Monday, January 11, 2010

Startups and Stakeholders

Part 1 of a 3 part series on surviving the funding transition

When I first became a CEO, one of the greater challenges I had to face was learning how to balance the conflicting demands of various stakeholders in the company.  In particular, having to deal directly with the demands of shareholders in more than just an abstract "delivering shareholder value" speech took several years.  So what relevance does this have if you're a startup CEO.

One of the known stumbling points for a new founder/CEO is the transition from being a "friends and family" backed startup to having institutional investors (i.e. VCs). First timers often fail to understand how having professional investors can change the way a company is run.  They either continue to run it as if the new investors were the same as their "friends and family" or they become overly sensitive to the new investor's demands.  Both have the potential for disaster.

So how can you prepare yourself and improve your ability to survive the transition?  Are there any guidelines for balancing off the competing interests of various stakeholders?

The answer is yes.  Several frameworks exist to answer the question of rights, responsibilities, and prioritization amongst different stakeholders.  To understand how this works, we first need to understand what makes up a company.

What is a Company?
A company at its most basic is a legal entity created for the purpose of generating some economic value which is then shared over time by stakeholders, interested parties who contribute something to the company in exchange for a share of the economic value (i.e. money or capability).  The core stakeholders common to all companies are shareholders, managers, employees, customers, suppliers, and the community.  At the risk of oversimplification:
  • Shareholders contribute money and resources.  In exchange for risking their resources, they are the company's owners and are entitled to all the excess economic value generated by the company after obligations to other stakeholders are fulfilled.  Because they are last in line, they get to set overall direction for the company and hire/fire management.
  • Managers are agents of the shareholders responsible for day-to-day operations of the company.  They contribute management skills and know-how.  In exchange, they may receive equity, in which case they receive the value of shareholders, or wages, in which case they receive the economic value of employees.
  • Employees contribute their know-how, skills, time, and labor under the direction of managers.  The economic value they receive is wages.
  • Suppliers contribute products and services to the company in exchange for money.
  • Community is most typically represented by government, which establishes the legal and economic infrastructure (e.g. roads, schools, fire protection) shared in common.  In exchange, economic value is received in the form of taxes, jobs for community members, and charitable support for non-governmental organizations.
  • Customers contribute money in exchange for the capabilities of the company delivered in the form of products and services.  Unlike the first five stakeholders, the economic value they receive is a capability.
Entrepreneurs create companies by figuring out how to combine the money and resources from shareholders with the know-how, skills, products, and services from managers, employees and suppliers to create something that customers will pay for with sufficient excess profits to comply with community obligations and pay the other stakeholders their share of the economic value created.

The Competing Interests of Stakeholders
Unfortunately, while all stakeholders recognize that they have a common vested interest in seeing the company thrive, because they receive value from the company differently, this leads to conflicts of interest with respect to (1) how much of the economic value they should receive and (2) their precedence in receiving that value.  Obviously, everyone would like to be first in line for the biggest share.

In the U.S. at least, by law and as embodied in generally accepted accounting principles (GAAP), precedence is captured on the right side (liabilities + equity) of the balance sheet, which lists the sources of capital.  Again at the risk of oversimplification, moving from top to bottom the precedence order is:
  1. Community - If you don't believe this comes first, try not paying your taxes.  The law supports this; the limited liability protection extended to corporations, LLCs, and LLPs does not extend to non-payment of taxes.
  2. Employees - Labor laws exist to protect employees from unpaid and unfair wage practices.  And because the government collects payroll and income taxes, they have a vested interest in making this priority #2.  Again, the law supports this;  certain violations of wage and hour laws as well as non-payment of payroll taxes are exempt from limited liability protection.
  3. Customers, Suppliers - Note that customer prepaid obligations and accounts payables are at the top of the current liabilities list.
  4. Shareholders - Only after all liability holders are paid off do equity holders receive their share of a company's economic value.  But while liability holders receive an amount fixed by contract or percentage (e.g. taxes), there is no cap to what equity holders can receive.
To the degree which management's economic value is received as wages vs. equity, their interests receive treatment as either employee or shareholder's respectively.

Given that precedence is fairly well defined, the main conflict between stakeholders centers around how much economic value to allot to each stakeholder.  Managing these tradeoffs ultimately falls to the CEO.

Next week, we'll look at what happens when the demands of a stakeholder are out of balance with the rest.  The following week, we'll conclude by focusing on the difference between "friends and family" and institutional investors, and what this means for a founder/CEO.

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