Today, we take for granted new apps and devices connected to the internet of things appearing seemingly overnight and reaching tens of millions of users – and just as quickly falling out of favor. But in the 20th century, dominated by hardware and software, technology swings inside an existing market happened slowly — taking years, not months. And while new markets were created (i.e. the desktop PC market), they were relatively infrequent.
This meant that disposing of the founder, and the startup culture responsible for the initial innovation, didn't hurt a company's short-term or even mid-term prospects. A company could go public on its initial wave of innovation, then coast on its current technology for years. In this business environment, hiring a new CEO who had experience growing a company around a single technical innovation was a rational decision for venture investors.
However, almost like clockwork, the inevitable next cycle of technology innovation would catch these now-public startups and their boards by surprise. Because the new CEO had built a team capable of and comfortable with executing an existing business model, the company would fail or get acquired. Since the initial venture investors had cashed out by selling their stock over the first few years, they had no long-term interest in this outcome.
Not every startup ended up this way. Bill Hewlett and David Packard got to learn on the job. So did Bob Noyce and Gordon Moore at Intel. But the majority of technology companies that went public circa 1979 to 2009, with professional VCs as their investors, faced this challenge.
Founders in the driver's seat
So how did we go from VCs discarding founders to founders now running large companies? Seven major changes occurred:
1. It became OK to go public or get acquired without profit (or even revenue)
In 1995 Netscape changed the rules about going public. A little more than a year old, the company and its 24-year-old founder hired an experienced CEO, but then did something no other tech company had ever done – it went public with no profit. Laugh all you want, but at the time this was unheard of for a tech company. Netscape's blow-out IPO launched the dot-com boom. Suddenly tech companies were valued on what they might someday deliver. (Today's version is Tesla – now more valuable than Ford.)
This means that liquidity for today's investors often doesn't require the long, patient scaling of a profitable company. While 20th century metrics were revenue and profit, today it's common for companies to get acquired for their user base. (Facebook's approximately $20 billion acquisition of WhatsApp, a 5-year-old startup that had $10 million in revenue, made no sense until you realized that Facebook was paying to acquire 300 million new users.)
2. Information is everywhere
In the 20th century learning the best practices of a startup CEO was limited by your coffee bandwidth. That is, you learned best practices from your board and by having coffee with other, more experienced CEOs. Today, every founder can read all there is to know about running a startup online. Incubators and accelerators like Y-Combinator have institutionalized experiential training in best practices (product-market fit, pivots, agile development, etc.); provide experienced and hands-on mentorship; and offer a growing network of founding CEOs. The result is that today's CEOs have exponentially more information than their predecessors. This is ironically part of the problem. Reading about, hearing about and learning about how to build a successful company is not the same as having done it. As we'll see, information does not mean experience, maturity or wisdom.
3. Technology cycles have compressed
The pace of technology change in the second decade of the 21st century is relentless. It's hard to think of a hardware, software or life science technology that dominates its space for years. That means new companies are at risk of continuous disruption before their investors can cash out.
To stay in business in the 21st century, startups do four things their 20th century counterparts didn't:
- A company is no longer built on a single innovation. It needs to be continuously innovating – and who best to do that? The founders.
- To continually innovate, companies need to operate at startup speed and cycle time much longer their 20th century counterparts did. This requires retaining a startup culture for years – and who best to do that? The founders.
- Continuous innovation requires the imagination and courage to challenge the initial hypotheses of your current business model (channel, cost, customers, products, supply chain, etc.) This might mean competing with and if necessary killing your own products. (Think of the relentless cycle of iPod then iPhone innovation.) Professional CEOs who excel at growing existing businesses find this extremely hard. So who best to do it? The founders.
- Finally, 20th century startups fired the innovators/founders when they scaled. Today, they need these visionaries to stay with the company to keep up with the innovation cycle. And given that acquisition is a potential for many startups, corporate acquirers often look for startups that can help them continually innovate by creating new products and markets.
4. Founder-friendly VCs
A 20th century VC was likely to have an MBA or finance background. A few, like John Doerr at Kleiner Perkins and Don Valentine at Sequoia, had operating experience in a large tech company, but none had actually started a company. Out of the dot-com rubble at the turn of the 21st century, new VCs entered the game – this time with startup experience. The watershed moment was in 2009 when the co-founder of Netscape, Marc Andreessen, formed a venture firm and started to invest in founders with the goal of teaching them how to be CEOs for the long term. Andreessen realized that the game had changed. Continuous innovation was here to stay and only founders – not hired execs – could play and win. Founder-friendly became a competitive advantage for his firm Andreessen Horowitz. In a seller's market, other VCs adopted this "invest in the founder" strategy.
5. Unicorns created a seller's market
Private companies with market capitalization over a billion dollars – called unicorns – were unheard of in the first decade of the 21st century. Today there are close to 200. VCs with large funds (more than approximately $200 million) need investments in unicorns to make their own business model work.
While the number of traditional VC firms have shrunk since the peak of the dot-com bubble, the number of funds chasing deals have grown. Angel and seed funds have usurped the role of what used to be Series A investments. And in later stage rounds an explosion of corporate VCs and hedge funds now want in to the next unicorns.
A rough calculation says that a VC firm needs to return four times its fund size to be thought of as a great firm. Therefore, a VC with a $250 million fund — five times the size of an average VC fund 40 years ago — would need to return $1 billion. But VCs own only approximately 15 percent of a startup when it gets sold or goes public (the numbers vary widely). Just doing the math, $1 billion divided by 15 percent means that the VC fund needs $6.6 billion of exits to make that 4x return. The cold hard math of "large funds need large exits" is why VCs have been trapped into literally begging to get into unicorn deals.
6. Founders take money off the table
In the 20th century the only way the founder made any money, other than their salary, was when the company went public or got sold. The founders along with all the other employees would vest their stock over four years, earning one-forty-eighth a month. They had to hang around at least a year to get the first quarter of their stock (this was called the "cliff"). Today, these are no longer hard and fast rules. Some founders have three-year vesting. Some have no cliff. And some have specific deals about what happens if they're fired, demoted or the company is sold.
In the last decade, as the time startups have spent staying private has grown longer, secondary markets – where people can buy and sell pre-IPO stock — have emerged. This often is a way for founders and early employees to turn some of their stock into cash before an IPO or sale of company.
One last but very important change that guarantees founders can cash out early is "founder-friendly stock." This allows founder(s) to sell part of their stock (approximately 10 to 33 percent) in a future round of financing. This means the company doesn't get money from new investors, but instead it goes to the founder. The rationale is that since companies are taking longer to achieve liquidity, giving the founders some returns early makes them more willing to stick around and better able to make bets for the long-term health of the company.
7. Founders take control of the board
With more VCs chasing a small pool of great deals, and all VCs professing to be the founder's best friend, there's an arms race to be the friendliest. Almost overnight the position of venture capitalist dictating the terms of the deal has disappeared — at least for "hot" deals.
Traditionally, in exchange for giving the company money, investors would receive preferred stock, and founders and employees owned common stock. Preferred stock had specific provisions that gave investors control over when to sell the company or take it public, hiring and firing the founder etc. VCs are giving up these rights to get to invest in unicorns.
Founders are taking control of the board by making the common stock the founders own more powerful. Some startups create two classes of common stock with each share of the founders' class of common stock having 10 to 20 votes. Founders can now outvote the preferred stock holders — the investors. Another method for founder control has the board seats held by the common shareholders — the founders — count two to five times more than the investors' preferred shares. Finally, investors are giving up protective voting control provisions such as when and if to raise more money, the right to invest in subsequent rounds, who to raise it from and how and when to sell the company or take it public. This means liquidity for the investors is now beholden to the whims of the founders. And because they control votes on the board, the founders can't be removed. This is a remarkable turnabout.
In some cases, 21st century VCs have been relegated to passive investors or board observers.
And this advent of founders' control of their company's board is a key reason why many of these large technology companies look like they're out of control. They are.
The gift and curse of visionary CEOs
Startups run by visionaries break rules, flout the law and upend the status quo (Apple, Uber, Airbnb, Tesla, Theranos, etc.). Doing something that other people consider insanity/impossible requires equal parts narcissism and a messianic view of technological transformation.
Bad CEO behavior and successful startups have always overlapped. Steve Jobs, Larry Ellison and Tom Seibel all had the gift and curse of a visionary CEO – they could see the future as clearly as others could see the present. Because they saw it with such clarity, the reality of having to depend on other people to build something revolutionary was frustrating. And woe to the employee who got in their way of delivering the future.
Visionary CEOs have always been the face of their company, but today with social media, it happens faster with a much larger audience; boards now must consider what would happen to the valuation of the company without the founder.
With founders now in control of unicorn boards, with money in their pockets and the press heralding them as geniuses transforming the world, founder hubris and bad behavior should be no surprise. Before social media connected billions of people, bad behavior stayed behind closed doors. In today's connected social world, instant messages and shared videos have broken down the doors.
The revenge of the founders – founding CEOs acting badly
So why do boards of unicorns like Uber, Zenefits, Tanium, or Lending Club let their CEOs stay?
Before the rapid rise of Unicorns, when boards were still in control, they "encouraged" the hiring of "adult supervision" of the founders. Three years after Google started they hired Eric Schmidt as CEO. Schmidt had been the CEO of Novell and previously CTO of Sun Microsystems. Four years after Facebook started they hired Sheryl Sandberg as the COO. Sandberg had been the vice president of global online sales and operations. Today unicorn boards have a lot less leverage.
- VCs sit on five to 10 or more boards. That means most VCs have very little insight into the day-to-day operation of a startup. Bad behavior often goes unnoticed until it does damage.
- The traditional checks and balances provided by a startup board have been abrogated in exchange for access to a hot deal.
- As VC incentives are aligned to own as much of a successful company as possible, getting into a conflict with a founder who can now prevent VC's from investing in the next round is not in the VCs interest.
- Financial and legal control of startups has given way to polite moral suasion as founders now control unicorns.
- As long as the CEO's behavior affects their employees not their customers or valuation, VCs often turn a blind eye.
- Not only is there no financial incentive for the board to control unicorn CEO behavior, often there is a downside in trying to do so
The surprise should not be how many unicorn CEOs act badly, but how many still behave well.
This post was originally published on Blank's blog on Oct. 24.
Steve Blank is an entrepreneur, author and professor. Blank has delivered talks on "The Secret History of Silicon Valley" and has been named among Forbes' 30 most influential people in tech.