Here are three founder scenarios, all with parallels to cases I teach our MBA students:
#1: You have an idea for a great product and want to start a company. Do you start it yourself (and keep all of the equity) or do you find a good co-founder (with whom you have to split the equity 50/50)?
#2: You have 2 similar offers from potential investors. However, one is from angels (who want one board seat out of 3, leaving you in control of the board) and the other is from VCs (who want 2 of 3 board seats). Which do you take?
#3: You have been doing a good job as a founder-CEO, and have really enjoyed being able to control major decisions and being able to “put my stamp on my company.” However, you are starting to feel that a more experienced CEO would be able to grow a more valuable company than you could. Should you keep your CEO seat, or should you offer to step down (into a “ceremonial CTO” role) and find a better CEO to take over your “baby”?
Is there a common thread running through these decisions?
To me, the first choice in each decision would increase the chances that you will be able to keep control of the company and retain more of its equity. However, this control might come at the expense of building a more valuable company; you would probably end up with a less-capable founding team, lower quality investors (yes, I am going out on a limb here and assuming that the typical VC will add more value than the typical angel :->), and a less experienced CEO, preventing the venture from reaching its full potential.
In contrast, the second choice in each decision would require you to give up more control and more equity, but it would enable you to attract more and higher-quality people who could help build the company’s overall value. In my keynote address last month, I used this image to capture the tradeoff.
Perhaps a bit too colloquially, I refer to these choices as “Rich versus King.” The phrase comes from our ONSET Ventures case, where the VCs try to identify which founder-CEOs will willingly step aside when the VCs want to bring in a better CEO (to ONSET, these founders want to be “rich”) and which founder-CEOs will fight such a change (to ONSET, these founders want to be “king”). In this paper, I extend this phrase to encompass the much broader set of decisions faced by founders who need to attract a wide variety of resources (human, financial, other) to their ventures if the venture is going to reach full potential.
King options are ones that will enable founders to keep control of key decisions (by keeping control of the CEO position and of the board) and, often, to keep more of the equity for themselves. Rich options are ones that should enable the company (and, likewise, the value of the founder’s equity stake) to become more valuable, but which sideline the founder by taking away the CEO position and control over major decisions. In the 3 scenarios above, each of the first choices are “King” choices, each of the second choices are “Rich” choices. The chart below (oh no, an HBS 2X2 matrix!) captures what should result from the consistent selection of King or Rich options when making (1.) co-founder decisions (scenario #1 above), (2.) investor/board decisions (scenario #2), and (3.) non-founder hiring/succession decisions (scenario #3).
The ideal scenario is one in which the founder can be both rich and king. (“Rich and Regal,” if you will.) It’s easy for all of us to name some founders who achieved this ideal: Gates, Dell, et al. However, these founders are by far the exception. (That is why they are so well known!) In my “Rich versus King” paper, I establish that most founders should (theoretically) and actually do (shown using my multi-year dataset of hundreds of private IT ventures) face the Rich-versus-King tradeoff, where the actions they take to build company value can compromise their ability to control key decisions and to retain equity, and, conversely, the actions they take to keep control and equity harm their ability to build a more valuable company.
Academic aside: The theoretical foundation for this paper integrates Stevenson’s definition of entrepreneurship with resource dependency theory (RDT). According to Stevenson’s definition, “Entrepreneurship is the pursuit of opportunity beyond the resources currently controlled” (e.g., Stevenson and Jarillo, 1990 SMJ). Unless they already control all of the resources needed to pursue their opportunity, founders will have to gain control over — or secure the cooperation of — the resources they are missing. RDT highlights how gaining such control over external resources will require the manager (here, founder) to give up things of value (here, equity stakes or decision making control) in order to secure those resources, especially when those resources are critical and scarce. The result: founders will have to give up equity and control if they want to attract key resources — i.e., will face a Rich-versus-King tradeoff.
My field research indicates that a critical factor in this tradeoff is the founder’s motivation: Is the founder starting the venture in order to “run the show” and leave his or her imprint on the venture, or is the founder pursuing the good old profit motive? The key isn’t that a particular Rich choice is better than the competing King choice (or vice versa), but how well each choice fits with the founder’s motivation. Founders who make choices that are consistent with their motivations and goals (e.g., a King-motivated founder who doesn’t give up a lot of equity and decision-making control to co-founders, non-founder hires, or investors; a Rich-motivated founder who does give up equity and control to attract excellent co-founders, hires, and investors) should have a much better chance of achieving their goals.
It could be argued that the key isn’t what percentage of equity the founder holds but the value of that equity stake (a “smaller slice of a larger pie” analogy), and that when equity value is considered, there won’t be a Rich-versus-King tradeoff. In actuality, even when using an estimate for the current value of the founder’s stake, I find a significant tradeoff between that value and whether the founder has kept control of the CEO position and board.
Side note: A related factor that might also affect the founder’s motivation is the founder’s perception of the venture’s potential. Founders who think their ventures have the potential to be extremely valuable may make very different choices from founders who think their ventures will be successful but not extremely valuable. To cite an example with added relevance to anyone reading a Blogger.com blog (e.g., this one): Last week, the Wall Street Journal quoted Evan Williams, founder of Blogger.com, about the different ways he approached his last two ventures. First, Evan built Blogger.com without any VC money, before selling the venture to Google in 2003. However, for his current venture, Odeo (podcasting), he took VC money from Charles River. Why?
With Odeo, “we thought we had the opportunity to do something more substantial,” and that required venture capital, he says.
Same person, very different approaches to building his ventures. Evan seems to have expected Blogger.com to be “less substantial” (have less potential value) than he expects Odeo to be, and this expectation affected his investor decision. (Revisiting our 3 scenarios: Does anyone know if it also led to different co-founder and hiring decisions in Odeo vs. Blogger.com?)
I wonder also whether the Rich/King dichotomy is simply a solitary choice for the founder. That is, if a founder decides to give up control, does that mean not only a new CEO but a new cast of characters throughout the top management team (TMT)? If investors are questioning the founder’s ability and judgment it seems reasonable that they would question the VPs put in place by the founder.If true, this might add a social aspect to the decision. How is the founder influenced by the impact on the rest of the management team? Does the founder even discuss the issue with them? What’s the impact on TMT attrition following the demotion of the founder?
Given that there are a few (albeit only a few) founders who have managed to be both Rich and King, what is it about their ventures/abilities/motivations that allows them to achieve both? Could it be that these founders started the right ventures with the right products at the right time, or was there some inherent capability that they possessed?Also, in the ongoing study of founders, is there any way of knowing these founders’ a priori motivations at founding? Did they found their firms to be rich or king? I ask because the motivation may well direct the path the venture takes, so that one or the other outcome becomes inevitable.
1. Find a co-founder (but you don’t have to split it 50/50). You should be able to convince at least one other person of your propsects.2. Angels, definitely. Not only do VCs not add value, they limit the company’s prospects by inflating the capitalization too rapidly.3. Find a new CEO at some point. But be very prudent.
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I think that one of the most important points in this excellent post is <><>It could be argued that the key isn’t what percentage of equity the founder holds but the value of that equity stake….<><>. There are two sides to this coin: problem one is “valuation at all costs” in which a founder takes the best valuation they can get from any VC at the expense of not only who that particular investor is but also at the expense of all other terms in the deal. Valuation, especially in the early stages, doesn’t end up being that important if you have a winner on your hands. The opposite issue is one in which the founder thinks that the A-list VC is a cure-all and that they should put up with whatever dicey terms and valuation they’re getting from this A-list team in order to get proven winners on board. The point being that too often, founders ignore important but “currently irrelevant” deal terms when determining how to fund the company. Great post.
Some great points, Dick! I was hoping you could elaborate a bit further. You allude to “all other terms in the deal” and “important but currently irrelevant deal terms.” It would be great to have more specifics regarding such terms, as well as how they may eventually impact outcomes for founders. For example, are terms regarding liquidation preferences frequently overlooked by founders since they don’t seem very pressing at the beginning? Can this result in founders not realizing as much value as they might have down the line? Vishesh
What leads to the regal rich quadrant of your graph? I don’t think it’s all that mystical. The regal rich quadrant are CEO’s that <>had a very specific idea of how they wanted to run a company<> and weren’t just in it for the technology or the money. These people wanted to innovate not only technology but the <>business of technology<>.What I mean by this is that frequently we assume there is a formula for value generation in a business, the “right way” to build a company. I call this focusing on the process instead of the product. As a fledgling entrepreneur myself, I understand this feeling of the great “unknown” of business. This “process” thinking leads to the call for replacing the CEO with someone with business experience, the “right person”, probably with an MBA. Someone who can follow the historical playbook for company growth. I think this is the right choice in some situations, but I think there is a finer granularity to your king versus rich theory.I think it mostly boils down to motivation.King - Wants to feel in control. Probably has perceived, whether real or not, that “idiots” have been running things before and demands control. This type of king will seek the same playbook to try and “play better than those other fools”. When using the same playbook though, those with experience are <>probably going to be much better at it<>. These people are more interested in the process than the product.Rich type 1 - Obviously not really interested in the process, just the end result, the big paycheck. This can be the serial entrepreneur who states “ok this time it’s for the money”. This type is smart enough to care just enough about the product and process to succeed, while handing both off as quickly as possible to someone else and cashing out.Rich type 2 - I call this the product passionate individual. Frequently this passion is to see the idea or product succeed and “get out there”. More focused and passionate about the product, they’re quite willing to bring in the professional for the process, one who can execute the playbook correctly.Regal Rich - Has a passion for the product and wants to see it “out there” but <>also<> believes that there is a new playbook. This new playbook is one that’s innovative and hasn’t been tried before. This new business playbook <>couldn’t be executed by a ‘professional’<>. This can mean innovating the product but also the company creation and growth process in lots of specific dimensions. This can mean supply chains (Dell), managing creative tech people (early Microsoft or now Google), or even something more radical such as 37signals eschewing growth for growth’s sake and achieving success through keeping the company small and simple (and implicitly counting on the Web and it’s pervasiveness for growth through good “karma”). Ironically, I would argue that “getting rich” was a second order motivator for all the Regal Rich.
Vishesh, I think the terms that founders shouldn’t worry about in an early round are all those terms related to registration rights and other “ipo” terms. These docs are going to get rewritten five more times before you ever IPO, and as we all know, the ipo is a very infrequent exit. Liquidation preferences are at the top of the list of terms I think entrepreneurs should work hard to minimize. 1x liquidation preference is fair - over that and you should negotiate hard. Negotiate the dividend down. you think your business isn’t going to go sideways, but it might, and you could find yourself doing “ok” five years down the road and if you didn’t negotiate for a non-cumulative low dividend, you’re going to find yourself staring at some big payments. Board control can be very important in the early going. Boy, it’s a long list and probably worth its own lengthy posts. Things not to worry about our VC’s veto rights on M&A. A VC can never sign away their right to veto. Imagine a suitor approaches the company and says “we’ll pay .5x revenues for the company, but give the founders 5x revenue earnouts in years 1 and 2. obviously the venture folks are going to try to block that and the deal docs need to protect them there, so it’s foolish to try to eliminate their blocking right. Ditto their pro-rata rights on future rounds.
I faced this situation and opted with my first startup to mitigate risk at all costs, i.e., bring in as many people who could add value (and money) as possible, practically ignoring dilution. My rationale was that the thing I wanted to avoid was not getting the business off the ground in the first place (not having enough money, stumbling for lack of talent, etc.). I was not thinking of upside but protecting against the downside. With that in mind, I brought on two co-founders, a professional CEO, and offered plenty of equity to talented employees. We also worked hard to bring in vc money, which we did — three rounds, each larger than the next. My strategy, which was part of my long-term career plan as someone who desperately wanted to be an entrepreneur and not have to work for a big company, was that if I succeeded in being part of an even moderately successful business at a young age, I would likely make a decent amount of money and I would attain experience sufficient to call the shots next time around.It worked out more or less as I had hoped. We managed to get the company aloft and I predictably ended up with a smaller and smaller slice (larger, however, than I probably deserved; this all took place during the bubble valuation days). I was always a major player within the company but was never an absolute monarch.We sold the company after seven years and I walked away with a ton of experience (in every aspect of starting a company from recruiting talent to raising money) and enough money in my pocket to do it again, this time with a lot more clout. As an aside, I don’t think I knew myself at the time I started the company where I stood on the rich vs. king spectrum. I mean, even if I had my druthers, I was so new to running companies that I didn’t know what being a king really meant (in terms of lifestyle, responsibilities, stress, etc.) The seven years I spent growing a start-up allowed me to sort that out and I discovered that I like certain aspects of control but I don’t really want to be the CEO. To young entrepreneurs dreaming of being Bill Gates or Michael Dell, I say: beware of what you wish for. I did enough of it to know that this is a tough job.So if you’re a young, first-time entrepreneur like I was, my advice is to give up control and equity liberally in order to bring on as much help as you can get. Do everything you can to avoid having your business run out of gas early on. Even if your company grows to 1000 people and you have a tiny sliver of equity, you’ll always remain “founder” which is still pretty regal (girls dig founders).And even if the company ultimately fails or ends up with an outcome where you don’t make much money, you will have a much better shot at doing it over again with better terms (thanks to your track record), more investors to choose from, good people from your last company to partner with, and wisdom about what you personally want out of the experience. If all goes well the second time, maybe you can even attain the elusive rich and regal status.
The key to being Rich in a venture situation is to be at the Company in an exit. Therefore, one can go in wanting to be both Rich and King, but then be stripped of the Kingdom. At the point at which it looks like the Kingdom is in doubt, pursuing the Rich strategy seems optimal. Doing so means finding a meaningful place in the new world order. The Technical-King can make this transition. The Business Guy-king usually resists and is beheaded.
Thanks for the reflections, Galen! Sounds like you were/are quite a central figure in your company.In your 22 years of sole ownership, were there times when you came close to needing/taking outside capital? Why did you not take it then, but did now? In 2002, if the private-equity investors had told you that they planned to only have you stay CEO for 6 months before they would replace you, would you have taken their money? Also, in a slightly different vein (though still related to your centrality to the company): After all of these years in your “baby,” I assume that you’ve thought about succession planning. Was the private-equity round part of that plan? What are the other key parts of your plan?
Good article. I guess I’m an odd ball compared to your Rich/King scenario. My 22 year old start-up was purchased in 2002 by a private equity firm and I was asked to remain as CEO. I did so for three years, with my agreement ending Dec. 3 of this year. I have been asked to remain and continue on building value for the investors and myself. The interesting part of this is that if I had remained the sole owner, we wouldn’t have had the cash to weather the past three years and we’d have all lost the opportunity to continue. But, with the capital and strength of the investors and debt lendors, we were able to move on to a rewarding future. Often, we CEO/Founders find that we want our “baby” to make it and flourish even if we don’t do quite so well. Part of what makes me run is watching and nurturing the business to success, rather than reaping the huge windfalls. Not that I haven’t been treated quite well along the way. I am very fortunate to have investors that recognize my contribution and vision for the future of our market sector. Thanks for the article. Good work!
The answer to your first question, I managed with my team to not bring in capital from the outside other than bank debt so the team could keep as much of the equity as possible. By 2001, the market was such that our clients were starting to demand a change in the product we were producing that would have taken a complete recapitalization of equipment, and our bank simply wouldn’t go along with further leveraging the business, nor was it sane. So we opted for the salvation of the business via the private equity buy-out. Actually, I was asked to remain as CEO only 30 days prior to the deal closing by the PE investors. I had planned to step aside if that was best for the company. They changed their minds at the last minute after we worked on the deal for almost 11 months. I had emotionally unplugged from the reality that I’d get to remain as CEO and had accepted the need for me to be a consultant to the company and on their Board. ——- The investors actually brought in a President and a Chairman from outside the company with deep experience in the business sector at the time they purchased us. Both proved to not understand the market changes since selling their business 8 years earlier. After they left (we left them), we attempted to bring back to the company a former executive that had shown interest in returning. That plan failed. We have a three year plan to sell the business today and at that time, I’ll either be asked to stay or leave. Should I be hit by the proverbial truck, there is a strong management team beside me. They’d be just fine for an extended period of time. They’d be missing the visioning portion of my role, but that could be shored up pretty quickly (although probably with a slight twist). I’m expecting the company to be sold prior to that to one of the industry new comers that is interested in our technologies. I’d probably be asked to hang around again, as would several of my key executives. Decisions, decisions….Good questions. Sorry it took so long for me to respond.
I think 99% of businessman want to be king & regal. But what so ever, we must carefully consider on two parts of god coin:
01-Consider on contract on our rights, obligatons, role, duty in the company.
02-Keep your eyes on daily operation.
At last, use your talented skill to fix problems flexibly. So, you still the one that can play the game. We don't care it is the black chess or white chess on chessboard but we just know that WE ARE THE CHESS PLAYER.
Hi Noam,
I am working with a small start-up company with a serious case of founder's syndrome. It seems to me that it is going to be very difficult for this leader to make necessary changes in management style, because in addition to wanting to control his company, below a thin veneer of confidence bordering on arrogance he seems to be very insecure and not open to any hints that his management style may be anything other than perfect. Have you found this (i.e. arrogance masking insecurity) in your research with founders?
Getting into the conversation a bit late (like 5 years…) but wanted to add the time dimension to this discussion. I'm actively in the process of starting a new venture, and have spent quite a bit of time thinking about how important equity is versus probability of success, and how closely the two are correlated. While these are important topics, right now, it's very early, and I'm loath to give up more equity and more control when things are just starting.
In other words, when looking prospectively, it's difficult to identify the point at which one is willing to give up on control or equity, in pursuit of the greater good. Perhaps the right time is very early on, or maybe it's better to bootstrap as long as possible, and then to broaden the pie.
In my case, I probably fall somewhere in between the rich/king continuum, but figuring out when to make the jump to one side or the other is part of the complexity of this question. Nobody wants to be a sucker - you don't want to give up part of your company before it really takes off. On the other hand, perhaps giving up control and taking more financing may create that success.
So, this is a work in progress. I'd be very curious to hear how other founders approached the timing question, and whether or not this has been a topic of your research (Noam).
Thanks for the high quality content - it's greatly appreciated.
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