Page 71 - Harvard Business Review (November-December, 2017)

FEATURE WHEN FOUNDERS GO TOO FAR

small number of VC firms, today, some would argue, In the unicorn era, special powers are flowing the
too much capital is chasing too few quality start-ups. other way, to founders. Today many start-ups imple-
Angel and seed funds have usurped the role of what ment a dual-class structure whereby the founders’
used to be Series A venture capital investments. common stock confers 10 times the voting rights of
Hedge funds and mutual funds have begun investing other stockholders. Historically, family-owned compa-
in large, more mature private companies. Now operat- nies have used dual-class stock to reap the benefits of li-
ing between those two stages are nearly 200 VC firms quidity through an IPO without giving up control. Ford
with funds that exceed $200 million, and for funds Motor Company is one example: When it went public,
this large, buying stakes in the hottest unicorns—pri- in 1956, it created a special class of stock that gives Ford
vate companies valued at more than $1 billion—feels family members 40% of voting shares, despite hold-
essential, because it’s very difficult to earn respectable ing just a 4% economic interest in the firm. Berkshire
returns for a fund that size by making smaller bets. Hathaway, News Corp., Nike, and The New York Times
That dynamic gives start-up founders much more Co. are other examples. In its 2004 IPO Google was the
leverage. There are two visible indicators of how they first tech company to implement dual-class ownership.
have used that leverage to gain power: a change in the Facebook, Zynga, Snap, Workday, Square, and others
typical start-up board composition, and a more fre- did the same in their IPOs. Dual-class shares give these
quent use of new kinds of stock that allow founders to publicly traded companies the freedom to operate
dominate the boardroom. without fear of undue influence by hedge funds.

STACKING THE BOARDROOM IN THE UNICORN ERA, SPECIAL
n his 2008 HBR article “The Founder’s
I Dilemma,” Noam Wasserman, now a POWERS ARE FLOWING THE
OTHER WAY—TO FOUNDERS
professor at the University of Southern
California, demonstrated why entrepre-
neurs who create a successful company
must ultimately choose a priority: to get RATHER THAN TO INVESTORS.
rich or to be king. To get rich, founders sell equity,
diluting control. To be king, they retain ownership
in the company and control over the board, but at a
cost: Their wealth remains illiquid, undiversified, and In the past five years, however, tech founders have
at risk if anything should happen to the company’s gone a step further, setting up dual-class shares even
value. The rise of unicorns has changed that calculus, in pre-IPO companies. This allows them to outvote
as founders have used their leverage to negotiate deals their preferred-stock-holding VCs, giving founders
that give them the potential to be rich and kings. extraordinary control. Theranos founder and CEO
Until 10 years ago a start-up board typically had Elizabeth Holmes, for instance, has received $686 mil-
five members: two founders, two VCs, and one inde- lion in venture capital funding, but she retains 98.3%
pendent director. In the event of a conflict, indepen- of voting shares.
dent directors tended to side with the VCs, which is These formal governance rules aren’t the only
why so many founders were ousted. factor reducing the power of directors. Today many
Contrast that with the composition of Uber’s board, VCs sit on five to 10 boards, where they nominally
which isn’t atypical for a unicorn. The company’s provide oversight to companies that are many times
corporate charter designates 11 board seats, but until larger than the pre-IPO start-ups of 15 years ago. That
Kalanick’s ouster, only seven of them were filled. Three stretches many of them thin. I often hear directors of
were held by Kalanick, his cofounder Garrett Camp, private companies say that they read about a critical
and an early employee, Ryan Graves. Only two were incident involving the company in the press or on so-
held by outside investors. One independent director, cial media before they hear about it from the CEO or in
Arianna Huffington, served as a key Kalanick ally. By the boardroom. And when a crisis does develop, the
leaving four seats empty, Kalanick increased his con- VC directors who used to act with wisdom and author-
trol: If the outside directors ever challenged him, he ity have a new incentive to behave meekly: Because
could quickly stack the board with allies. unicorns are staying private longer than earlier start-
Founders’ power goes even further. Traditionally, ups did, they require additional rounds of funding—
when a start-up takes money from VCs, the investors and VCs who earned a board seat by investing in a
receive preferred stock, leaving the founders and em- previous financing round generally want to remain in
ployees with common stock. Preferred stock typically the founder’s good graces to obtain preferred access
gives investors control over when to sell a company, during subsequent rounds. This weakens their moti-
when to take it public, the number of board seats, and vation to ask hard questions, to push back, or to rein in
when to hire or fire a CEO. a founder who begins crossing ethical lines.

100 HARVARD BUSINESS REVIEW NOVEMBER–DECEMBER 2017