B17 – Founder’s Dilemma

Why is there such an influx of entrepreneurs out there?  Why did I get pulled into these trendy area?  How many people actually understand the risk and statistical improbability they will be facing to make that startup successful?

Successes, failures, and washes aside before I started down this path, many friends, family members, and peers encouraged me to look and delve deep into what it means to actually accept the journey of an entrepreneur.  Not the touted movers and shakers of the world, but the countless others that get stuck in the valley’s of entrepreneurial despair, that make one slight misstep in a prior string of perfected maneuvers, that one decision way back at the start came to destroy a jubilant finish.

It was during a heated emotional discussion with a fellow entrepreneur stuck in one of these valleys that I decided I needed to spend a little time “sharpening the saw and measuring twice” before taking the first whack.  I really had no notion of what was to come, but at least I had found The Founder’s Dilemma by Noam Wasserman that detailed the pitfalls and problems that plagued thousands of failed startups.

Success stories detail exactly what had to happen in that one situation to succeed.  It is quite doubtful that you will face the same exact scenarios that you can emulate and apply to your situation.  Failure stories, on the other hand, can be far more effective towards understanding and navigating the potential future landscape you face.

History of business failures is one of the most important and under ratted areas of study.

So without further ado, let’s take you through the steps, stages and decision points founders face and where, how, and why things go wrong (and sometimes right).

 

Introduction

  • Not making those difficult decisions might be good in short term, but not long term
  • Perils of passion, optimism, and instinct in making decisions need to be overcome
  • There is a divergence from what the founder can, should, and do do
  • Founders face giving up either wealth or control, have to give up one usually
    • If try to keep both, will end up worse off
  • Most often founding CEO’s are replaced (against their wills) 10,000+ examples
  • While many founders have different teams (solo, friends, fiancé, outsiders), hires (friends, family, inexperienced, experienced), and funding (VC, Angel, Private) all face similar issues
  • When career, market and personal factors are all favorable for you, go for it

 

Career Dilemmas

  • When do you try to do it
    • Too soon and will fail
    • Too late and handcuffed to job and might never do it
  • Stage of life: not a strong indicator of when you should be starting
    • Average is 14 years of work experience but standard deviation is 10 years
  • Should you do it at all?
    • Risk aversion does not affect decision to be an entrepreneur
    • Early influences are a strong factor
      • What kind of family did you grow up with
      • Were your parents owners or employees
      • What kind of culture were you raised in
      • Who were your role models
  • Motivation to be a founder:
    • In 20s if value: power, autonomy, managing people, financial gain
      • Should be an entrepreneur
    • In 20s if value: security, prestige, financial gain, affiliation
      • Should not be
    • Financial vs control motivated = leads to different decisions
  • In favor of waiting
    • Human capital: develop skills, knowledge, expertise, aka schemata (system of processing information)
      • Only 18% had managerial experience, 55% found startup idea in subject they trained/worked at
    • Social capital: school, jobs (depth and breadth), networking events, friends
    • Financial capital: large barrier, the greater your social capability the easier it is to fundraise
      • Lack of any of these areas means you need to fill it by finding people who have those skills and bring them in as co-founder/employee
  • In favor of not waiting
    • Career handcuffs and becoming too deep in one area of focus
    • Soon will no longer have energy to pull it off
    • Family handcuffs (have to support family)
      • But 70% who founded companies were married and 60% had at least 1 child
    • If spouse didn’t work, less likely person would become an entrepreneur
    • Ways to get out of golden handcuffs: employer has slow growth so you have low raises and minimal promotions, employer has a change in strategy, you lost your job, you get an unexpected increase or decrease of cash, your children grow up and leave leaving no expensive college bills nor heavy time commitment
  • CEO requires a lot of time to prepare for monthly VC meetings, and already have a ton to do (so create “not-to-do lists” to minimize the time wasting activities that are urgent but not important)
  • Background of founder: If experience in
    • Output functions (sales, marketing, R+D): tend to emphasize product innovation, diversification and advertising
    • Throughput function (production and process engineering): tend to focus on automation, up-to-date PPE, and backward integration
  • Key factor to keep in mind is roles, relationships and rewards

Solo-versus-Team Dilemma

  • Solo team: 16% of companies
    • When you go solo when shouldn’t you increase risk of failure
    • When you should go solo and don’t you face team tensions
    • Go solo if not missing important human, social, or financial capital or don’t need the missing pieces at time of founding (hire later), and if you prefer to work alone
  • Challenges
    • Team
      • Learn new roles
      • Negotiate economic rewards
      • Trust each other
    • Solo
      • Much greater risk of failure
      • 26% founders more likely to go solo if had previous management experience
      • Startups are more work than founder imagines and it’s only you
    • How many should be in founding team: Considerations
      • Each person cuts into the pie
      • Risk of overlapping skills
      • Slower to coordinate
      • Less control for those who desire it
      • People underestimate the cost and complications for bringing in new team members
      • People overestimate the value of bringing in someone with redundant skills
        • You could use the equity given to that redundant person to attract a better employee down the road
      • But…larger groups bring larger resources, recall more info, check and correct errors, consider more solutions, and bring more perspective
        • If built right, larger the team, the higher the growth rate and rate of survival of the startup
      • Reasons for a team are tangible and intangible
        • Tangible: human capital (skills), social capital (network), financial capital ($)
          • If money is only reason for bringing on a person, rethink including that person
        • Intangible: Task preference (current founders don’t like doing x, y, and z which are necessary for the company), collaborative style, supports and validates founders to hire a person
      • Types of companies
        • Solo founder works if a distribution company and easy to run
        • Team of founders if it is a product in a fast paced industry (research, design, test ASAP)
      • “Founder Title”
        • Higher status and more entitled to stay and work
        • Free additional tool to give in compensation package
        • If it is the first hire for that position (even if it’s employee #10) might think about giving founding title
      • Starting a company is like a jungle, dirt road, and highway: need people on team who’s best suited for each stage when company is at that stage

 

Relationship Dilemmas

  • Choices for founders: Direct relationship (friend/family), indirect (friend of a friend), and impersonal searches (job postings)
  • Homogenous versus diverse team
    • People try to flock together with same/similar people (homophily)
      • Example: 5x more likely to be an all guy or girl team with same number of years of experience (no greater than 10 years difference)
    • Trust and relationship developed for personal relationships don’t correlate to business relationships (fairness and equality vs equity and merit)
    • Homogeneity
      • Pros: On same page, speed, communication, trust, easier access, company identity and come up with differing views without splintering
      • Cons: Overlapping human capital, exploitation strategy, won’t challenge the other creatively
    • Heterogeneity
      • Pros: diversity of networks, quickly adapt to changes, exploration strategy
      • Cons: greater risk of interpersonal conflict and lower level of integration, hard to know if compatible without working on projects first, might have different soft factors (commitment, opportunity costs, risk preferences, etc)
    • By including friends/family: potentially sacrifice the relationship
    • Classmates are good choices are you see them more in a social realm as opposed to co-workers, but “try before buy” them
    • Teams with prior co-workers much more stable after 6 month honeymoon stage
      • But need to align and discuss the new co-founder relationship and code of behavior and conflict resolution protocol
    • Overcoming the hemophilic issues
      • Overlapping capital: must have a structured approach to define what human, social, and capital needs are and how to fill them
        • Usually best friends share same strengths and weaknesses
        • Have to redefine role while working versus outside of work friends
        • Hire people with complementary skills and networks
      • Create systems for when there’s been damage to social relationship and don’t address “elephant in room” which most people avoid bringing up
        • You will be playing with fire, so keep open and honest communication
        • CC’ an argument to all execs, create a disaster plan on how to leave company if breakup, use mediator, report to another person
        • Compartmentalize relationships, envision negative scenarios and plan for them, and force sensitive discussions
      • Eve means “a helper against him” – startup is like a family, need founders who create cohesive solutions and relationships in the face of tension that arises from different opinions, skills, etc.
      • Each additional social relationship increases hazard rate (founder leaving) by 29%

 

Role Dilemmas

  • Guard against
    • Avoiding conflict
    • Underestimating “title inertia”
    • Inflating titles
    • Wanting allies on board
    • Ignoring incompatible motivations
  • Difference between what can do, what they should do, and what they do do
  • Titles (esp. CEO) have symbolic significance which translates to authority
    • Others who don’t get the title often complain
    • Idea people are usually the ones who get it
  • C-level positions (CTO, CFO, COO) are usually given to the 1st people in that type of position created, even though no workers under them
    • Title may be given too loosely and early which hurts recruiting
  • Who get’s what title (CEO, CTO, Chairman)
    • Based on level of commitment, who came up with IP/idea, each founder’s social, human and capital network
    • CEO—founding experience, invested more than others
    • Chairman—work experience, founding experience, and invested more
  • During early stages having flexible and overlapping leadership and roles is okay, but becomes a problem later on
  • Might decide to not name a CEO, but shows team you might have trouble resolving difficult issues which compromises clarity of decision making, however, also avoid making a pre-mature association
  • Can vacate position of CEO to signal need for new operator
  • Egalitarian decision making: too slow for “high-velocity” environments
    • Most veterans avoid this approach but most startups still use it
    • Stage of company can affect what approach is used, later on almost always hierarchical
  • Possible solution to get “buy-in” on an idea: everyone talks about it and if indecision, CEO and appropriate VP of that department must reach consensus
  • More than 3 people creates more cognitive conflict, but tie-breaker, mixed bag of pros and cons for 3+ founders
  • Board Members: as company gets bigger, fewer founders are on the board
    • Being on board requires more time and effort
    • Having multiple founders on board might mean avoiding discussing necessary but personal issues,
    • Power struggle if CEO is not on board but another founder is (who is really in power)
    • Can have other founders “in limited role” sit-in but no vote
    • When founders more wealth oriented, more likely to be aligned, same when both are power oriented as long as trust is there on founder in power

 

Reward Dilemma

  • Equity splits are emotional, visceral, and fixed pie
  • Many splits occur less than 30 days into starting the company to attract key players, but waiting provides advantages to see how things play out
  • If sooner, before the company is worth a lot could be good to do
  • Understand that the founder’s input, impact, and importance will wax and wane
  • Criteria for person’s equity
    • Past contribution to startup
    • Opportunity cost
    • Future contributions
    • Wealth or power motivated
      • Sometimes there is an idea premium
        • There is a difference between idea and making money off the idea
        • Could be because idea person contributes more effort
        • 10-15% more equity than others (not basis points)
      • 41% put $0, 42% all put in money, 59% 1-25k and could reflect a person’s commitment
      • Opportunity cost: when have other options (paying jobs) need more equity to be worth the cost
      • Future contributions: time, dedication, if done a startup before worth more than other experience 7-9% more and higher title
        • Any work in other companies no matter what or for how long had no sizeable difference
      • Personal: degree of risk aversion (tolerance of conflict), confidence in own abilities (prior relationships) and startup’s prospects of succeeding (macroeconomic factors)
      • Quick discussions resulting in equal distribution signal inability to discuss tough issues and signal to VCs that can’t handle things
      • One person getting 51%: one person is focused on control instead of crafting effecting partnership or dysfunctional dynamic
        • But once get more funding, the shares will dilute anyways, and VC will have more power than their equity
      • The longer it takes to make agreement, more likely to be unequal and written down
      • Biggest mistake is writing the split in stone with no room for changes
        • Founders assume no bad changes/short term view, same roles, responsibilities, etc. without any change in equity distribution
        • Almost 50% admitted business changed between start and finish in what they do
        • Founders personal life affects role down the line: kids, marriage, sickness, etc
      • “Close to equal” founding teams tend to split equally, heterogenous split unequally
      • Solutions
        • Suggest dynamic parts (also different phases to assess the split)
          • Buyout terms
          • Vesting schedule (1 year get 25%, the 5% each month after
          • Think of the known-knowns, known unknowns (contingencies)
          • Vesting:
            • Time
              • Only if don’t underestimate time to do something
            • Milestones
              • Only when can define objectively, clear link to founder, but not good for fast changing companies
              • Should stress test milestones under variety of scenarios
            • Cash compensation: founders usually get paid equally, founder discount so below FMV
              • 63% are paid under average (by 25k)
              • As company grows, gap lessens
            • Agent vs Stewardship
              • Agent: hire people because they are acting in personal self-interest so want more money
              • Stewardship: founders tied to the success of the company so know can get away with paying them less money
            • When to do equity split
              • Right time
              • When company and roles solidify
              • Try to find long term expected contributions
              • Dynamic
              • Remember
                • Working together is long term and negotiation is short term and fighting for small percentage difference could be poisonous
              • Company and roles will change so try to define what could change and how that should effect equity split, including planning for unforeseeable (buyout terms for a founder)
              • Co-founders who received less equity than they deserved were significantly more likely to depart during early years of the company
              • It is unlikely 2 people would contribute equal value to company so why split equity equally
              • Negotiation is double edge sword: leaves teams wiser, smarter, and through a lot OR it can undermine unity of group
              • Equity split should reflect each members past and future contributions as accurately as possible and motivate each co-founder without seeming too unfair to the others

 

Three R System (Relationship, Roles, Rewards)

  • Relationship, Roles and Rewards must make sense collectively given the situation
  • Even one founder who’s out of alignment with the others can cause an emotionally draining breakup
  • Founding with friends and family
    • Expectation of skills, feelings, behavior, etc are higher than reality
    • Vocalize whether or not the company will sacrifice personal relationship to make the business better
    • Closer the relationship is, more likely egalitarian equity split/control
    • More likely there will be a “commitment” model
      • New hires selected based on predominately how they fit into the culture
      • Universal buy-in for all major decisions made
    • Founding with co-workers
      • Find more natural to have hierarchical structure
      • Con is that both are building company from scratch and almost act as co-founders so it is not in reality hierarchical at the start
    • Founding with strangers
      • Hard to know what they bring to the table
      • Defer 3 R conversation for later until know what the company is doing, what they are doing, and roles that naturally occur
      • Should create some type of history together (previous project, groups, etc.) if they have overlapping roles, otherwise need to define the roles
      • Fight the urge to define roles amid the chaos because it could be a big mistake
    • Equity division
      • Prior history (roles people were in) affects split
      • Family members (all else equal) received higher stake than comparable role/title in non-family startup
      • Need to decide if you are using social logic or business logic
        • Whether you are making business or the relationship the priority
        • Then align rewards with that decision
      • Most teams have much to gain by postponing the equity division
        • Keep in mind, one might need some equity set aside to attract others
        • Don’t forget vesting and dynamic splits
      • Roles and Rewards
        • Overlapping roles make it harder to determine value each person has contributed to the company
        • CEO premium, idea premium, board premium, CTO premium (cash equity)
        • Power or money motivated affects outcome
          • Might give up more money for more power
          • Could be that power follows equity stake (it shouldn’t though)
        • Barriers
          • Communication: capture agreements in writing
          • Change: things change, so leave room for equity and roles to change
          • Inertia: although might have it right now, something could happen to make it change, so allow roles and rewards to change as well

 

Beyond the founding team

  • Two biggest parties involved in startup are the non-founding members and investors
  • Company transitions from informal to formal company/organization when
    • Close initial round of financing
    • Create first product
    • This new stage of the company requires new skills and people
  • Mature stage of the company
    • When well funded and stable income
    • Decentralized and more hierarchical decision making
    • New people often come in at higher positions than founders
  • Founders have to give up money, equity, and control in order to get the highly skilled to work for the company and do what founders want
  • Different functions of the company go through different stages at different rates/points in time
    • Replacing CTO might come before hiring a non-Founder CFO

 

Hiring Dilemmas

  • Hire employees based on a blueprint that is a combination of:
    • Recruitment style
    • Rewards and control combination
      • Commitment—recruit on fit, reward on love of the company, and control through peer enforcement
      • Autocracy—recruit on immediate skill set, reward on financial remuneration, and control through direct oversight
      • Star—recruit on potential, reward on cutting-edge work, and control through elite socialization
      • Engineering—recruit on skills, reward on cutting-edge work, and control through peer enforcement
      • Bureaucracy—recruit on immediate skill set, reward on work, control through formal HR
    • Blueprint affects rate of company’s growth
    • Need to change the blueprint as company changes stages
    • Company is 2-3x more likely to fail if changed blueprint between hires at same stage of company
  • Finding potential hires based on company’s stage:
    • Begin with personal network because more coherent
      • 37% higher valuation
      • Cost: CEO’s time in searching for hire
    • Then investor’s connections (especially CFOs)
      • Changes from stewardship to agency and creates loyalty issues
    • Then other forms such as search firms
  • It is always a struggle with integrating new hires with the close knit team
    • New hires might have different motivations
    • Already existing bonds, way of doing things, inside jokes, and shortcuts
  • If hire family members or close ties, it is always harder to fire them if they underperform
  • Roles: transition from top-heavy C-levels to VPs as company evolves
    • Bring in new hires to replace founders or be their boss
    • CFOs usually always are non-founders and come in at mature stage
  • If have COO/President & CEO as two different roles it might be duplicate roles
  • When companies create job postings: sometimes first time they have to formally define the role and responsibilities and differences in roles
  • Fast growth company: initial C-level person might not be able to grow skills as fast as role needs
    • Decide whether to stick with, replace, or hire someone in a higher position
    • Could be another founder
  • Generalist vs specialist
    • Company needs generalists early on when tasks and roles are fluid
    • If get specialist too early, he might not know how to act with undefined tasks
      • If there’s a crank, he’s the best cranker, but doesn’t know how to create the crank
    • As things become more certain, company needs more specialists who will stick to their job more
  • Company will see high turnover as stages of the company changes
  • No such things as a “manager” early on, everyone “does”
  • Who do you hire: Experience versus Inexperience–rising stars or rock stars
    • Often determined by how much the company can afford
      • Rock stars are expected to contribute a lot right at the start
    • Benefits of rock stars: skills, contacts, credibility, hiring leverage (can hire own underlings), better able to handle company’s growth
    • Down side of rock stars: bigger paychecks, cultural control (have own way of doing things and expectations)
  • Rewards: cash (salary and bonus)
    • Salary: pretty similar across C-level titles
      • Stage of company, number of rounds of financing, employees (40+), revenue ($5M+) affects salary
      • Geography does not
    • Bonus: VP Sales has highest percent of bonus versus engineers who have the lowest
      • Women mostly VP Marketing and salary differed by geography and hired later stages of company
    • Should focus on creating a consistent package: recruiters ask whether you want higher salary and low equity or vice versa
      • Find ones that align with your interest to prevent misalignment/resentment for buyout offers, etc.
    • CFO’s 1.3% of equity, VPs 1-1.3%: vest over 4 years with accelerated vesting if certain triggers occur like buyouts or going public
  • Option pools: amount of equity to be give to new employees at next dilution phase which indicates how many new hires will want to be hired
    • Amount of equity given up versus cash dependent on founder’s motivations
  • New hire dilemmas are like founder’s (career, role, rewards, power versus money) with the added consideration for
    • Stage of Startup
    • Formality of Startup
    • Availability of resources

 

Investor Dilemma

  • Capital Sources: friends/family, angels, VC
    • Factors: sources of capital, access to investors (costs and risk faced by founders for taking capital), investors potential to add value
  • Founders 77% of the time put money in, but it runs out fast, burn rate is about 75k/month and have about 4 months worth of month
    • Smaller the cash cushion, the higher the fail rate
  • Outside investors: bring capitals needed to get to the next stage and improved governance to do so
    • Either “Money only” or “Money Plus”: 3 types of capital
  • Family/Friends as Investors
    • Easiest access, invest less than other types, little human/social capital, don’t boost company’s credibility
    • Risk losing their money, friendship, or both
      • Best way is to treat investment as a gift with no expectation of return
    • If company beyond early stage development, getting family money signals weakness to higher up investors signaling that company can’t close anyone but close connections
    • It is easier to get money from them; they are not very objective which enables bad ideas and half-ass attempts at businesses leading to wasted time and money
    • “Burn the boat option”—no option to fail but that puts too much pressure to succeed leading to even more wasted time and money, business become an addiction—addictions which family and friends usually point out to help, but they can’t point it out because they are invested as well
      • This also makes founders risk averse and less aggressive in valuations
    • Usually they only invest in first round of financing
  • Angels
    • Farm system for VCs
    • Motivation is money, but also mentoring and helping
    • Harder to access Angels (58% were introduced from common friend)
    • Human Capital: small, maybe a professional angel, may be just wealthy
    • Social capital: gain credibility for the company, 40% of angels introduce the company to the VC that invests
    • Financial Capital: Average $450k, expects to continue investment in other rounds, smaller personal risk because they are wealthy
    • Account for many more investments than VC’s, but total investment is worth less because VC’s invest so much
    • Downside:
      • Sometimes money comes with no strings attached, but sometimes there is a general lack of understanding by the investor in field the company is investing in
      • Need more investors because smaller amount of money invested means managing a lot more pieces of the puzzle
    • VCs
      • Have fiduciary duty to LPs, funds last 10+ years, means more attracted to higher risk/higher reward companies
      • 22,000 VC-backed companies and 15% were liquidated or went bankrupt: not automatically in the money if they invest
      • More reputable and experienced than VCs which means more unfavorable terms (10% less valuation)
      • Invest with intent to invest in more rounds and they budge themselves to invest if company is moving well/meet certain benchmarks
      • VC’s are more able to introduce company to other investors than any other group could
      • By second round of financing, investors are 2nd highest group to refer potential new hires, so more reputable the VC and its connections, the better the candidates for new hires
      • Can be used as a sounding board/judge of ideas for executive team
      • Just because the firm is reputable, doesn’t guarantee individual partner from firm will be effective and committed
      • They usually demand a board and to be on it, more rounds means more VCs and few founders on the board
      • Longevity: unlike angles who leave board after a while, VCs stay on longer, but provide greater guidance, and build relationships with the CEO
        • Closer VC is to company, more likely it will play an important role
      • Board of Directors
        • Larger boards means more expertise but harder to manage, more time spent
        • Can include to have founders “sit-in” on board meetings
        • Frequency: early on, meet once a month, later bi-monthly to quarterly
          • Average 7.9/year
          • Fewer later because formalized company and better metrics
        • Founder CEOs have much more experience boards
          • If experience of CEO is midrange: they hold the most amount of meetings and have the largest boards
          • Means those with least experience don’t get enough help
          • If external background: fewer meetings than internal
        • Build board with CEOs weaknesses and strengths in mind
        • Board controls CEO compensation, if CEO should be replaced, financing, and when/how to exit
        • If there is a CEO spot on board, make it a founder’s spot so if get fired, still on board
        • Supermajority/veto rights are extra powers to give to VCs to make decisions, this is dangerous as could veto all budgets and force an exit
        • Boards could also be risk averse or too risk tolerant based on who is on it and their motives
        • Unanimous decisions are sometimes impossible and lead to lowest common denominator
        • Slit +1 approach
          • Equal number of insiders and outsiders, plus neutral tie-breaker by independent director
          • Then issue becomes who gets to pick this director
        • Evenly split means potential for gridlock
        • CEO’s time is like an hourglass: time spent to prepare meeting, meet and then do follow-up = a lot of time
        • Want number of people on the board to match size of company, can’t have that many if small company because ridiculous and not efficient or effective
        • As company grows, so does board and have formalized committees like audit and compensation (no founders on compensation, conflict of interest)
      • 2 rights affected by ownership by others: economic and control rights
        • After C-round financing, VCs owned majority (53%)
        • When don’t reach certain milestones, VCs get aggressive and have down round, where invest more at a de-valued price
          • VCs “staging” investing only a little at a time to see how company does and then makes new demands before investing more
        • Liquidation preference: investor gets all of its money out at “x” rate before anyone else gets it (22% of co’s have this greater than 1)
          • If have high preference, forced to swing for fences and be risky because founders won’t get any money from buyout at low valuation
        • Participation: explains how the remaining money after preference is divided up
          • Entrepreneurs foolishly agree to these terms because too optimistic
          • Avoid this by having multiple VCs so they don’t play on your optimism or push you around
        • Protective provisions: give investors more voting rights
        • Drag along rights: who can authorize company sale
        • Anti-dilution protection: prevent dilution from subsequent rounds of financing
        • Accrued Dividends: investors can accrue for months until payout
        • When they invest, VCs want equity for founders to be re-vested to create golden handcuffs so founders will stay and make sure allocation is appropriate
          • Leads to high turnover when VCs invest
        • 75% of founders of VC backed Cos got no financial return for their work
        • At this point financing occurs every 15-17 months
        • Investors more attracted to wealth-motivated founders because more aligned with their interests
          • Founder’s strategy and goals affect who, what, and when to approach investors
        • com: model term sheets
      • How long you wait in between rounds affects outcome
        • If need cash, VC’s will try to take advantage
        • Don’t want too much money or early because then no sense of urgency to work hard, need to find balance of greed and fear
        • If resist investment
          • Keep more control, but holes in capital
        • If take investment
          • Tap resources to grow but lose control
        • Losing board control is the first step to being replaced

 

 

Founder-CEO Succession

  • Succession is not an event but a process: when look at it this way become more rewarding
  • For VCs their opinion is to try to coach, and then replace if isn’t working
  • Have frank dialogue in the beginning and make it clear the CEO will be replaced
    • Even when think you make it clear, founders think “I can prove I’m good” and they ignore the cautions, so hammer it home
  • When founders trigger the replacement search leads to better results for him
  • CEO succession: 73% of the time initiated by the board or other party (62% by board)
    • Usually because the role of the CEO changed to something outside the ability of the current leader
  • Voluntary succession: seek CEO from outside the startup (opposite to healthy corporation which is to promote from within)
    • CEO understands new role of CEO and isn’t best suited for that role
  • Wealth motivated CEO: quicker to step aside because see that benefit of brining on a new person
  • Power motivated CEO: more likely to fight the succession
  • To fire because of failure
    • Board should have honestly and consistently convey whether the CEO has met the standard or not, and when doesn’t he/she is out
  • Paradox of success
    • Each stage of the company brings on a different “dominant problem” which requires people with very different skills to run
    • A successful founder brings a company so far and so fast, that the role changes so quickly, he/she can’t catch up
    • Stages: product development and fund-raising
    • Product development: premium on technical/scientific skills and project leadership/management, but once developed, need much more from role like sales, marketing, and support
      • Further, employees might not have necessary skills for next stage of the company, but CEO is loyal to them and won’t fire them or treat them objectively
      • Founder may be attached to original idea which may need to evolve/change
    • Fundraising: more money you raise the faster you lose control of board-level decision making (decision making in general)
      • Each successful round comes with loss of board control
      • VCs make clear that there will come a time when CEO will be replaced with a person with different skill sets
      • Data shows increased CEO change after each round of financing
      • Bad but true: if want to remain CEO, be “medium-successful” to make sure growth and employment don’t escalate faster than your skills do, or else you will be fired
    • VC triggered succession occurred .5-1 year earlier (in 3-3.5 years since founding) than founder triggered succession (4 years)
      • This reveals new challenge: successful transition to new CEO
    • About 33% of CEOs who are replaced leave the company
      • Depends on who initiates it (24% founder initiated, 37% board)
    • Search for new CEO
      • For startups almost always from outside in order to make big changes
      • Major changes—typically that former CEO could not or would not do
        • Organizationally (more professional)
        • Strategy (new business concept)
        • Team (fire founder’s friends)
      • Sources of new CEO: served on board, did consulting work for them
      • Takes a while: fewer than 1/3 of replacements were hired within 1 year of making decision to replace (usually 14 months)
    • New CEO
      • Board must consider what they would gain from certain level involvement from former CEO with what would cost
        • Former CEO’s think it’s a title change, not a tidal change (things will continue as they were—to be led by former CEO, wrong)
      • Must be technically qualified: meet expectations of wealth motivated investors on board
      • Must fit in with culture: according to control motivated former CEO who might try and find ways to stay in control over certain things
      • Easier for former CEO to step down if new one obviously has more skills and experience
        • Might be drawn to person with similar skills because much like him
        • Or drawn to person with different skills so can fill in where there were former CEO lacked
      • New CEO must assess if company/CEO is ready for new leader and is at an inflection point where new sills are needed
        • Will there be fierce opposition to a takeover
        • Does board fully support new CEO
        • Wealth or control motivation of ex-CEO
        • Make these questions known because new CEO will have to make rapid changes fast and deal with being the new guy and higher than ex-CEO who might resist power change
      • 63% of CEO founders who were replaced stay on as an executive (60% of those stay on board), if CEO initiates it, goes up to 76% (96% remain on board)
      • Pros to keeping a founder on
        • Keep his insights, institutional knowledge, relationship, and employee buy-in
      • Con to keeping founder on
        • Risky if old CEO is control motivated and unhappy with the change
      • First new CEO is like a new organ in the body, body rejects it (23% of companies by D-round financing have had 2 new CEOs
        • Another reason to keep CEO either as CEO or on the team
      • Responsibilities of boards: determine motivation of founder CEO, conduct regular reviews
        • Relate to CEOs motivation: if wealth show what new CEO could do that founder could not that would add value to the company
          • If old CEO doesn’t see much difference, might resist the change more, even if wealth motivated
        • Convey to founder the changing role of CEO so he understands, event if wealth motivated if doesn’t understand, will resist the change
          • World’s best speedboat captain can’t pilot an oil tanker, it’s not about who’s the overall best leader, but who’s best for the next stage of development
        • Skills of ex-CEO could help find a spot for him and help him accept the change
          • Highlight that what he doesn’t like doing, is necessary for the CEO to do
          • Put him in a role where he is doing only what he likes (meaningful vs administrative work)
        • Try using a bridge CEO
          • Only there for 18 months, set time makes less threatening to founders
        • Try 2 stage replacement
          • Bring person in in another role with intention of him becoming new CEO
          • Allows new guy to build relationships with employees
          • Roles: focus on big scale and transition ex-CEO to work together and figure out who does/will do what
          • Rewards: partial buyouts ease monetary concern for founders, or a vesting “bonus” for stepping down from CEO

 

Wealth-Versus Control Dilemma

  • Entrepreneurship: process by which individuals pursue opportunities without regard to the resources they currently control
  • In real life, key choices are rarely aligned as they should be to be aligned with their motivations
    • There is always a tradeoff between wealth and control at all stages of the company
  • Can try second-tier resources: don’t always have to pick best co-founders, employees, etc
    • B-team less loss of money and power, could adequately cover task, but not the best product
  • Hybrid path: aware of control and wealth motivated options, and purposely switch one or two decisions to “hedge”
    • (80/20 rule) 3 decisions, 1 different change from “success” 52% of time to 16% of time
    • When you shift strategies, create tension within the company
      • Great employees but won’t pay more because need more financing and will lose control with diluted shares
    • Unless there is a short timeline and it is capital intensive (in which money is greater than power), neither power or wealth motivations are significantly better than the other
      • What is worse is inconsistent choices
    • 4 ignorances of first time founders/CEOs
      • Do not understand the stages of growth
      • Do not understand stages require different leaders
      • Whether they have those skills necessary for new stage
      • Whether they are control or wealth motivated and are willing to trade power for greater value
    • Founder must consider motivations for other founders/employees/et. Which creates complex situations
      • Co-founders must share consistent or complimentary motivations
        • Power and Money okay as long as Power is good CEO
        • Both power motivated could create a clash
      • Potential hires must also consider the founders’ motivations before joining
      • Rich ($) vs King (P)
        • Rate of growth: slower increase power decreases wealth
        • Capital intense projects: lower demand means more power but less risky therefore less wealth possibility
        • Social Capital: greater social capital a person has more power and wealth they get
        • Financial Capital: founders should be avid savers with low burn-rate to increase wealth and power as well as show to investors they are good leaders
      • Anticipating Trouble
        • Playing with fire (friends and family): create firewalls to separate work with personal life and manage expectations
        • Equity splits that are static: create ones that are dynamic, vest, and have buyout terms
        • Capital from a VC that tends to change CEOs: do due diligence on VC’s
          • com
        • Serial Entrepreneur: more startups you do and apply what learn, more likely you are to succeed
        • Addressing issues
          • Why do it if you get paid less than being employed by a company
            • Power, challenge, and other motivations besides money
          • Do founders really have all that much power and equity
            • Founding doesn’t mean you will have more equity and power because they sacrifice those rewards for making sure the idea happens, one has to give up either money or power

 

Exiting

  • Based on motivation
    • If power: may not want to lose power, but after years of working, may still not want to cash out
      • They have too rosy of a picture of what future will bring to the company
      • There is more they want to do with the company
    • Reasons to sell
      • Eroding future prospect of the company
        • Low cash
        • Changes in industry
        • Burnout of founders
        • Want to sell before another round of financing dilutes equity even more
      • Key is to know when to sell
      • Attractive post-acquisition possibilities
        • Work on next project with more money to get more equity in it
        • Work for buy-outer to get a steady job and have work/life balance
      • Buyout types
        • Cash only: means replace executives (usually lower price than earn-out
        • Earn out: cash plus future performance—maintain key employees and feel for the ones who are done or not excited with company anymore or future prospects of the company (they leave)
          • This option appeals to confident founders
          • But the founders lose control
        • IPO
          • New source of capital to acquire smaller businesses
          • Prestige and trust to acquire larger customers
          • More scrutiny and financial disclosure
            • Difficult to run company because employees stock options means employees are either happy or sad depending on price of stock
          • Much more for a VC exit
            • 62% of VCs on board leave after IPO
            • Means new set of board members have to work with
          • Personal conflict of selling shares
            • Like giving away your baby
            • And limited to how much you can sell and when
          • Team conflict on buyout depending on their risk-aversion and ideas about company’s future growth (try for higher price or take the offer)

 

 

Summary

  • While persistence, passion, optimism are good, if you make the leap before you are ready, you discount dangers of founding with friends/family, misjudge ability to be CEO during different stages of the company, fight for larger equity stake than you deserve, don’t recognize holes in teams abilities and don’t hire to fill those, agree to investment terms that you think will never be an issue (like high liquidation terms), you will run into problems
  • Stewardship is greater than agency, but intense stewardship leads to issues for founders regarding money and power
  • This advice only applies to tech and life science companies, not small businesses or family run companies, and only in the US
    • Did not examine partnerships to fill in capital holes or if where one founds makes a difference
  • Having a calling is not enough, you need a clear picture, there are different motivations which yield different choices, so need to know your motivations
  • “If one doesn’t know which port one is sailing, no wind is favorable” Seneca

 

So, do you now have a greater understanding of the road an entrepreneur will take?  Do you have a more refined approach to how you will build your company?  Are you ready to?