When the directors of Uber ousted its CEO and cofounder, Travis Kalanick, in June 2017, the move was paradoxically both long overdue and somewhat unexpected. For months Kalanick and the company had suffered a string of scandals, any one of which might have undone a typical chief executive. A female engineer had posted a long public account of rampant sexual harassment and the company’s “bro culture,” to which Uber’s HR department had turned a blind eye. The company had been caught ordering and canceling rides from its competitor Lyft, poaching Lyft’s drivers, and using software to surreptitiously track its own customers even if they closed the Uber app. During years of jousting with local taxi authorities over the legality of its car service, Uber had been discovered using a tool called Greyball that disguised the location of its cars and showed a fake version of the app to city officials. Kalanick himself was captured on video condescendingly berating an Uber driver who complained about falling fares.
Yet despite the near-weekly scandals, which led to customer boycotts and increasing calls for Kalanick’s dismissal, the 40-year-old founder seemed, for a time at least, untouchable. Even after the former U.S. attorney general Eric Holder, who’d been hired by the board to investigate, issued a scathing report on Uber’s culture, Kalanick and his directors initially decided that vague promises of coaching, the hiring of a chief operating officer, and a slap-on-the-wrist “leave of absence” for the CEO were sufficient remedies. That changed when key investors staged a revolt.
Why was Kalanick shown such extraordinary deference by Uber’s board? In a word, power. Kalanick controls the majority of Uber’s voting shares and until recently controlled most of its board seats. He is part of a generation of company founders who’ve managed to remain at the helm long past the point when VCs would traditionally have brought in “professional” CEOs. Although the specifics of this scandal may be unique, the governance issues Uber has faced are not. Zenefits, Hampton Creek, Tanium, Lending Club, and Theranos are all start-ups that have endured scandal and founder misbehavior-but some of their founders are still calling the shots. Rather than being an outlier, Uber illustrates the remarkable and little-understood ways in which founders, no longer systematically pushed aside as their start-ups grow, have come to dominate their boardrooms. I think of this trend as “the founders’ revenge.”
In this article I will outline the forces that have allowed founders to accrue such power. I will also argue that this trend has resulted in a power imbalance that can negatively affect employees, customers, and investors. To remedy that, I’ll offer some initial prescriptions for creating a more equitable and sustainable system of start-up governance.
But first, to understand how 21st-century founders have come to hold such a powerful hand, we must recall why venture capitalists were once allowed to walk all over the people who launched some of the world’s greatest companies.
When VCs Set the Rules
In the 1980s and 1990s tech companies and their investors made money through initial public offerings. In that era an IPO was the eventual goal for nearly every start-up. Turning illiquid private-company stock into cash by selling shares to the public required engaging a top investment bank, which typically wouldn’t take a company public until it had had five profitable quarters of increasing revenue. To achieve that, companies generally had to be able to sell stuff -not just acquire nonpaying users or build a compelling freemium app. Persuading customers to pay for something involved creating a stable product and organizing a professional sales staff to sell it.
Many founders were wildly creative but lacked the discipline or skills to drive profitable growth. They also lacked the experience and the credibility to manage a large company, which is what everyone hopes a start-up will become someday. To the investment banks that acted as gatekeepers, such credibility was crucial for an IPO. Part of the IPO process was the road show, for which the bankers would fly the company CEO and CFO around the country to present to institutional investors; the last thing institutions wanted to see was an inexperienced founder at the helm of a company. To venture capitalists, who generally controlled the majority of a start-up’s equity and board seats, green and unskilled founders were a problem that had to be solved if they were to reach their IPO payday.
So after a product gained a foothold, VCs routinely removed founding CEOs and replaced them with “suits”-experienced executives from large companies-to scale up the sales force, build a true organization (including an HR department that would prevent problems like those at Uber), and lead the public offering.
The best-known example of this, albeit with a somewhat different backstory, is Apple. At its IPO, in 1980, Steve Jobs was still at the four-and-a-half-year-old company, as an executive VP and vice chairman, largely because of his charisma and ability to articulate a vision for the evolution of computing. But because Jobs and his cofounder, Steve Wozniak, had taken several rounds of VC funding by then, they together owned just 23% of Apple’s equity, and Jobs had few allies on its six-person board. Jobs’s firing in 1985 and his replacement by PepsiCo president John Sculley may be Silicon Valley’s Shakespearean tragedy, but it was hardly surprising. In fact, what’s surprising is that Jobs held on as long as he did.
This stereotypical fire-the-founder pattern has notable exceptions. Hewlett and Packard founded their company in 1939, many years before the advent of modern venture capital, so they retained control of HP for decades. Microsoft, founded in 1975, became profitable so quickly that it didn’t need much venture funding; when it went public, in 1986, Bill Gates, Paul Allen, and Steve Ballmer owned 85% of the company, and its sole VC owned just 4.4%. Likewise, Jeff Bezos controlled 48.3% of Amazon’s equity when it went public, in 1997, and even today he holds three times as much stock as Amazon’s largest institutional shareholder. But until fairly recently, ousting the founder was standard on a start-up’s journey to an IPO.
The convention had solid theoretical underpinnings. Venture capitalists sought to mitigate the agency costs and moral hazards created when a start-up founder has much more information about what’s happening inside a company than the board does. Because investors bear most of the financial risk if a start-up fails, preferred shareholders (primarily VCs) were given protective provisions (such as the right to block a sale of the company) and the majority of board seats. As start-ups required successive rounds of VC funding, founders saw their ownership in the company (and with it, their control) dwindle. Over time, Silicon Valley filled up with people who had founded iconic firms but spent the remainder of their careers telling woeful stories of how “the VCs stole my company.” The luckiest of them retained nominal titles, such as chief technical officer.
For three decades, from the mid-1970s to the early 2000s, the rules of the game were that a company must become profitable and hire a professional CEO before an IPO. During most of this era, founders faced a buyer’s market, because there were many more good companies looking to get funded than there were venture capitalists to fund them. With a deep supply and limited demand, investors could set the terms.
In fairly short order that dynamic began to change.
The Decline of the IPO Gatekeepers
The shift began in 1995, when Netscape changed one of the rules. The web browser company was a little more than a year old-and unprofitable-when it made its IPO. Its cofounders, Marc Andreessen (then 24 years old) and Jim Clark, hired James Barksdale, an experienced CEO, but otherwise ignored the investment bankers’ conventional wisdom about the need to show consistent, profitable growth. Netscape’s blowout IPO launched the dot-com boom and led to a new era, in which tech companies would be valued not for what they had done but for what they might deliver someday.
The elimination of a traditional hurdle for an IPO meant that new start-ups needn’t endure long, patient growth to become profitable companies. Instead they could go public right now, with the founder still in place. From 1980 to 1998 the median age of a VC-backed company that went public was seven years; in 1999-2000, at the height of the dot-com boom, it was four-and-a-half years.
The gatekeeping bankers’ expectations weren’t the only thing that changed. Founders still started out lacking the skills and experience to scale up a company, but they had newfound access to information that would help them gain those skills. In the 20th century there were no start-up blogs or useful books on how to launch and grow a company. Business schools taught entrepreneurship, but they focused on how to write business plans, which sounds useful but has limited utility once you actually start exposing products to the market. (Modern start-up founders recognize that no business plan survives first contact with customers.) The only way for aspiring founders to get effective training was to apprentice at other start-ups-a time-consuming detour that many would just as soon skip.
Founders in the 21st century can learn best practices far more easily. Anyone can read online all there is to know about running a start-up. Incubators and accelerators like Y Combinator have institutionalized experiential training in crucial tasks such as finding product-market fit, figuring out when and how to pivot, utilizing agile development, and dealing with VCs. In Silicon Valley and elsewhere, mentors abound.
Two financial shifts have also allowed founders to stay in control. The first is the emergence of secondary markets, in which founders and employees can liquidate some pre-IPO stock and thus stay private longer. Before secondary markets became popular, founders had a big incentive to rush toward an IPO (and meet investment bankers’ requirements for doing so), because they lacked an alternative way to monetize and diversify their wealth. By further reducing the power of the IPO gatekeepers, secondary markets enhanced the power of founders.
The second shift is the growth in acquisitions. In 2016 there were 3,260 acquisitions of technology companies and only 98 tech IPOs, according to CB Insights. If that ratio holds, a start-up is 30 times as likely to be acquired as to go public. When a larger tech company acquires a smaller one, having the smaller company’s founder retain a leadership role can make a deal more attractive. VCs recognize this, so they’re more inclined to leave founders in charge.
The Emergence of “Founder Friendly” VCs
At a certain point those changes were supplemented by an attitudinal shift: VCs began to see founders not as a problem that needed to be solved but as a valuable asset that needed to be retained. That stemmed in part from a change in their own backgrounds. Twentieth-century VCs typically had MBAs or a finance background or both. A handful, including John Doerr at Kleiner Perkins and Don Valentine at Sequoia, had operating experience at a large tech company. Very few were themselves entrepreneurs. But in the 21st century, VC firms began hiring experienced founders as partners, and not surprisingly, this cohort was more optimistic about other founders’ ability to become successful long-term company leaders.
The pivotal figure in this shift was, once again, Marc Andreessen. In July 2009, when Andreessen cofounded the VC firm Andreessen Horowitz with Ben Horowitz, also an experienced entrepreneur, it was with a key philosophical difference from rival firms: a “founder friendly” focus. “Above all else, we are looking for the brilliant and motivated entrepreneur,” Andreessen wrote when he announced the firm’s launch. “We are hugely in favor of the technical founder….We are hugely in favor of the founder who intends to be CEO. Not all founders can become great CEOs, but most of the great companies in our industry were run by a founder for a long period of time, often decades, and we believe that pattern will continue. We cannot guarantee that a founder can be a great CEO, but we can help that founder develop the skills necessary to reach his or her full CEO potential.”
Understandably, advertising your firm as “founder friendly” creates a competitive advantage in a business where success has much to do with your ability to source and negotiate deals with founders. So in short order, many venture capital firms began emulating Andreessen’s outlook.
Founder friendliness was driven partly by context. Twentieth-century companies, which competed in slower-moving hardware and software markets, could thrive for long periods on a single innovation. If the VCs threw out the founder, the professional CEO who stepped in might grow a company to dominance without creating something new. In that environment, replacing a founder was the rational decision. But 21st-century companies face compressed technology cycles, which create the need for continuous innovation. Who leads that process best? Often it is founders, whose creativity and restlessness, comfort with disorder, and propensity for risk taking are more valuable at a time when companies need to retain a start-up culture even as they grow large. VCs love how professional managers can bring discipline to the chaotic environment created by a founder, but today they recognize that too much discipline may kill off the culture that made the start-up so innovative.
The retain-the-founder mentality was also driven by, again, that most fundamental of economic forces: supply and demand. Whereas once too many start-ups chased limited amounts of capital from a relatively small number of VC firms, today, some would argue, too much capital is chasing too few quality start-ups. Angel and seed funds have usurped the role of what used to be Series A venture capital investments. Hedge funds and mutual funds have begun investing in large, more mature private companies. Now operating between those two stages are nearly 200 VC firms with funds that exceed $200 million, and for funds this large, buying stakes in the hottest unicorns-private companies valued at more than $1 billion-feels essential, because it’s very difficult to earn respectable returns for a fund that size by making smaller bets.
That dynamic gives start-up founders much more leverage. There are two visible indicators of how they have used that leverage to gain power: a change in the typical start-up board composition, and a more frequent use of new kinds of stock that allow founders to dominate the boardroom.
Stacking the Boardroom
In his 2008 HBR article “The Founder’s Dilemma,” Noam Wasserman, now a professor at the University of Southern California, demonstrated why entrepreneurs who create a successful company must ultimately choose a priority: to get rich or to be king. To get rich, founders sell equity, diluting control. To be king, they retain ownership in the company and control over the board, but at a cost: Their wealth remains illiquid, undiversified, and at risk if anything should happen to the company’s value. The rise of unicorns has changed that calculus, as founders have used their leverage to negotiate deals that give them the potential to be rich and kings.
Until 10 years ago a start-up board typically had five members: two founders, two VCs, and one independent director. In the event of a conflict, independent directors tended to side with the VCs, which is why so many founders were ousted.
Contrast that with the composition of Uber’s board, which isn’t atypical for a unicorn. The company’s corporate charter designates 11 board seats, but until Kalanick’s ouster, only seven of them were filled. Three were held by Kalanick, his cofounder Garrett Camp, and an early employee, Ryan Graves. Only two were held by outside investors. One independent director, Arianna Huffington, served as a key Kalanick ally. By leaving four seats empty, Kalanick increased his control: If the outside directors ever challenged him, he could quickly stack the board with allies.
Founders’ power goes even further. Traditionally, when a start-up takes money from VCs, the investors receive preferred stock, leaving the founders and employees with common stock. Preferred stock typically gives investors control over when to sell a company, when to take it public, the number of board seats, and when to hire or fire a CEO.
In the unicorn era, special powers are flowing the other way, to founders. Today many start-ups implement a dual-class structure whereby the founders’ common stock confers 10 times the voting rights of other stockholders. Historically, family-owned companies have used dual-class stock to reap the benefits of liquidity through an IPO without giving up control. Ford Motor Company is one example: When it went public, in 1956, it created a special class of stock that gives Ford family members 40% of voting shares, despite holding just a 4% economic interest in the firm. Berkshire Hathaway, News Corp., Nike, and The New York Times Co. are other examples. In its 2004 IPO Google was the first tech company to implement dual-class ownership. Facebook, Zynga, Snap, Workday, Square, and others did the same in their IPOs. Dual-class shares give these publicly traded companies the freedom to operate without fear of undue influence by hedge funds.
In the past five years, however, tech founders have gone a step further, setting up dual-class shares even in pre-IPO companies. This allows them to outvote their preferred-stock-holding VCs, giving founders extraordinary control. Theranos founder and CEO Elizabeth Holmes, for instance, has received $686 million in venture capital funding, but she retains 98.3% of voting shares.
These formal governance rules aren’t the only factor reducing the power of directors. Today many VCs sit on five to 10 boards, where they nominally provide oversight to companies that are many times larger than the pre-IPO start-ups of 15 years ago. That stretches many of them thin. I often hear directors of private companies say that they read about a critical incident involving the company in the press or on social media before they hear about it from the CEO or in the boardroom. And when a crisis does develop, the VC directors who used to act with wisdom and authority have a new incentive to behave meekly: Because unicorns are staying private longer than earlier start-ups did, they require additional rounds of funding-and VCs who earned a board seat by investing in a previous financing round generally want to remain in the founder’s good graces to obtain preferred access during subsequent rounds. This weakens their motivation to ask hard questions, to push back, or to rein in a founder who begins crossing ethical lines.
Given the extraordinary power imbalance that’s now the norm in Silicon Valley boardrooms, it should be no surprise that many founder-CEOs are behaving badly. In fact, the real surprise may be that so many of them still behave well.
Fixing a Broken System
So what should we do?
The first step is to recognize and define the problem. To be clear, I’m not saying that founders should not or cannot become high-performing CEOs; we see any number of examples-notably Jeff Bezos-of ones who have. (See “The Best-Performing CEOs in the World 2017.”) Rather, this is a problem of too much control and not enough oversight. Pre-IPO companies like Uber are becoming much larger but, by staying private, avoiding many of the regulatory and governance requirements that public companies face. For context, Uber currently has a $50 billion market cap (on par with Monsanto and General Motors) and 12,000 employees (comparable to McKinsey & Co.).
Mary Jo White, then the SEC chair, described the problem in a 2016 speech at Stanford. “As the latest batch of start-ups mature, generate revenue, achieve significant valuations, but stay private, it is important to assess whether they are likewise maturing their governance structures and internal control environments to match their size and market impact,” said White, who suggested asking a list of questions: “Is your board expanding from founders and venture seats to include outsiders with larger, and ideally public, company experience? Do you have the right regulatory and financial expertise on your boards to appropriately make decisions on behalf of all investors? Do you have the relevant expertise in the particular industry in which your company functions to bring to bear different viewpoints and spot critical issues? Is your company, in short, being run and governed for the benefit of all of your investors-a requirement whether the company is public or private?”
To White’s insightful questions, let me add several suggestions. First, even as “founder friendly” VCs opt to allow founders to remain on as CEOs, they should aggressively adhere to the best practice of pairing those leaders with strong, experienced chief operating officers-and this should be done before the CEO suffers a misstep, not as an after-the-fact remedy, as at Uber. Facebook hired Sheryl Sandberg as COO just four years after its founding and four years before its IPO; her partnership with a very young technical founder has been exemplary. Getting this hire in place should be a standard part of scaling up a company-and a prerequisite for subsequent rounds of funding.
Second, the general partners who are the active leaders of VC firms should engage with their limited partners (the institutional investors who put up the capital) about the trade-offs between ethical issues, heightened agency risk, expected returns, and the amount of power and control they are ceding to founders. Do the LPs expect firms to invest in unicorns despite concern over the treatment of employees, a lack of diversity, or questionable behavior toward regulators and other authorities? Is it acceptable for a VC to say, “We think this will be a great, valuable company, but we’re going to pass on investing because of concern over these issues”? Similarly, VCs should consider establishing a formal policy regarding their willingness to invest in companies where the founder has voting control. If several prominent VCs decided not to invest in companies with dual-class shares, for instance, the practice might abate. Better yet, VCs might work through the National Venture Capital Association or some other industry group to try to implement broad guidelines; this cooperative approach would avoid putting any one firm at a competitive disadvantage because it went first.
Third, everyone in Silicon Valley should read the recommendations Eric Holder delivered to Uber’s board-in particular, the section on enhancing board oversight. Holder suggested that Uber add additional independent directors; install an independent board chair; increase the size, role, and independence of its audit committee; and create an oversight board. Again, these steps should become the norm as a company grows-not something done in response to a crisis or a black eye.
Finally, everyone involved should recognize the lessons conveyed by the Uber story. The Wall Street Journal chronicled how, despite Kalanick’s control of voting shares and board seats, the venture capital firm Benchmark persuaded four other large Uber investors to sign an ultimatum asking the CEO to resign. If Kalanick refused, the investors would publicly release the letter, putting the onus on directors to continue defending him. Within hours Kalanick e-mailed employees to say he was leaving. Weeks later, Benchmark sued Kalanick for fraud, breach of contract, and breach of fiduciary responsibility; the complaint focuses on Kalanick’s control over Uber’s board makeup.
Even as Uber’s governance problems illustrate how a founder’s power can go too far, Kalanick’s dismissal serves as an important reminder: No matter what a board’s composition or who holds how many voting shares, a determined and cohesive group of shareholders can still effectively wield soft power. More of them should consider doing so to offset the power imbalance that has become prevalent in the boardrooms of Silicon Valley.
A version of this article appeared in the November-December 2017 issue (pp.94-101) of Harvard Business Review.
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