Be Careful What You Ask For
Last week, I started the column with a particular point to make, but by the time I finished telling entrepreneurial Òwar stories,Ó it would have taken me another columnÕs worth of explanation to tie it all together.
This week then, IÕm going to lead off with last weekÕs original point to make sure it gets made:
SIX OUT OF TEN CEO-FOUNDERS OF VENTURE CAPITAL-BACKED
COMPANIES ARE NO LONGER WITH THEIR COMPANIES WITHIN FOUR YEARS OF RECEIVING
THEIR FIRST VENTURE CAPITAL INVESTMENT.
I hope thatÕs a sobering thought.
Once an entrepreneur and a venture capitalist have
successfully proceeded through the mating process and have closed on a deal,
everyone is supposedly on the same side of the table and pushing in the same
direction.
In an ideal world the first-time entrepreneur will execute
well against his plan. Constructive relationships will be created among
management, investors and the board of directors. Unanticipated events will cause minor mid-course
corrections, but the company will weather those storms. Over time the company
will grow and prosper ultimately providing an exit for the investors through an
acquisition or initial public stock offering. Presumably the entrepreneur has set the stage for his
personal goals, be it cashing in himself, or achieving a platform for explosive
growth through the liquidity event.
EverybodyÕs happy.
In fact, if you are the first-time entrepreneur, you
expect this to happen.
If you are the venture capitalist, you hope this will
happen, but you donÕt really expect it to.
Your experience is likely to be that over half of your
portfolio companies will never achieve the commercial (and financial success)
that had been hoped for. Less than
30% will provide attractive returns, and less than 5% (1 out of 20) will be the
Òhome runsÓ that Òmake the fund.Ó
Also, as a venture capitalist, while you really do hope that
the founder-CEO will grow with business and continue in the role of CEO throughout
this process, you know thatÕs highly unlikely. Further, if the founder is not the long-term CEO, you hope
that the founder is sufficiently mature and self-aware that he can play an
ongoing and meaningful role with the company. But being realistic, you know
that itÕs better than 50-50 that the CEO-founder will have to be separated from
the company.
You hope that this founder will prove to be the exception
that proves the rule, but in your heart-of-hearts, you donÕt really expect that
to be the case.
ÒHow can this
be?Ó you may ask. Everything
youÕve heard about this process has been that the investor bets on the jockey,
not the horse. YouÕve heard the
standard VC observation, ÒIÕll take an A team and a B idea every time over an A
idea and B team. The A team will figure out how to make the business work. The
B team isnÕt likely to,Ó more times than you care to remember. If this is true and theyÕve invested in
you, then they must consider you part of an A team.
The irony is that they do, at the time of the
investment. You are the right
person to lead the company today.
YouÕve gotten it this far and you will be important in taking the
company to the next level.
BUT the likelihood that the company will achieve this new
level without some serious challenges along the way is unlikely. Will you rise to the challenge? Will
you be able to work with your board and investors to take the necessary steps? Do you even know how to respond to
these bumps in the road? Do you have the skills to execute these responses?
Very frequently, in my experience, first-time entrepreneurs
will assume a bunker mentality. Due to inexperience, misplaced loyalties,
personality quirks, or any of a number of reasons, a first-time entrepreneur
may do exactly the wrong things.
Instead of discussing the circumstances, he hides them. Instead of preparing the Board and
investors of likely unpleasant future events, he plays ÒostrichÓ and hopes they
go away.
All of these things undermine the relationship with the
Board. If it gets to the point
where the Board doesnÕt trust the founder, then a change in CEOs is the likely
to occur.
Note that it isnÕt the business issues, per se, that
cause the separation of a CEO from a company, it is the relationship of the CEO
with the board and their faith in him.
Even when your company achieves that next level, there are
no guarantees that you will be an A player under these new circumstances. The skills that made you an A player at
the time of the investment may not be the ones the company needs to achieve
commercial traction. It is the
rare person who can create a company as well as lead its commercialization
efforts.
ÒBut, I still own a significant part of the business. They canÕt just throw me out, Ò you may
protest. Yes, they can.
Even if you owned over 60% of the outstanding stock at the
time this occurs, the nature of the deal that you did with the VC to get its
money will contain such provisions.
When you take outside investment, your company is no long
YOUR COMPANY, particularly if the outside investment is from a venture capital
firm.
As part of the deal, percentage ownership and control will
be separated. Typically, there
will be a shareholders agreement in which all shareholders, including you, will
agree to vote their shares for a specific board structure. For many early stage companies in this
situation, it is common for the board to have five members, two nominated by
the founder (or common shareholders), two nominated by the investors (or
preferred shareholders) and one mutually agreed upon. Your signature on this
shareholders agreement takes precedence over your percentage ownership rights.
I do not know of any VC that would do a deal that didnÕt have such provisions
in it.
So, returning to corporate structure 101, the shareholders
elect the members of the Board of Directors. The Board then chooses the management of the company. Since you do not have an absolute
majority, you are at risk. If the
investor board members can convince the independent third party that a CEO
change is needed, then you are out!
In most cases the Òhand writing is on the wall,Ó and some
negotiated separation can be structured.
If such a negotiated agreement cannot be worked out, the legal agreements
will serve as the default rules.
In most cases, you wonÕt want that to be the case. Work out a deal.
1. Accepting venture capital is not without its risks.
2. Do not assume that you will be the exception that proves the rule.
3. It is essential that you build constructive, positive, high-integrity, mutually respectful relationships with the members of your board and your investors.
4. Be careful what you wish for. You may get it.
5. Build a network of mentors, advisors, professionals, and entrepreneurs who have Òbeen there and done that.Ó
Frank Demmler is Adjunct Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (Website)