Thursday, May 17, 2007

Lesson #18 - Control your Destiny

“It's choice--not chance--that determines your destiny.”

Every entrepreneur is faced with decisions that relate to power and control. If you decide to raise capital and bring in investors, you are giving up some level of control and power. Even when you hire a management team you can relinquish too much power and control if you are not careful.

Anytime you make a decision to include another party in the management or ownership of your venture, you need to make sure that you still control the destiny of the company.

How do you maintain control?

1. Make sure any action to change the operating agreement or bylaws of the corporation require your approval.

2. Make sure any issuance of stock or sales of assets in the company require your approval.

3. Make sure your employment by the company can not be terminated by anyone or by the Board of Directors without your consent.

So many entrepreneurs make the fatal mistake of trusting a partner or investor in the early stages of a venture, and not putting the proper controls in place to ensure their interest is protected.

It is absolutely critical in the early stages of your venture that you have clear documentation on who are the stakeholders and what powers they hold. Here are some classic examples of ways a founder can be hijacked if they are not cautious:

1. 51% Force Out - In most corporations the majority of shareholders rule the company. If you have partners or investors that total up to over 50% ownership - then you are vulnerable to being forced out. You can be the CEO, on the Board and feel like you are the most valuable employee - but at the end of the day - one vote by the shareholders can put you on the streets. They may not be able to take away your stock, but I have seen companies maliciously dilute a large shareholder to literally nothing over time.

2. The Power Drain - Most entrepreneurs raise capital to grow their company. Many times the company is desperate for capital to survive, so investors balance their risk by making the terms of the investment very onerous. Typically, investors not only want to take a big chunk of the company and limit their downside - they also want to drain the power of any major shareholders (especially the founders) in order to protect their interest. One example. is having the founder (who is typically the CEO) sign an employment agreement that gives the company (or Board) ability to terminate their employment based on subjective reasons. One of my favorites is when Investors create a new class of stock and require all corporate decisions to have majority approval of all classes of stock (which essentially gives equal power to the investors and founders, even though the investors may only own 10% of the company).

3. Outsider Board - I have had a lot of experience with Board of Directors. I have sat of many Boards and I have answered to many Boards. Every time I have raised capital, the investors demand a seat on the board, and then once they do get a seat, they demand to have an "outsider" on the board. Although they tell you its because they want an industry expert with experience, they are really trying to stack the Board to their favor. Here is my short advice on Board of Directors. Only major investors (of time or money) deserve a seat on the Board of a startup company. If you want "industry expertise" than just ask the person to be an advisor, and when you need advice pick up the phone and call them. They don't need to be on the Board. Keep your Board small (ideally 3 people) in the early days. Don't put too much energy in thinking Board's are critical. A Board can be a powerful sounding board if you choose the right people, but if its constructed simply as a way for investors to keep tabs on their investment - it most likely will be impotent.

4. The Dilution - If you have ever raised capital, you know the word Dilution well. Essentially, anytime you sell stock in a company - all existing shareholders are diluted (which typically means their investment is losing value or they are losing power). When a company is underperforming and continues to raise capital to fund operations dilution becomes a major problem. You can start out owning 100% of a company, and after a few rounds of capital have less than 20% of a company - and not much to show for it. Unfortunately, this is something you cannot avoid if you need the capital to survive but it is something you can minimize by being smart with your capital, and making sure you can reach cash flow positive in your first round.

In summary, make sure you understand who has the power in the company - and realize their are inherant risks associated with distribution of power. There is also a sense of security for investors when there is a balance of power - and many entrepreneurs are forced to relinquish power when they bring on new partners, but just make sure you are not giving too much away. Think about all potential outcomes - from worse case to best case - and make sure you have the ability to control your destiny.