
If you are going to take VC money, be like the famous CEOs above, and negotiate. Founders who negotiate greater control rights ended up receiving on average $3.7 million more than those who failed to negotiate! As famous VC and entrepreneur Paul Graham stated, Mr. Zuckerberg likely would have been forced by his venture capital investors to sell Facebook, but Facebook has always been controlled by Mark Zuckerberg.
In other words, the rights negotiated by founders when taking venture capital matter. Many entrepreneurs get so excited about the money and are overly optimistic about the prospects of the company they don’t hire outside counsel or negotiate as hard as they should.
How to Secure More Control of Your Company
1. Negotiate for More Board Seats
Control of a company is more complicated than simply having more board seats, but if you can assign more board seats AND are a large equity owner, then your opinion about what's in best the interest of the shareholders will tend to prevail. So while board control is not total control it's not imaginary either.
2. Negotiate for Better Contractual Terms
Unless you are a well-established entrepreneur or have a well-developed innovation, you are going to be at a bargaining disadvantage when compared to funding partners. One of the reasons is over-optimism—which is helpful during the creative process—is a liability when bargaining.
Over-optimism can cloud judgment of a deal and lead you to enter contracts that are disadvantageous if the company begins to struggle. Additionally, over-optimism can lead you to believe that the “founder's disease” will not apply to you.
3. Negotiate When is Your Bargaining Power is the Highest
Your bargaining power is the highest when you have choice regarding funding partners and are in possession of the human capital and the technical expertise for the innovation. However, there are costs associated with finding the right venture capitalist to work with and withholding and protecting that intellectual property.
Bargaining power is higher during boom periods of venture capital—which we are currently in—when there simply is too much money chasing too few deals. “For the entrepreneur, today is much better. They can just walk down the street — Sand Hill Road — and drop in. The odds are that somebody will like their idea."
When there is too much money in the funding market it is crucial for entrepreneurs to take advantage.
Negotiate with the Assistance of Counsel
Due to the superior bargaining strength of funding partners, the prevalence of preferred stock, and the provisions contained therein, it is very unlikely you will have the bargaining strength to negotiate all the unfavorable terms away.
Understanding each term a deciding which are the most important to you is vital and will vary depending on your business, exit strategy and goals. For example, if you are ill-suited to be CEO, but have all the technical knowledge, then focusing on the allocation of board seats is crucial so that a development friendly CEO can be appointed. Alternatively, if there is a good chance of high profitability in the future then negotiating to give up the least equity and keeping liquidation preferences in check is more important.
VCs can be harsh when negotiating with startups and will act as if founders retaining board control after a series A is unprecedented when in fact many don't care about whether an active founder keeps board control if the VC retains other control rights. Therefore, distilling what control rights are the most beneficial to you is a necessity before moving forward in contract negotiations.
Venture capitalist negotiate these contracts for a living, whereas this may be the first deal that you have been involved in or your first exposure to these terms. Venture-capital contracts provide you with important information about transactional risks, yet some of the most important provisions are hidden behind legalese. You are better off seeking the advice of a trusted venture capital attorney with relevant experience. The most crucial aspect is finding a lawyer you can trust to look out for your interest and that the lawyer uses all the bargaining advantages you have at your disposal to negotiate the most crucial terms in your favor.
The one-sided contracts so prevalent in the industry stem from the superior bargaining power of funding partners during negotiation and are exacerbated by over-optimism by the entrepreneur and lack of knowledge. However, entrepreneurs and venture capitalists can work together and entrepreneurs can maximize bargaining power by hiring their own venture capital attorney to explain and negotiate the important provisions on their behalf to avoid the devastating result of losing your company.
The United States wants to see entrepreneurs succeed. The innovation that has built Silicon Valley has shaped American ideals. However, if this is smothered during venture capital deals then America loses the creativity that is one of the cornerstones of its economy.
This article was written by Curtis Roberts, the founder of The Founder's Attorney.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
*See, e.g., Arnold C. Cooper & Albert V. Bruno, Success Among High-Technology Firms, Bus. Horizons, Apr. 1977, at 16, 18 (study of 250 high-technology firms with multiple founders, finding that fifty-two percent of the firms four or more years old had experienced the departure of at least one founder). A recent study found that among a sample of venture capital deals, the common shareholders in roughly half the cases were entitled to nothing when the company was sold, even when the sale was for tens of millions and the majority of the sale proceeds went to the venture capitalists and other holders of preferred shares. Broughman 113 at 388–89.
**Mark Zuckerberg kept control of Facebook's board through the series A and still has it today. Paul Graham, Founder Control, (Dec 2010).
***Jobs revolutionized personal computing and created an iconic brand—only to be forced out of the company by the Board and to be replaced by the new CEO John Sculley, “I was out and very publicly out . . . [w]hat had been the focus of my entire adult life was gone, and it was devastating.” Joel Siegel, When Steve Jobs Got Fired By Apple, ABC News, Oct 6 2011.
Len Bosack and Sandy Lerner, who founded Cisco were ousted by famed venture capitalist Don Valentine of Sequoia Capital who invested $2 million and appointed John Morgridge as CEO. Julie Bort, Cisco Just Turned 30: This Is The Dramatic Story Of How The Founders Were Ousted, Business Insider, Dec. 12, 2014.