This article looks at the interaction between three groups of people who control a company, and helps to explain where an entrepreneur might best fit in. There are shareholders who own the company, Directors who together form a Board and govern the company, and managers who execute the daily functions of the company.
The backdrop to the interactions of these three groups is the wider community of stakeholders in a company. This includes the government and regulators, employees, suppliers, customers, the environment, and many others. Their interests must be served also, for legal, moral, and reputational reasons.
Shareholders
Founders are the first group of shareholders in a company. They begin with 100% of the equity and over time see this proportion reduced. Any given reduction should make the founder better off. If you own 100% of a company that is worth £100, then an investment of £25 would bring the company value up to £125. Your share would need to be 80% of £125 to still be worth £100, so in this case the maximum equity you would give up is 20%.
Of course, the point in taking in an investment (whether in money or something else) is that you don’t just increase by the amount raised, but you then use that to acquire new assets which let you bring in even more money.
People sometimes obsess over their equity stake. At time of reading, you may well have 100% of your company. Travis Kalanick, by the end of 2017, only had 10% of his (by economic value). But Uber, because it had taken in so much investment, was worth $48bn at that time, so his “measly” 10% was worth $4.8bn (more below). 100% of nothing or a smaller percent of something?
After the founders, two more groups of shareholders will usually appear. First are investors, who provide capital for newly issued shares. The amount they take will depend on the valuation of the company at the time of investment (see article here) but as a very rough guide for UK investment rounds, you might expect the following:
- Angel Round or Seed Round c. 10-20%
- Series A Round c. 25%
- Series B Round c. 15%
Note that this can vary hugely. As an example, imagine a founder and cofounder with 90% and 10% of the company respectively. They take in a seed round for 20%, giving a split of 72% – 8% – 20%.
Then they take a series A round for 25%, diluting everyone down to 54% – 6% – 15% – 25%. Finally a series B at 15% results in a final cap table of 45.9% – 5.1% – 12.75% – 21.25% – 15%. Between them the two founders now have a total of 51%; but if the company was valued at £1m in the seed round and £100m in the series B, their personal equity value has gone up 50x.
The last group of shareholders are the employees. Young companies often do not have the money to pay market salaries, so they offer shares to attract, retain, and reward employees. A normal equity pool for staff is around 15%, although not all of that will be given out for a number of years. Balderton, a UK investor, provide a great article on Employee Share Option Plans which is linked in the Useful Links page.
Shareholders- whether founders, investors, or employees- are not owners in the normal sense of the word; someone who buys a share in Coca Cola doesn’t really own a bit of a Coca Cola factory in any meaningful sense. If your flower pot falls on someone’s head, you may be legally liable for that person’s injuries as the flower pot was your property. But the wider shareholding community of Coca Cola is not liable for a workplace accident at Coca Cola’s factory.
This kind of ownership- limited liability ownership, hence (inter alia) the name Limited Liability Company- is different. Instead shareholders have a right to the economic interests of a company, namely the cash it generates and can pay as dividends. And with that they have a right to appoint the Board of Directors (BoD).
At shareholder meetings, shareholders can vote on who they want to appoint to the BoD, and on some of the BoD’s proposals. A common one in the news is the remuneration package, as recently shareholders of public companies have been voting against CEO pay packages.
It is important to note that the key power a shareholder has from a corporate governance perspective is the ability to vote to change the BoD. Therefore, owning 51% of the equity does not provide any magic power over the company as is so often made out. The exact thresholds of how many votes are required for any given action will differ by company- agreeing a sale, changing a director, and so on.
Board of Directors
A director is a person appointed by the shareholders to the board of a company, for the purpose of organising and supervising the executive functions of the company. Put simply, the directors choose the executive team (CEO, CFO, etc.), set the team a strategy, and then supervise the execution of that strategy by the team.
Setting the strategy for the company means providing a long-term goal or direction. The BoD does not handle day-to-day issues; it asks questions about the company and its future, identifies and hires people who can answer them (the executive team), sets rules about how they should go about answering them, and then supervises them as they do that.
Functions the BoD performs in pursuance of this include hiring and firing senior executives, deciding on remuneration for the executive team, setting targets, overseeing relationships with key suppliers, approving annual accounts, and providing strategic input from the BoD’s knowledge and experience.
The BoD is usually constituted of a Chairman, who manages the Board, and then the directors, who can be grouped according to two dichotomies; executive or non-executive, and inside or independent.
Executive directors are directors who are also part of the executive, which usually includes the CEO, CFO, COO, and potentially others. Non-executive directors usually make up the majority of a larger company’s board, and are not executives of the company.
An inside director has a meaningful connection to the company. Executive directors necessarily fall into this category, but it is wider and also includes the representatives of large shareholders, for example. In Germany, trade unions usually have board representation. Independent directors have no link to the company and are not meaningfully connected in any way.
A good BoD will provide views and expertise that the company would not have without it. As a founder, that means you should be seeking people with experience and different viewpoints. Diversity is one of the biggest assets a BoD can have, even if it does mean more people voting against you.
A discrepancy arises in the responsibilities of the BoD. Directors are appointed by shareholders, but they are responsible to the wider stakeholder community, not just to shareholders alone. Previously, the BoD focus was just on shareholder returns, but today the view is that a BoD has a responsibility beyond that.
Directors are legally liable for the company’s behaviour. They face personal legal consequences if the company goes bankrupt or has financial irregularities. This means that appointment usually comes with a remuneration package to reward the work and risk being undertaken.
Note that a board of directors is not the same as an advisory board. An advisory board is a group of people who are willing to meet to help and support a company in its growth, but these people are not appointed by shareholders, they have no say over management, and they do not perform any legal or formal role, thus obtaining no legal responsibilities beyond insider trading. Advisory boards are useful for startups with no money for larger paid boards, but are not a governance substitute.
Executive
The executive of a company is its senior management. The Chief Executive, Financial, Operating, Marketing, and other Officers, who run the company on a day-to-day basis make up the executive.
A number of them will usually sit on the BoD because they have the most intimate knowledge of what is happening in the company at any time. But they have an inherent misalignment of interests from the people on whose account they are appointed to run the company, the shareholders.
First, the executive, like the BoD, have responsibilities to the wider stakeholder community. Second, their salaries and bonuses are drawn from gross profits, whereas dividends to shareholders come from net profits. Trying to align senior management with the shareholders of a company is one of the ongoing challenges of corporate governance.
The granting of equity to senior management is one way in which companies try to align interests, by making the executive more interested in long-term share price than in annual remuneration.
Overlap
The old view in corporate governance was that Fair Share was the target. The problem with this view was that people might differ on what they consider to be a fair share. For example, who deserves a product?
- Libertarian view = the person who made it
- Egalitarian view = the person who needs it
- Utilitarian view = the person who can best use it
Each view is as morally acceptable as the next, and as mentioned, diversity is to be desired; but the problem arises when it comes to resolving differences. An entrepreneur might be a large shareholder, have a few board seats, and be CEO. In reality, the resolution mechanism would be the entrepreneur getting his or her way, through whatever backroom dealing might be necessary. Fair share leads to conflict and power as resolution mechanisms.
Today the view is that Fair Process is better. A transparent and open process that gives all voices a chance will lead to an outcome that is inherently fair, even if any given person disagrees with any given outcome; everyone approves of the process.
One important step towards achieving fair process is addressing and balancing sources of informal power. As an entrepreneur, this means imposing checks and balances on yourself. An example of the cost of not doing so is Uber.
Travis Kalanick was founder, CEO, and Chairman (meaning a board director) of Uber. This meant he had overlapping power in all three of the key controlling sectors of the company. However, under his stewardship Uber had a series of sexual harassment and other scandals in 2017. The company’s value before the scandals was $68bn. In 2017 after Kalanick finally resigned, it was $48bn. A few months later it was back up to $70bn.
He was a great founder (shareholder) and Chairman with his long-term vision, but he did not succeed as a CEO. He cost the company $20bn by retaining all three positions, and given his 10% economic interest in Uber that means he cost himself $2bn by holding onto titles. In his capacity as CEO he damaged himself as a shareholder.
A Challenge
The challenge to an entrepreneur: you will be one of the largest single shareholders in your company, and therefore you will be able to vote on BoD membership. You will also receive inside board seats to represent your shareholding, and you will have a say in appointing the rest of the directors. And right now you are probably the CEO. So you are shareholder, board and executive.
You are setting your company up with a propensity towards bad corporate governance- there is no suggestion of malevolence, it is just a fact that a single power source is not helpful for fair process. You will have enough challenges to face with customers, suppliers, competitors, employees, investors, regulators, and others; don’t create an extra challenge that you don’t have to. Your skills and energy are needed elsewhere.