Who holds the stakes in the startup game of thrones?
Every time a founder raises funds, they end up losing equity, and with time, control. Last week, Ola took steps to protect itself and possibly try and retain control. It raised a question that was running in all our minds–can founders retain control of their company as it scales? What are the dynamics involved? How does the power play actually work?
- Ola’s recent move to protect itself and restrict Softbank’s powers shows signs of a maturing ecosystem.
- For years now, we have wondered if we can have founders like Mark Zuckerberg, who can hold control of their organisations for long.
- How much stake to lose and at what cost? All these depend on the founder’s bargaining and negotiation skills.
In April last year, Facebook’s Founder Mark Zuckerberg was in news yet again. But this time round, it wasn’t on Oculus or on Instagram, but it was to announce its earnings.
Facebook had announced it will create a new class of common stock – Facebook’s third, to ensure that Zuckerberg could control Facebook as long as he wants it.
Essentially Facebook gave him the right to sell $32.7 billion worth of stock and keep control of Facebook. For those who have been a part of the startup ecosystem, this seems like a huge move.
This wasn’t the first time Facebook’s Founder was in the news for his ability to retain control of his company.
In 2012, there were a string of voting arrangements that were outlined in Facebook’s SEC filing that showed that the most powerful shareholders of the company had ceded their voting rights to Zuckerberg. Then, he was able to get about 56.9 percent of the shareholder voting power that gave Zuckerberg complete control of the company’s decision making.
An article in the VentureBeat, quoted Menlo Ventures Partners Mark Seigel saying, “This is not common at all. He has negotiated a very unique deal.”
Power of the Unicorn
Zuckerberg’s power to negotiate unique deals that give him control over the company he founded has been aspirational for many in the Indian startup ecosystem. Especially this year, when the Unicorn founders seem to be losing control in their own companies.
On January 9, 2017, when Kalyan Krishnamurthy took over as the Flipkart CEO and Binny Bansal moved on to become the Group CEO, the Indian startup ecosystem was taken by storm. More recently, the Snapdeal sad saga has left everyone shaking their heads in resignation.
More than anything, when Kalyan took over as the CEO, people wanted to know how much control do Indian founders actually have over their own companies, and why isn’t there a Zuckerberg in India?
India’s next Zuck?
Recently, Ola made a rather bold move. The Articles of Associations (AoA) filed by the company suggests that the founders are strengthening their rights and restricting those of Softbank’s.
Ola is set to issue additional shares to Ola’s Founders, Bhavish Aggarwal and Ankit Bhati, thus keeping their combined shareholding between 10.9 and 12.38 percent. While this shareholding will depend on how much the Bengaluru based cab-aggregator raises in its next round, it will not drop below 12 percent.
The AoA also suggests that the founders have taken steps to restrict the ability of its investors to increase stake. Any transfer of shares by the investors representing 10 percent or more of the company’s capital will need to be approved by Bhavish and Ankit.
It possibly was one of the first moves seen in the Indian startup ecosystem that showed signs of maturity from the founders. And also the need to retain more control and power over their company. Whether this move is in direct correlation to what is happening with Softbank’s other portfolio company Snapdeal is yet to be ascertained.
Important that founders retain control
But it nevertheless shows positive signs. It shows that founders hope to see through the vision they had for their startups when they started up. It is important that founders continue to play a key role in the company even as it scales. The founder brings in the intrinsic vision and value to a company that a non-founder cannot bring in.
A study conducted by Bain & Co. to figure out why exactly founder-led companies outperform discovered that during the starting days founders built their companies on the inside, influenced their success on the outside, for a significantly long period of time.
This view seems to be quite favoured among investors like Andreessen Horowitz. He, in fact, has been very vocal about his preference for investing in businesses where the founder is the CEO.
Sanjay Nath, Managing Partner, Blume Ventures, which is a shareholder in Ola (which acquired Taxiforsure), believes that founders buying additional shares back from the company shows more commitment to the company and thus more skin in the game.
“If you look at Andreessen Horowitz, the reason they focus on investing in companies where the founder is the CEO or has more control, is because long-term shareholder value is created that way,” says Sanjay.
We want you in-charge
As investors, one of the most important thing he or she is looking for is - returns. Every move taken is to ensure that there are enough returns on the investments made. If we go back to the Facebook example – when Zuckerberg first announced his plan to give away his wealth, the shares briefly fell.
This was because the investors thought he was giving up voting control immediately. A Bloomberg article quotes – “Investors seem to want Zuckerberg in charge.” The article goes on to describe that Zuckerberg has a majority voting control of Facebook even after spending billions of dollars because all of his ambitions have made a lot of money for shareholders.
But Facebook is a unique example. In its case, the investors were willing to pump in money from day one, it was the product that was the ‘next big thing’. Udayarkar Rangarajan of Khaitan & Co says that Zuckerberg had, in a sense, the power in his hands for most negotiations. Fundraising, as we know it, is also a negotiation game.
A poker game
What kind of stake to keep and give essentially lies in when and how much of funding you raise. In most cases, raising funds is critical, but timing it in order to have bargaining power is also important. Uday explains,
“If you raise it too early, especially in the idea stages, there isn’t proof of concept. And investors will seek more stake. If it is too late, then company operational costs make it difficult for you to bargain. In the end, it all depends on the founder. It is a difficult question to answer – when to raise funds? It is how the founder negotiates. And if they have the power to wait it out, then they should till they can strike a deal that favours them."
Unfortunately, for most Indian founders, the problem arises right at the beginning when they first raise their funds. Ashish Fafadia, CFO, Blume Ventures, explains that many angels and investors took large amounts of equity as much as 30 percent of their stake in the early seed rounds itself. He explains,
“If you, as a founder lose that much stake earlier on itself, you are hardly left with anything. And in the later rounds you end up losing more stake. Founders are hardly left with anything then. But it doesn’t happen in all cases.”
Ideally, in the initial rounds, the founders need to hold at least 80 percent of their equity and in later rounds 30 to 40 percent of their equity. Uday explains that there are different ways to ensure the control remains in the founder’s hands.
“There are different classes of shares. Equity share capital and preferential share capital. Equity share capital can be split into Class A and Class B shares, or multiple classes as per the Company’s Act.”
The power dynamics
For example, if an investor invests in a company and their interests are purely financial and they are just focussed on the growth of the company – then it makes sense for the founder to keep management rights. They will have the right to appoint people to the board and the investor, in turn, will get higher returns on the money that is invested.
In such a scenario, supposing there is an exit, and the investor has invested $15 million in a company that is valued at $50 million. The investor is looking at a return of $45 million, because of the split of the classes, the founder is obligated to give the investor $45 million and keep $5 million.
Uday adds that all of this is determined purely by how the shareholder agreement is. With the split of the equity share into multiple classes, the investor, as per the class split, will have the right to appoint one or two members on the board and veto certain items at the board meeting. So, even with the investor holding different classes, there are certain rights he or she holds.
The dynamics are subtle. The power play involved needs strong legal teams, negotiation powers, and a long-term view of what the founder wants to achieve with their organisation.
Another display of this kind of power other than Facebook has been from Travis Kalanick of Uber. Despite the negative Press and backlash that Uber has received since the beginning of the year, several investors still have faith in Travis.
Two investors of Uber told The Information that they have confidence in Kalanick and one of them was even quoted saying – “You can’t ignore the sheer scale of what he’s built and the strategy.” They even believed that he can turn the company over.
The article even went to explain that any move to oust Kalanick would be difficult, as he along with Ryan Graves, Uber’s former CEO, and Garrett Camp, Co-founder, have majority of shareholder voting power.
The article in The Information quoted, “At a minimum, which means together they control decisions about fundraisings, going public or staying private, and other key decisions. And it may give them control over Mr. Kalanick’s status as CEO.”
Mark Siegel has also commented that such supervoting powers that companies like Facebook and Uber have allows the founders to invest in long-time projects which may or may not get investor support, even make controversial acquisitions, stay private longer, and yet create enormous value.
Apart from the ability to negotiate such a deal, all these examples also show that investors, in the end, need to believe in the ability of the founder to run the company towards a powerful growth trajectory.
In Uber’s case, even with all the negative publicity, the company retains a strong share of the market and is a formidable force. And in terms of Facebook, the investors believe Zuckerberg to be the face and the power of the company. It is in the end all about the personality and kind of skills the founder holds.
Failing isn’t an option in India
So does this mean that Indian founders need to learn to negotiate better? Probably, but Uday also believes that the scenarios between India and the Silicon Valley are different. He explains,
“In the US, solvency is easier. The legal processes are clearer and there are laws in place that benefit founders. In India, the legal issues are deeper and have stronger repercussions. Also, failing is just isn’t an option. Founders have to work harder to make things work in India, this in turn hampers a bit of the negotiation powers. Everything isn’t that founder-friendly in India. When you have a sword perpetually hanging over your head, it becomes difficult to play the game.”
Adding to this, Ashish also believes that in many cases, the stakes for investors are marked higher. He adds that when the market is analysed the different parameters and chances of failing are generally perceived to be higher in India.
Therefore, investors in most cases look for higher stakes. In that sense, the scales are already tipped towards the investor side. India currently is a land of first-generation entrepreneurs, who are possibly just getting the hang of negotiations and cap-tables.
Does that mean second-time entrepreneurs fare better? Sometimes, but not always. Ashish adds that the reason a second-time entrepreneur would possibly be getting a better deal is because they have a proven track record and not because of superior negotiation skills.
Again, does it mean that Indian founders need to prove themselves more like Travis and Zuckerberg? Or do they need to seriously work on their negotiation skills? The answer is both. The reason that Kalanick and Zuckerberg are able to hold control is because they have the negotiation skills and investors continue to believe in them.
Ola’s move is one the first steps seen in that direction in the Indian startup ecosystem. Now, what it needs is a little more powerful wins.