Monday, January 18, 2010

Stakeholders Run Amuck!

Part 2 of a 3 part series on surviving the funding transition

In last week's post Startups and Stakeholders, we started to address the question of how a new founder/CEO can prepare themselves for the transition from leading a "friends and family" backed startup to one with institutional investors.  We described how a company is comprised of six core stakeholders - shareholders, managers, employees, suppliers, community, and customers - each receiving economic value from the company differently.  Unfortunately, this difference can lead to conflicts of interest, particularly with respect to dividing up the economic value.  And to some degree, it's a zero sum game;  what goes into one stakeholder's pocket comes out of another's.

So what happens when a stakeholder's claim on a company's economic value gets out of whack?  In the worst case, the death of the company.
  • Shareholders - Because shareholders have the legal authority as owners to set direction and hire/fire management, they can drive action that maximizes short term shareholder value and profits.  But this can mean cutting employee headcount and wages, squeezing suppliers, creative tax sheltering, sacrificing product quality, or raising prices to customers.  Remember "Chainsaw" Al Dunlop?  Before the Sunbeam debacle caught up with him, he was the darling of Wall Street and champion of the view that the primary goal of business is to make money for its shareholders.  As CEO of Scott Paper, by drastically cutting the workforce and closing factories, he improved profitability at Scott, subsequently sold the company to Kimberly-Clark and became a hero to Scott Paper's shareholders.  What the downsized employees thought of him was quite different.  In a venture backed startup, the pressure for short term profits can arise as the company approaches its target exit date, typically around year 5 after funding, especially if the company is lagging on its plan.
  • Managers - Think AIG, the recent sub-prime mortgage led meltdown of U.S. banks and the billions in bonuses "earned" by the executives at these banks, banks that would no longer exist if it weren't for a taxpayer bailout.  Who paid?  The shareholders whose stock value plunged, the employees and suppliers who lost their jobs, and the communities which will be suffering the collateral damage from shattered local economies for years to come.  Enough said.
  • Employees - Think inflexible union work rules, rich pension plans, and wage rates that, along with poor management, helped drive GM and U.S. Steel into bankruptcy.  Also, remember those great dotcom parties in 1999?  Great fun and great lifestyle...until the shareholders' money ran out.
  • Suppliers - As long as cash is sufficient, suppliers generally can't force a disproportionate receipt of economic value.  But when cash is short, it's a different story.  Suppliers can force a company into court or bankruptcy to collect debts owed even if this means destroying the company.  One could make the case that the leading cause of startup death (next to lack of customers) is when suppliers refuse to extend products and services the business needs to keep going in the absence of cash.
  • Community - Want to boost local employment?  Require local resident hiring quotas.  Need more community services?  Just raise taxes.  Hate large billboards?  Impose new zoning restrictions.  Hey, why are all the car dealer's leaving Palo Alto?  Why did sales tax revenues just drop 10%?  We need a new business license tax!
  • Customers - How is this possible?  Are you a Twitter fan?  When's the last time you paid to use the service?  When are you ever planning to pay for the service? I'm sure the folks at Benchmark Capital and Institutional Venture Partners would like to know...before their money runs out.
So how can a CEO decide what the proper balance between stakeholders should be?  Some guidelines and examples:
  1. Define what kind of company you want to be.  Rank your stakeholders in order of fit to your mission.
  2. Determine the importance of each stakeholder's contribution to your company and rank accordingly.  Cross-check this against the first list.
  3. Prioritize.  No ties allowed.  If you're having trouble breaking ties, play out some scenarios where the tied stakeholders would be in conflict and ask yourself how you would resolve it and why.  Some examples:
    • 5% price hike to customers vs. no salary increases for employees
    • Profit share bonus to employees vs. dividend distribution to shareholders
    • Slowing payments to suppliers to enable installment payments from customers
    • Employee layoffs to hit profit targets enabling  management bonuses
  1. Determine the line you won't cross for each stakeholder. This might take the form of a trigger (e.g. no management bonuses in a year where there is a layoff >5% of the workforce) or a number (e.g. no supplier payments >90 days).
In practice, I've found that shareholders, customers, and employees are the big three stakeholders with managers grouped with employees.  Here are some examples of how some well known companies prioritize stakeholders:
  • Customers 1st - Johnson & Johnson's Credo and its application by CEO Jim Burke to the Tylenol recall is the best known case.  J&J explicitly ranks customers (doctors, nurses, parents) first followed by suppliers, employees, community.  Shareholders are ranked last with the Credo explicitly calling out a "fair return" not a maximized one.
  • Employees 1st - Southwest Airlines' mission statement focuses on employees.  Their reasoning?  Happy employees lead to happy customers from which profits flow.
  • Shareholders 1st - As you might expect, many financial services firms place their shareholders first.  KKR, a private equity firm, is one example.  Surprisingly (perhaps), one that does not is Goldman Sachs.  They place customers first.
  • Community 1st - Most groups placing community first are humanitarian or charitable groups (e.g. the Red Cross) and newspapers.
  • Suppliers 1st - I've yet to find a case where suppliers are placed first.  If you should come across one, let me know!
As you might expect, determining how to balance stakeholder demands takes time and evolves as you are forced to make the real life tradeoffs.

Next week, in the final post of this series, we will focus on the difference between "friends and family" and institutional investors, and what this means for a founder/CEO.

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