Why Founder CEOs Get Replaced

first_imgWhy Founder CEOs Get ReplacedJune 18, 2019 by AlleyVoice 157SHARESFacebookTwitterLinkedin Raising money, particularly in a VC round with outsiders planning to join a startup’s Board of Directors, is often a founder’s first real introduction to corporate governance. A Board of Directors – the head governing body of a classically structured startup – approves all of a company’s most important decisions (including hiring/firing executives). Boards have fiduciary duties to the startup’s stockholders, which means that directors are entrusted to take actions that protect and maximize value for those stockholders, instead of looking out solely for their own self-interest.As fiduciaries, a Board is required to do things that might be painful to a particular person, but are essential for the well-being of the company as a whole. That includes replacing employees when their poor performance is hurting the company; including founder executives.So is it that simple? When startup Boards move to replace founders, is it always out of well-intentioned and principled fiduciary concerns for the company? Not quite. A Board of Directors is a powerful governing body entrusted with making very high-stakes decisions on behalf of constituents (like employees) who are often not nearly as well-informed and experienced as the directors themselves. That means power politics inevitably comes into the picture. This article is, in part, about the political games in startup governance that don’t get written about nearly enough.Performance, or Power?While performance can very well be the reason that a Board chooses to replace a set of executives, the desire to gain greater control (power) over management and the company’s decision-making is a potential ulterior motive. Disagreements between investors and common stockholders (founders, employees) can be annoying friction for aggressive investors who would much prefer to be able to issue directives and ensure they are unflinchingly followed.Where might these disagreements come from? Often differences in incentives.In a typical early-stage startup, first-time entrepreneurs and early employees are the largest holders of common stock. Unlike investors, the vast majority of common stockholders are not independently wealthy. They also don’t have a portfolio across which to diversify their net worth. So what little wealth they have is heavily concentrated in this one startup’s outcome. This affects their risk tolerance.Investors are in a fundamentally different place. They’ve usually already achieved some level of financial success. That’s why they can invest in risky early-stage startups. And they have a diversified portfolio of investments. Unlike common stockholders, investors also typically have downside protection: most of the time, equity investors have a liquidation preference and debt investors have first claim to assets, ensuring that they get paid back first. This subsidizes their ability to take risks.So one side (founders, employees) is not wealthy, not diversified, and not downside protected; while the other (investors) is a complete 180 of that profile, with existing liquid wealth and a diversified, downside-protected portfolio. This disconnect between common stockholders and investors (preferred stockholders) inevitably leads to disagreements on how to grow a company, who should lead it, how much risk is acceptable in doing so, and when is an appropriate time to exit. Those disagreements are inconvenient for investors, which incentivizes them to maximize their power (via a number of strategies) to push through their perspective, instead of negotiating with the “other side.”Tying this issue back to the topic of replacing a CEO: poor performance is sometimes the true motive for finding new executives, but other times gaining more power over a startup’s governance, in order to silence disagreement, is the real motive. Entrepreneurs are the most vocal representatives of the common stock because they are typically the largest common stockholders, and an extremely large percentage of their net worth is concentrated in that stock. Maximal “skin in the game” so-to-speak, including on the downside.Tying this issue back to the topic of replacing a CEO: poor performance is sometimes the true motive for finding new executives, but other times gaining more power over a startup’s governance, in order to silence disagreement, is the real motive. Entrepreneurs are the most vocal representatives of the common stock because they are typically the largest common stockholders, and an extremely large percentage of their net worth is concentrated in that stock. Maximal “skin in the game” so-to-speak, including on the downside.Professional CEOs, brought in to replace founding CEOs, can come to the table with very different incentives and different loyalties. They’re often more financially successful independent of the startup and have long-standing relationships with investors already on the Board. Also, because their stock is being issued later in the game, at a higher price, they are more incentivized to take a “big swing” for much more value appreciation, because a bust (the downside of that risky big swing) won’t hit them nearly as hard as those who’ve been grinding away for years to get the startup to where it’s currently at.Startup governance best practices. So how can common stockholders protect themselves from potential bad actors, and ensure that executive succession in their company is driven by performance, and not politics? Here are a few best practices our firm has observed across decades of collective experience:Do diligence on lead investors. Taking money from a lead investor means signing up for an extremely high-stakes, likely decade-long relationship. Treat it that way, and do your homework. Investors will often provide references for you to speak with, and that’s great, but obviously they are going to cherry pick the teams who will have the nicest things to say.Do some research, and get into contact with teams whom the VC has funded but weren’t on their reference list. Importantly, have conversations off-the-record, to the extent possible. In tightly connected ecosystems where investors can wield significant power, many startup teams will be reluctant to speak honestly unless there’s no possibility that word will get back to a bad actor regarding who spilled the beans.Be skeptical of “founder friendliness,” which has become a marketing strategy for investors.As the number of early-stage funds has expanded, competition for getting into desirable deals has increased accordingly. Looking for ways to differentiate themselves, investors have started competing on how “friendly” they can portray themselves to entrepreneurs. We’re not going to say this is inherently a bad thing, but understand that “friendly” marketing, medium posts and virtue signaling on Twitter do not change fundamental incentives. Last time we checked, the investors in VC funds still, rightfully, demand returns.Some of the worst actors we’ve seen put on a great public persona of “friendliness,” while we’ve seen entrepreneurs build great relationships with investors who are far more no-BS, straight-shooter types; acknowledging their misalignment, not buttering things up, and always playing above the belt.Make executive succession a discussion topic pre-closing.Before money hits the bank and contracts are signed, you should want to know how your investors really think about corporate governance and executive succession. Smart players often push entrepreneurs to rush financings with clever statements like “time kills deals” and “don’t lose momentum,” which allows them to get permanently on the cap table and on the Board without hard, honest discussions.When do founding executives typically get replaced in their portfolio? Are coaching / mentoring resources provided to ensure inexperienced executives get an opportunity to learn and grow before replacements are called in?What will the process of recruiting new executives look like? Will the process send the correct message that the new executives work for the entire Board, including representatives of the common stock, instead of being “owned” by the money? If so, how candidates get sourced and vetted should be discussed.Agreeing on foundational governance principles, and healthy, balanced recruiting processes can go a very long way to avoiding conflict in the future.Get independent advisors, including counsel.As we wrote in Relationships and Power in Startup Ecosystems, common stockholders are substantially disadvantaged relative to investors in terms of “relationship leverage.” By being well-connected repeat players, investors have the ability to offer executives, directors, advisors, and even lawyers, key “access” to deal flow and opportunities in order to buy political loyalty.Just as one example, if the law firm used as company counsel has a long-standing relationship with your lead investors and receives regular referrals from them, whom do you think they really work for? We’ve lost count of how many times inexperienced startup teams have been led to use a certain law firm preferred by their investors, only to find out years later that all the advice they’d been getting was biased and one-sided. See When VC’s “own” your startup’s lawyers.Given the substantial imbalance of experience and influence between startup teams and investors, and their misaligned incentives, ensuring that startups have trusted, independent advisors whom they can rely on is essential for healthy corporate governance. It’s the only way to level the playing field, and protect the early common stock’s valid perspective from being muzzled via clever political games.Given the substantial imbalance of experience and influence between startup teams and investors, and their misaligned incentives, ensuring that startups have trusted, independent advisors whom they can rely on is essential for healthy corporate governance. It’s the only way to level the playing field, and protect the early common stock’s valid perspective from being muzzled via clever political games.To be very clear, the point of this post is not to paint some exaggeratedly adversarial picture of the startup funding landscape. There are lots of great people out there funding companies, and they always respond favorably when startup teams exhibit reasonable caution in doing their homework, and ensuring they are independently well-advised. They have nothing to hide. Responses are often a key tell.Before asking for “friendliness,” demand honest discussions, time to do private diligence, and the right to be independently well-advised. Like any high-stakes, long-term relationship, transparency and balance are infinitely more valuable than smiles and platitudes.Jose Ancer (@ancerj) and Jeremy Raphael (@jraphs) are Emerging Companies Partners at Egan Nelson LLP (E/N), a Lean, World Class Law Firm delivering top-tier, scalable legal counsel to leading startups, without the unnecessary overhead costs associated with traditional firms. PREVIOUS POSTNEXT POST Filed Under: Advice, Management, Resources, Strategiclast_img

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