December 13, 2010
Paul Graham recently published an essay on founder control of start-ups. How much control over the business should the founders have once the company reaches a certain size? Paul’s answer bucks the “golden rule” of investor control past Series A. But what does control actually mean?
As valuations for early stage ventures shoot into the sky, so does the perceived need for investors to protect their deals. A lot of those new terms focus on asymmetric distributions of wealth (e.g. participating preferred with liquidation preference). But slightly less obvious is an increasing desire to have a higher level of control over the venture. These terms don’t deal with money directly so they are often overlooked by entrepreneurs.
Control terms range from fairly benign additional access to company information to more aggressive requests such as guaranteed seats on the board. Of course the most fundamental level of additional control isn’t even mentioned explicitly in the term sheet: unless your articles of incorporation and drag along clauses are very sophisticated, each class of shares can veto major decision.
So what are those terms really good for? Have investors used them to steer companies towards greatness by making sure that their superior wisdom is heard? Frankly, I don’t think so and the dismal performance of the Venture Capital industry in the last decade seems to support me here. Forced control only addresses those cases where the major stakeholders disagree for bad reasons. And when that happens it is usually already too late for the company anyhow. There are of course many good investors out there who will actually contribute greatly to a company. But I would be surprised if they actually needed control terms to do so.
Picture a board meeting during the early days of my first start-up. The directors in the room with me are:
- Inventor of the core concept, Provost of the source university and founder of half a dozen spin-offs including running one for a decade
- Entrepreneur and self-made multi-billionaire in the medical systems space (we were focused on medical displays back then)
- Computer scientist, Dean of Engineering at Princeton and on the Board of Microsoft today
- Entrepreneur and builder of organisations with hundreds if not thousands of staff
None of these people had any operational connection to the company (e.g. management roles). Some made big investments while others only invested modest sums to add a “stake in the game” to their board position. Collectively, they represented the interests of the founders, the universities supplying the intellectual property and the investors. Our board evolved over the years, but this is a pretty good indication of the types of people involved. None of these individuals held a majority of the shares, nor did any of them represent a group of shareholders with anywhere near voting control. Founders collectively had majority control of the company until about the fourth or fifth round of financing (some founder, including myself, also invested so the line is a bit blurry).We had a common share cap table so in strict legal terms their “control power” was near zero.
Does anybody really think that this group couldn’t influence the direction of the company because they didn’t have preferred shares or majority control? That the management team wouldn’t have listened extremely carefully if they all agreed? It would have been certifiably insane to ignore their input.
Of course we had the occasional disagreement on strategy at board meetings, the odd crisis and plenty of lively discussion. But at the end of the day these people had tremendous influence on our business and were some of the greatest mentors I have ever had. Some might not even realise it, but all of them had a profound impact on my way of thinking in some way or another.
Empowering investor terms would have added absolutely nothing to the company – at least nothing good. In fact, I would argue that they are only relevant when major stakeholders behave irrationally or have conflicting agendas. The former ought to be something that good bi-directional due diligence between founders and investors can mostly eliminate. If a crazy person slips through the system somehow then you are in a world of pain anyhow, regardless of legal terms. In the latter case of conflicting agendas you will just end up amplifying the conflict. Give people the tools to pursue their own (conflicting) agenda and they will do so. Entrepreneurial ventures are about alignment of interest so any departure from that alignment should come with an extremely good reason, not just because “that’s how it is always done”.