Beyond Being a Start-Up

Stephen DeAngelis

November 23, 2010

Every entrepreneur begins a new endeavor with dreams of success. Some entrepreneurs, however, never ask themselves what success will look like. Everyone has his or her own idea of what success looks like. Generally, however, success for a business means profitability and continued growth. At some point, a start-up company either fails (i.e., goes out of business) or becomes sustainable business. Financially successful businesses often face several challenges associated with growth. Those challenges include: scalability, fundraising, maintaining equity, increased hiring, new management, and so forth. Each of these areas has its own challenges and thinking about those challenges before they become a crisis is a good idea. Let’s begin the discussion with equity ownership. Raman Kumar, vice-chairman and chief executive officer of CBaySystem (a leading provider of healthcare business process outsourcing) provides some thoughts on that subject [“Equity Dilution and Your Business,” Wall Street Journal, 19 August 2010]. He writes:

“When faced with the prospect of scaling the business and raising funds, the looming fears of dilution and losing control over the business come to the surface. While most founders are concerned about dilution and control, they do not really understand them. Let’s consider the issue of dilution. Any infusion of additional capital in exchange for equity results in dilution. That means one ends up owning less of the whole. However that’s only half the story. The founder must analyze if he is economically diluted. As long as the new equity is sold at a higher valuation to that of the founder’s shares, the founder is better off economically even though he or she has a smaller percentage holding in the company.”

Deciding how many shares represent full ownership of a company is never easy. Most investors will think that the founder has over-valuated the worth of the company while the founder will try to protect as large an equity position as he can. The most common scenario is offering a lot of shares (so that the founder can hold on to a significant number of them) with some portion of those shares initially sold at a low price to make them attractive to investors. The promise for early investors is that each subsequent round of funding will see an increase in the asking price of shares. When all goes well, investors are happy because their shares are worth more and the founder is happy because his financial position continues to improve even as his equity position is diluted. What about scenarios where that doesn’t happen? Kumar continues:

“Often new equity dilution happens at a lower price than the previous rounds of funding which isn’t always bad. If the ‘down round’ of equity financing reduces risk and brings in cash to grow the business to achieve the founder’s business plan and vision, then the overall economic value of the company increases. However, most entrepreneurs overlook the deeper value creation in these cases because they dilute ownership and erode financial value for the early investors.”

Even if you don’t “overlook the deeper value creation” of a down round, convincing early investors that a down round is a good idea is problematic. Kumar reports that he was once involved in a down round that involved acquiring a company that was seven times the size of the company he founded. Because the acquisition represented significant long-term value added, he “went ahead with an equity round at a lower price than the previous round.” He explains why:

“The economic value of the company changed dramatically within a year of that transaction. The lesson is that dilution is often for the greater good. Moreover in economic terms, it is all relative. A founder’s 10% stake post dilution can often be worth a lot more than his or her 100% was before strategic investors came in.”

Kumar notes that financial positions are not the only considerations that come into play when equity is diluted. Pride and ego also play a role. He explains:

“The problems some have with losing control over a business they grew from the ground-up is often driven by emotional factors and a lack of trust in outsiders. However you need to look at raising funds in the context of spreading your risk. A strategic investor can bring great value to the table in terms of providing a long-term vision, domain knowledge and most importantly a proven track record of growing businesses. Losing control is less about not being able to make autonomous decisions and more about creating a support system that can guide a business through those decisions and take it to a new level of growth.”

Sometimes entrepreneurs are better at coming up with ideas than they are with running businesses. When that is case, turning over day-to-day operations is probably a good, if difficult, idea. In a follow-up article, Kumar talks about the challenges of turning over management to someone else [“To Manage or Not to Manage,” Wall Street Journal, 26 October 2010]. He rhetorically asks, “What are the dynamics involved in founders handing over the reins to a qualified and experienced team of professional managers who are adept at managing the changing needs of an organization?” Kumar, who lives and works in India, goes on to note that “there are many instances of business dynasties whose founders have struggled to abdicate operational control, resulting in unwarranted business feuds and consequent stagnation and erosion of stakeholder value.” He continues:

“There are different phases in the evolution of every company. A business is started by a group of like-minded people with a shared vision and commitment. The key members then divide key functions and responsibilities such as finance, operations, legal, and assume different roles within the organization. While no clearly designated hierarchy exists initially, by natural selection a CEO emerges in the first few months — someone who is first among equals. In the next phase, the company expands and new employees are hired, making the founders increasingly busy dealing with the dynamics of a growing enterprise. The changing business requirements dictate the need to hire industry experts to catapult the company into a new phase of growth. History bears testimony that, in many cases, the founder group fails to put in place best-of-breed expertise in certain high growth areas of the company. This phase is a typical litmus test for the founders. The juncture can generate conflicted mindsets in the founder or founder group as they perceive the appointment of an external manager as a threat to their position. Most start-ups flounder at this stage. Rifts develop within the founder group, leading to ego battles. The company’s focus shifts from customer satisfaction to investing precious time in dealing with infighting among founders. If things are not resolved at this stage, eight out of 10 start-ups fail to reach their full potential or just close down.”

Understanding why turning over “the baby” to someone else can be heart-wrenching is not difficult. Emotional attachments remain strong. The vision that started the company remains clear. Admitting that someone else can move that vision forward better than you is hard to swallow. It’s not just a matter of taking the money and running. Kumar continues:

“In the process of building a business, many entrepreneurs often forget that loyalty and competence are not inter-related and that it is necessary to differentiate the two. ‘Creating maximum stakeholder value’ must be the business gospel for an entrepreneur and one must be willing to hand over the reins of the company to more experienced and capable hands as the needs of the business dictate. Hiring professional management to run the company has many benefits. They are able to incorporate industry best practices, add deep sector experience, streamline processes and lend a new vigor to the business. Further, a professional management has an objective and neutral outlook towards the company; which complements the company’s growth objectives. Moreover, the founder’s stepping down from running the company does not necessarily mean his absence in shaping the company’s future. There are ways to integrate founder involvement and professional governance by letting the manager run the company and having the founder don a strategic role as chairman or director with scope for intervention on matters of critical decision-making. This practice ensures that strategy and execution are well demarcated in terms of the division of work and there is a way to ensure collaboration between the two.”

Although Kumar is undoubtedly correct, you had better believe that turning over a company to professional management is easier said than done. Founders need to anticipate that the new managers will quickly move to assert their authority. After all, employees need to understand who is now in charge. Long-time employees will have almost as much culture shock dealing with the transition as the founder. Kumar insists that, in the end, the pain of transition will be worth the move. He concludes:

“In a nutshell, excellence in business is a function of excellence in management and this should be the driving principle for founders to shape their company’s future. It is important for a founder therefore to view success in the right perspective. If creating maximum wealth for shareholders and building a valuable company is the ultimate goal, founders will not view their stepping down from a top managerial position as a failure. It is this attitudinal shift that makes or breaks an enterprise.”

In another Wall Street Journal article, three executives explain how they coped with the transition when their companies moved beyond the start-up stage [“Small No Longer, Start-Ups Learn to Adapt,” by Piu-Wing Tam, 21 October 2010]. Tam writes:

“With many Silicon Valley start-ups in growth mode post-recession, some have found they aren’t small firms anymore. At what point does that change happen? We talked to three current and former start-up chief executives, two of whom have been beefing up their work forces and one whose firm was recently acquired by Google Inc. Each discussed when their start-up went from small to big, and what they did to cope with the change.”

The first executive interviewed by Tam was Bob Tinker, CEO, MobileIron. MobileIron is a smart-phone management that employs in excess of 80 employees. Tam continues:

“Among the changes [Tinker made in how he managed his business], he decided he could no longer personally interview every new employee who came through the doors, and that the company needed more structure. Last month, MobileIron introduced a ‘new-hire boot camp’ to orient new employees. And the firm has bought more video-conferencing technology and wireless microphones so workers—especially those who aren’t at headquarters—can better communicate. ‘Early stage start-ups are allergic to process,’ says Mr. Tinker. ‘Now we have to structure things a little bit more.'”

The next interviewee was Seth Sternberg, CEO, Meebo Inc, another Mountain View-based company. The Internet-communications company has grown “from fewer than 80 people last year to around 130 now.” Tam continues:

“Mr. Sternberg says that in hindsight, Meebo made the leap to bigger company at around 80 employees. ‘Getting past 80 is hard because everyone doesn’t know everyone else anymore,’ he says. ‘Now we need name tags at a company picnic.’ To manage the change, Mr. Sternberg says he promoted or hired a new level of manager dubbed ‘senior director’ to add more structure to the company. Mr. Sternberg says he also worried about ‘tribalism’ emerging among various groups—such as sales and engineering—and now holds conversations with each department every six weeks or so ‘to maintain empathy.’

What Sternberg calls “tribalism” is the beginning of what most business analysts call silo thinking. Long-time readers of this blog know that I believe that companies need to break down silo thinking whenever they come across it. It might surprise some people to realize that silo thinking takes place even in small- to medium-sized companies. The final executive interviewed by Tam was Max Levchin, former CEO, Slide Inc., the company acquired by Google in August. According to Levchin, the Internet company, based San Francisco, “stopped feeling like a small operation at around 65 people.” Tam continues:

“‘Once a founder of a company doesn’t immediately know an employee, that’s when you go from a small company to a big company,’ he says. Mr. Levchin says he quickly moved into a ‘tree structure’ at the company, a top-down structure where he had seven to eight direct reports, who had their own direct reports and so on. Mr. Levchin adds that as Slide grew, what he spent his time on shifted from being largely about the ‘true substance issues’ to what he dubs ‘all kinds of other issues,’ such as personnel and administrative matters. ‘In a small start-up, the latter class is pretty small’ while at a bigger company, the other issues ‘start encroaching,’ he says.”

I daresay that most entrepreneurs don’t start businesses hoping they eventually end up dealing with “all kinds of other issues” instead of “true substance issues.” That’s another good reason that founders might want to consider turning day-to-day management over to a professional management team. In an excellent article on this subject, Jonathan Moules asserts that entrepreneurs need to ask themselves, “Am I a Dyson or a Dell?” [“Should founders be left to run a business?Financial Times, 15 November 2010] Moules, of course, is referring to Sir James Dyson (famous for his vacuum cleaners) and Michael Dell (famous for his computers). He reports, “While Dell is chairman and chief executive of his business more than 25 years after it was founded, Sir James handed this role to one of his employees, Martin McCourt, in 2001, and now uses the title ‘chief engineer’. In spite of the column inches devoted to entrepreneurs such as Dell, most founders follow the Dyson route.” That is certainly something to think about if you are just starting a company. In a companion article by Robert Craven, managing director of a consultancy called, The Directors’ Centre, notes that the founder of a start-up company seldom goes from “the kitchen table to a great chief executive.” [“Great leaders know when to retreat,” Financial Times, 15 November 2010].

Although many entrepreneurs begin companies expecting to run them until they retire, serial entrepreneurs look forward to the day when they can sell the company and move on to the next challenge. If you are looking for a big payday, you might want to hold off selling your company for a while [“Businesses Put Up for Sale Smack Into Harsh Reality,” by Sarah E. Needleman, Wall Street Journal, 14 October 2010]. Needleman writes:

“Small-business owners banking on a big payoff when they sell their establishments may have to settle for a lot less than planned. A combination of tight credit, skittish buyers and business owners unwilling to sell at rock-bottom prices—factors similarly affecting home sellers—has left the small-business marketplace at a standstill. … Just 1,117 small businesses were sold in the U.S. in the third quarter, the same number as in the year-earlier period, reports BizBuySell.com, an online marketplace for small-business acquisitions in San Francisco. By contrast, there were 1,462 small businesses sold in the third quarter of 2008, according to BizBuySell. … One of the problems, experts say, is that business owners are proposing prices greater than their companies’ true value.”

Most of the businesses that Needleman is discussing are traditional small businesses rather than start-up companies developing new technologies or products. Whereas small businesses have lost value, many technology start-ups have continued to climb in value (although not as quickly as before the recession). My only advice — be realistic when it comes to selling your company. You can increase your company’s valuation by putting it on a good business foundation and ensuring that you have a competent and dedicated team in place.