When someone starts a company, they usually have an idea or vision and a passion to bring that idea or vision to market. Many founders get stuck in a difficult spot that most commonly comes up in the process of raising money. This is what I call a double-edged sword for startup founders, i.e. ownership and control of the company.
Many founders start to form a deep bond with their ideas and visions that are embodied in their new company. They take ownership of those ideas and the company. During the growth phase, they are asked to slowly give up some control of that company, usually through dilution of their ownership % by private sales of stock. One major identified reason that startups face major problems and may result in the company failing is the inability to give up control when the company starts to grow. New investors are coming in to get an ownership stake at a very risky stage in a pre-revenue company in exchange for potentially very high rewards. Part of what investors look for in investments are the ideas or vision, management team, and the passion of that team to drive the company to growth. If the founders are only focused on an exit where they go public or are acquired and retire early rich, investors will be put off by those founders who seem to care more about their own personal wealth than having a successful company. If Mark Zuckerberg would have pitched to investors that he was going to take Facebook public and make the company’s stock worth billions within two years, he would probably not have gotten many of those early investors, at least the experienced ones.
The most common example of investors slowly taking control away from the founders is when a venture capital firm comes in with an investment. Commonly venture capitalists take a large stake in the company, take seats on the board of directors, get certain voting and other preferential rights, and sometimes want to put some of their own trusted management team into the company at some point, such as a new CEO with years of business experience raising money, going public, or running a public company. Many technical founders don’t understand any of those aspects of the business, but feel like they are losing control of “their company.”
So whose company is it anyway? If the company uses the standard choice of entity by forming a corporation, technically the stockholders own the company. The board of directors are elected by the stockholders to manage the company at a high level and officers like CEO, CFO, CTO are put in place by the board to run the company day to day. The stockholders hold regular votes to exercise their ownership rights. In the early stages, the founders typically own 100% of the company and have complete control. Once the company starts giving out stock to investors, that percentage goes down substantially. This causes frustration and feelings that the founders are giving away their baby.
So how does a founder raise money and show passion for their long term vision without a quick exit, but also appeal to the investor that they will realize a return on their investment in a certain period of time? The biggest help can be an understanding of how corporate finance, corporate governance, venture capital, angel finance, exits, and other fund raising work. As long as the founders have a basic understanding of how control and dilution happen and that those things will eventually happen if they want to raise money to grow, they can better deal with it when they come up. That is not to say that a savvy founder can’t retain control and still raise money. In the example above with Facebook, Mr. Zuckerberg was able to retain a large amount of stock in the company (although less than a majority) and keep voting control through voting agreements and/or proxies.
In addition, although mostly applicable to public companies, regulations like Sarbanes-Oxley and Dodd-Frank are looking to force companies to provide more separation of control and other protections for investors. With attempts to separate the chairman of the board and CEO roles, the trend is to break up one person having too much control to avoid conflicts of interest.
Investors want to see your vision, so be passionate about that future and your company. You should also be able to discuss an exit for the investor so they can see the return, but hype up an IPO and 500x return within a year and you will probably find yourself without any investors except unsophisticated ones. Understand that it you want to keep it “your” company, you will probably have a difficult time with growth or fund raising.
For a basic understanding of items related to control, equity issuances, and fund raising, you can read my articles on my collection of resources for founders and startups at http://siliconvalleystartupattorney.com/wordpress/