Founders’ guide to ‘Game of Thrones’ in the startup world
“Ideas are worth a dime” – any budding entrepreneur would have heard this a zillion times when they enthusiastically articulate how great their idea is.
Of course, passion is crucial, but most would agree that the vision and capabilities of a startup’s founding team is what attracts them to invest. While this may well be the case in early stage startups, how does a startup’s founding team play a role in subsequent valuations? Specifically, does the founding team’s control of power influence a start-up’s valuation?
A recent study, analysing more than 6,000 US startups launched between 2005 and 2012, tries to address this question. The remainder of this article discusses the study’s key findings and implications.
What drives people to start their own ventures? Many would argue that the primary motivation is to create wealth. But research shows that entrepreneurs as a class make only as much money as they could have if they had been employees. In fact, entrepreneurs make less accounting for the risk. We also know that the chances of success in the hyper-competitive start-up arena are abysmally low. Entrepreneurs still take the plunge even after being well aware of these facts.
Wealth creation should therefore be nothing more than a desirable outcome at best. A quick chat with budding entrepreneurs about their role models can easily uncover another motivation – the drive to create and lead an organisation, and research shows that many founders are usually convinced that only they can lead their venture to success.
While this conviction about their capabilities coupled with their vision and passion for their startup is a key ingredient to its success, it could also cloud the entrepreneur’s mind when facing a trade-off between retaining control and increasing the value of the firm.
A previous research indicates that founder-cum-CEOs are a rare breed, and discovered that most founders surrendered management control well before their companies went public.
The research further found that by the time the ventures were three years old, 50 percent of founders were no longer the CEO; in year four, only 40 percent were still in the corner office; and fewer than 25 percent led their companies’ initial public offerings.
Uncomfortable truth: how does founder’s control influences valuation?
The results from the above-mentioned study may seem off to you, but, a recent research further confirms that a move by the founders to give up certain degree of management control could have a profound positive impact on company’s long-term value.
The study highlights that start-ups in which the founder maintained control (by retaining a majority of the board of directors and/or by remaining as CEO) have significantly lower valuations than those where the founder has relinquished control.
These results hold irrespective of whether pre-money valuation or capital raised is used for analysis. When using pre-money valuation as the dependent variable, each one-unit increase in the control-index (i.e., from no control to control of either the CEO position or the board, or from control of the CEO position or the board to control of both) decreases company value decreases by between 17.1 percent and 22 percent.
The results are even more stark when the dependent variable is capital raised, where founders’ retention of an additional level of power see a 35.8 percent to 51.4 percent decrease in the amount of financing they raise. This is especially true when the start-up is three years old or more as the founders’ technical expertise or visionary outlook typically become less crucial to the firm’s growth than its overall resources.
But founders don’t let go easily. In situations demanding such a trade-off between retaining control versus creating long-term value for the firm, founders often choose to remain independent and masters of their own destiny.
This often leads them to resist co-founders, not to grant stock to potential employees, to refuse to accept capital from outside investors, and to maintain control of the company’s equity.
There is nothing wrong with choosing to retain control, and it is even understandable as new ventures are usually labours of love for entrepreneurs.
It is not unusual for them then to be emotionally attached to their ventures, so much so that many of them even refer to their businesses as their babies. However, in doing so, one must be clear that in the long-term they carry a significantly higher risk of ending up neither wealthy nor powerful.
The implications from the research are clear for entrepreneurs, investors, and potentially even those who want to be part of a fast-growing enterprise.
Entrepreneurs: Understand your core competence
Yes, you have successfully led the organisation in the development of its offering and providing the firm with initial market traction. But that is only a limited testimony of your management prowess.
Make no mistake, gaining sufficient initial traction is one of the hardest things to do as an entrepreneur, but the gameplay is completely different after that first achievement.
A technology-oriented founder-CEO may be the best person to lead a tech start-up during its early days, but as the company grows, it will need someone with different skills. This is evident in how private companies are structured.
Research shows that outside investors control the board more often where the CEO is a founder, where the CEO has a background in science or technology rather than in marketing or sales, and where the CEO has less management experience. If you identify yourself as a visionary, then be open to sharing, or even letting go of some of your management responsibilities.
Investors and potential hires: Understand the founders’ motivations
Do your due diligence on founders, not just in assessing their skills and experience, but also to understand their motivations and determine their willingness to step back and cede power to someone else at the appropriate time.
At the same time, investors should also be mindful that although attracting outside resources may increase company survival, it can also increase the pressure to “swing for the fences” – to ratchet up the growth, usually increasing the risk of complete failure.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)