How to Prevent Shareholders from Taking Over Your Startup

Here’s a sce­nario that some startup founders dread: After years of devel­op­ing their busi­ness and prod­uct — and years of accept­ing rounds of cap­i­tal invest­ment — a company’s founder wakes up to find that they’re no longer in charge of their startup.

Best case sce­nario, they’re now a minor­ity owner with some influ­ence. Worst case, they’re rel­a­tively insignif­i­cant, have lost any and all con­trol of their com­pany, and face a total share­holder takeover. Some­one recently posed a sim­i­lar sce­nario on Quora, ask­ing how they could avoid a mutiny of their own company.

Truth­fully, I’ve been on both sides of the issue. As a co-founder and prin­ci­pal of a startup, I expe­ri­enced mul­ti­ple iter­a­tions of fund­ing and asso­ci­ated dilu­tion, even­tu­ally wit­ness­ing the com­pany become major­ity owned by investors. On the flip side, at Open­View Ven­ture Part­ners, I’ve been involved with pro­vid­ing mul­ti­ple rounds of fund­ing to a port­fo­lio com­pany, lead­ing to OpenView’s major­ity own­er­ship of the business.

So, I could answer the Quora questioner’s quandary with a pretty well-rounded perspective.

There are, in fact, a lot of rea­sons why founders cede con­trol of their com­pany to the ven­ture cap­i­tal­ists and share­hold­ers that invest in it. The Grasshop­per Group, a com­pany that helps entre­pre­neurs start and grow their busi­ness, sug­gests five main cul­prits:

• Poor lead­er­ship: Founders need to be the per­son to whom every­one else in the com­pany is held account­able. Some entre­pre­neurs aren’t cut out for that and, as a result, fail to pro­vide the lead­er­ship the com­pany needs as it grows. If investors see that, they may make appro­pri­ate moves to put the right peo­ple in charge to move the com­pany forward.

• Inad­e­quate sys­tems: Even if a com­pany sur­vives poor lead­er­ship, inad­e­quate sys­tems will be its undo­ing or the cause that neces­si­tates share­holder takeover. If the founder doesn’t under­stand how to fix those sys­tems, they may even­tu­ally lose control.

• No orga­ni­za­tional phi­los­o­phy: A clear, uni­fied orga­ni­za­tional phi­los­o­phy is essen­tial for every startup. If the founder and the com­pany lack a mis­sion, vision, and val­ues, the com­pany will strug­gle to drive toward achiev­ing long term suc­cess (which share­hold­ers obvi­ously want to see).

• Inef­fec­tive risk man­age­ment: Star­tups con­stantly face risk. If a founder doesn’t know how to mit­i­gate it or oper­ate with risk in mind, they’re much more prone to grad­u­ally los­ing con­trol of the com­pany or being vetoed out altogether.

• Cling­ing to an unre­al­is­tic idea: Startup founders can be stub­born, refus­ing to veer from their orig­i­nal vision for the com­pany in spite of mar­ket con­di­tions or con­sumer demand. That’s a recipe for share­holder takeover.

The truth is — whether I’m wear­ing the investor, board mem­ber, or founder’s hat — my advice to startup founders remains the same. There are a few con­sis­tent mea­sures that founders can take to main­tain con­trol of their busi­ness, with­out stag­nat­ing its growth and potential.

Here are the four things that any founder wor­ried about los­ing con­trol of their com­pany should do:

Don’t raise cap­i­tal (or raise as lit­tle as possible)

I don’t buy the adage that com­pa­nies should raise as much as they can in as few rounds as pos­si­ble to avoid the cost and effort of fund rais­ing. That is a non­sense per­spec­tive typ­i­cally espoused by VCs with large funds that need to deploy lots of money.

Yes, the first round of insti­tu­tional fund­ing is expen­sive, requires a lot of effort. But once you get the first round done, sub­se­quent rounds are much eas­ier. First, you can raise from cur­rent investors with­out extra effort, assum­ing they can and want to pro­vide that cap­i­tal. Addi­tion­ally, you can raise from other investors much eas­ier because the company’s finan­cial and legal houses were put into order after the first round.

I also think that equity based cash on your bal­ance sheet is an evil force, tempt­ing you to spend more than you should. For more on this, read The Ideal Path to Expan­sion Stage.

Never get into a des­per­ate finan­cial situation

If you’re run­ning out of money and des­per­ate to raise cap­i­tal, it’s a recipe for dis­as­ter. Part of an effec­tive CEO’s per­for­mance involves ensur­ing that the com­pany can sus­tain itself with­out des­per­a­tion to raise more money.

That doesn’t, how­ever, negate the need to raise cap­i­tal. But when you do, make sure that you can show clear, sus­tain­able growth and cap­i­tal effi­ciency. If you see your­self get­ting des­per­ate, cut your costs and fig­ure out how to do keep func­tion­ing with fewer funds. Once you dis­cover how to grow more effi­ciently, then feel free to raise the appro­pri­ate amount of capital.

Build a bal­anced and cohe­sive board

Make sure to allo­cate board seats to inde­pen­dent board mem­bers who can pro­vide an objec­tive and bal­anced view­point. Effec­tive and engaged inde­pen­dent board mem­bers are the best rem­edy for cre­at­ing har­mony between man­age­ment and investors.

By the same token, the more investors you raise, the more investors you’ll have on your board. With that comes more pri­or­i­ties (and egos) that you’ll need to man­age. All the more rea­son to raise less money from fewer investors. You’re bet­ter off hav­ing one investor, but make sure that investor doesn’t gain major­ity own­er­ship of your com­pany from the get-go.

Don’t hold on for too long

Founders need to know when they should step aside and let pro­fes­sional man­agers run the busi­ness. The fact is that most founders will not always rep­re­sent the best option for run­ning the com­pany. If you’re hon­est and aware, you can deter­mine that time on your own and avoid a messy share­holder takeover.

At some point, look in the mir­ror and ask this ques­tion: Would you hire your­self as the company’s CEO?

The real­ity of startup and expan­sion stage com­pa­nies is that if they accept cap­i­tal as a means to grow, they’ll likely begin to share some con­trol of their busi­ness with investors.

But shar­ing con­trol doesn’t have to mean ced­ing it com­pletely. If a company’s founder is real­is­tic about their expec­ta­tions and strate­gic in how they approach the business’s growth, they can remain a key cog. If, how­ever, they remain stub­born and short-sighted, a share­holder takeover may quickly become an inevitability.

Ulti­mately, if founders pre­fer to main­tain con­trol of their com­pa­nies, it’s up to them to make the effort to develop their skills from entre­pre­neurs to senior managers.