Where Does Power Lie

"In conflict, be fair and generous.
In governing, don’t try to control."
   — Lao Tzu

John Ketchum, who runs Corporate Programs at our portfolio company TicketsNow, reminded of this quote which is most relevant to yesterday’s post. Underneath all of the legal wrangling and finger pointing there lies a basic question: Where does power lie in a venture board?

After many years in the business, I have two rules about this:
1) as long as the company is burning cash, the VC’s have significant leverage.
2) entrepreneurs have as much power as they have alternative funding sources.
2) VC’s that feel inclined to run a business are in for a rude surprise in the end.

Most entrepreneurs focus on maintaining 51% or more of the voting stock with the belief that this will give them complete control over the company. Unfortunately, this is not the right place to look. It rests in the cash flow statement. You will notice that all major issues and changes occur around funding events. If a company needs capital, it must first turn to its current investors to determine their appetite and desire to continue supporting the company. If they are not happy with the company or with their relationship with the CEO, they can elect not to invest. If inside investors do not invest, it is often difficult to get new investors to come in. Furthermore, if the situation is so dire that old investors won’t re-up, then it is unlikely that new investors will see the situation differently. With the company burning cash and no place to turn, inside investors can name the terms under which they will reinvest. This can include changes in strategy, personnel or execution.

Even if the VC’s own 5% of the company, this need for capital is the source of their leverage. Entrepreneurs that can get their companies to break even, or that have alternative funding sources, have a much stronger position. By the time a company has had a couple of down rounds, it is usually in pretty dire straits. Even if the VC’s exert influence at that point, they are usually just rearranging deck chairs on the Titanic. No one wins and the VC’s end up with a bad rep.

I want to point out that it is not be the VC’s job to run the business, but rather to provide resources to it. No matter how knowledgeable, a VC usually can not know more about a business/industry than the CEO. That CEO lives in that job 24/7 while the VC simply visits it during the month. If the VC backs the wrong CEO and find him/herself continually questioning the judgment of the CEO, then he/she made a poor call in originally investing. Younger VC’s can often micromanage a deal due to nervousness and naivete. Some short-sighted VC’s can also demand certain changes, not because it is right or fair, but because they can. Fortunately, most VC’s are pretty descent and fair.

Good VC’s will give an entrepreneur significant room to operate, will give advice based on past experience and will bring resources or connections to bear as required. He/she will layout core principles or constraints which are important to them as well as define, with the company, critical milestones. Control is not determined by legal clauses or purse strings but, hopefully, by mutual, earned respect between them and the CEO. If law or finance is the basis of the relationship, then much has already been lost.

In short, investors’ influence and power wax and wane during the business cycle of a firm. It is highest when cash is dear. However, it is a mistake for VC’s to enforce unilateral control on a business since it poisons the relationship going forward (mutual assured destruction). If this force is necessary, then things have usually hit a pretty dire situation and the CEO will also have considerable responsibility for the resulting consequences.