Often overlooked in the excitement of starting a new business is one of the most important decisions a founder will have to face early on in their journey: 1. Should I do it alone and be in total control but be forced to bootstrap the venture and grow more slowly or 2. Bring in cofounders or investors to help fund and grow the business more rapidly, but be forced to share decision-making control? The choice of building it yourself, often on a shoestring budget, vs sharing control and accepting investments from others for rapid growth is known as the Founder’s Dilemma.
Founder’s Dilemma – Power and Control
“Even though I need your money, I do not want it to come with advice or recommendations because I have the vision and all the skills necessary to build a successful business.”
Many founders suffer from overconfidence bias and think they know everything. They want complete control and to be the king of their business. More than the desire to be rich, many founders are lured by the idea of leading an organization and telling people they are the President and CEO of a company. Many founders are convinced that they alone can lead their business. They say to themselves “I’m the one who had the vision and the desire to build a business. I have to be the one running it.” As a result, they want total control over the direction. Having supreme confidence in your abilities is a valuable trait for most entrepreneurs but the decision to do it alone is a choice.
During what I call the salad phase, founders are often naive about the problems they will ultimately face along their journey. Starting a business for them is a labor of love. They become emotionally attached and refer to the business as “their baby” or use similar parenting language without even noticing.
If the venture can be easily bootstrapped, such as if you want to become a freelancer or are starting a service-based business that does not require much capital infusion or skills beyond technical knowledge, then choosing power and control and doing it alone is often a viable option. However, where it gets sticky is when the venture needs money to gain traction.
Friends and Family and Debt Financing
When the founder realizes that debt funding from lending institutions, such as a bank, is not a funding option, many founders who prioritize power and control over potentially greater wealth and rapid growth turn to friends and family for a loan. Taking on debt from friends and family is not without risk. If the venture does not meet expectations and the business can’t repay the debt according to the expectations agreed to, friendships and relationships can suffer.
Institutional lenders focus heavily on quantitative factors such as collateral, cash flow, and financial ratios. Basically, they look at money-related issues. More often than not, debt from friends and family members focuses more heavily on qualitative factors such as the person’s history with the founder or the founder’s experience. After all, what parent does not believe that their kids will be successful? What family member or close friend does not feel, at some level, a sense of duty or moral obligation to help out another family member with a loan when asked?
If a founder receives debt financing from friends or family, they need to be professional about it and treat the lender like they were a regular lending institution. They should develop written agreements and be realistic in the expectations of repayment. According to Martin Zwilling, there are six keys to managing funding from friends and family.
One of the biggest problems with funding from friends and family and a lending institution is that it is dumb money. The founder believes they have everything necessary to do it alone. But often the founder lacks some skills and needs help. As Michael Gerber so eloquently explained in the e-Myth, many founders are technical experts and have limited business acumen and leadership qualities required to build a business from scratch. Maybe the founder can hire the expertise they need but often they can’t afford it. So, the founder’s dilemma may involve relinquishing some level of control in exchange for obtaining smart money.
When power and control over your venture are of paramount importance and you have all the skills necessary to start and lead a business, raising capital using a reward-based crowdfunding campaign may be an option. Reward-based crowdfunding is most often used as a way to presell a product, thereby giving the business the seed capital to manufacture and distribute its offering.
Crowdfunding is not as easy as simply building a campaign page and waiting for the money to roll in. For more information on what it takes to run a successful crowdfunding campaign, we suggest reading our Crowdfunding Primer.
Most founders eventually realize that their financial resources, their ability to inspire people, and their passion aren’t enough to enable their ventures to capitalize fully on the opportunity.
Founder’s Dilemma – Wealth and Rapid Growth
“I need your money and skills and would agree to have a smaller slice of a bigger pie.”
Founders need to strike a balance between their desire to control the direction of the business and attracting the best resources to grow it. One factor that influences a founder’s dilemma decision is the perception of a business’s potential. Founders often make different decisions when they believe their business has the potential to grow into something extremely valuable than when they believe their ventures have a more modest potential.
Since the business will take some time to generate the necessary cash flow to repay any form of debt financing, many founders are forced to look at taking on partners or investors in exchange for a stake in the business. Selling a stake in the business or giving away equity in exchange for attracting the right talent you can’t afford in the early stages of a business or obtaining risk capital from an investor involves giving up some level of control. As discussed in Raising Capital: A Lesson From The Ship Of Gold, the earlier in the venture the riskier it is and the more equity the founder will have to give up to attract top talent or funding.
Friends and Family Equity
Equity investments from friends and family, while sometimes possible, are most often dumb money. They may have some degree of control by virtue of their investment but friends and family member investors often lack the knowledge or contacts to help leverage their investment. That is where the real value of smart money comes into play since smart money sources provide more than just money to the business.
Partner or Co-Founder Equity
When the founder recognizes that they need help, they can look at adding partners. In rare cases, the founder voluntarily gives up equity in exchange for securing a set of complementary skills that they do not possess. For example, a technical founder may bring on a partner to help with sales and marketing. Since the venture is in the early stages, the business does not have sufficient cash flow to pay the partner what they are worth, so the founder has to sell the company’s vision and provide the partner with an equity share in the business to induce the partner to join them on their journey.
More often than not, the business also needs money and the partner is required to buy into the venture.
I faced the founder’s dilemma when I started a documentation and training business, I needed $75,000 to get it started. I personally could only contribute $55,000 of the needed startup capital via a HELOC (home equity line of credit). I needed a source of additional funding if I ever hoped to get the business off the ground. I did a personal SWOT analysis and discovered that for the business to be successful, I could use some help in several areas. Rather than pretending to be an expert in all business matters, I knew I had skills in some areas but needed access to additional business skill sets and network contacts to truly make the most of my business venture. I connected with two business partners that collectively contributed the remaining $20,000. Not only were they investors, with complementary skills and experience, they also brought their network contacts. Overall, the value of the business was dramatically increased with them onboard. This is the value of smart money.
Related Post: How to Allocate Equity in a Startup
One of the biggest business lessons I received was from one of my mentors when he shared with me that when you bring on a partner, the value or the price per share that you offer your partners does not have to be the same. Even though we were still pre-revenue, my two partners paid 40% more for the same share of stock than I paid.
While partners help with the day-to-day operations, angel investors will exert control over the directions, because after all, they have money at stake even if they do not roll up their sleeves and get their hands dirty with the day-to-day operations. Angel investors are considered smart money in that they often have some valuable contacts and experience they use to leverage their investment. Angel investors are never silent partners like perhaps friends and family members.
Angel investors are different in other ways from partners in that they are more sophisticated. They often have invested in other businesses and know how to create conditions that favor them. They may insist on a board of directors made up of their associates or use more sophisticated funding vehicles such as convertible promissory notes or SAFE agreements to mitigate their risk. Often, founders agree to terms that can come back to haunt them later because they are too emotionally attached to the venture, have an overconfidence bias, and are naïve to some of the complications the future will inevitability lay before them. Often, easy short-term choices manifest as long-term problems, however, this is not to say that angel investors are to be avoided. Often, angel investors are the best alternative to building a bigger pie faster.
Founder’s Dilemma – Scaling the Business
Many founders believe that so long as they are successful, nobody will challenge their leadership. They think investors should have no cause for complaint and should continue to back their leadership. They believe that “Since they have gotten the business to the stage where they are generating revenue, it should tell the investors that they have the skills to continue to lead the company.” Early success makes it harder for many founders to realize that leaders face a different set of business challenges as they scale up the business.
As a business grows, the finances become more complex. Founders of growing businesses need to lean more heavily on team members. The business has to become more structured, develop formal processes that are repeatable, and create a managerial hierarchy. The broadening of skills needed by the founder as the business scales stretches the abilities of most founders beyond their limits. This is especially true with technically oriented founders. There are seven stages of growth that a business can go through and the role of the leader needs to change as the business progresses from one stage to the next. This is why less than 25% of founders of successful businesses remain in command of their business if the business truly becomes successful.
Bill Gates, Elon Musk, and Mark Zuckerberg are true unicorns when it comes to leaders who have maintained control of their businesses as they moved from idea to success. This is rarely the case for most founders. In fact, there are four stages to a business’s evolution as it goes from birth to death. Often, the founder is what I call the “Oracle” such as Richard and Maurice McDonald who founded McDonald’s restaurants. But for McDonald’s to reach its full potential, it needed a different kind of leader that I call a “General”. Ray Kroc was the leader with a completely new set of skills that replaced the McDonald brothers and transformed McDonald’s into what we now know today.
Sometimes founders simply sell their business when they recognize they are not the person to take the business to the next level. Other times, the investors and/or a board of directors get involved and force the founder to step down from leadership. In either case, the founder does not walk away empty-handed, they just lose the ability to lead the organization.
Success makes most founders less qualified to lead the company and changes the power structure so they are more vulnerable to being removed from the leadership of the company as it grows. The message that many investors and boards send to successful founders who chose greater wealth and growth potential is “Congrats on your success so far! But sorry, you’re fired”.
Founder’s Dilemma – Conclusions
So, the founder’s dilemma is, therefore, to choose between remaining king and maintaining 100% control of the organization or looking for the potential to grow rich by taking on partners and investors to grow the business faster, but risk having to give up their baby for adoption when they are successful.
What is missing in most founder’s understanding is that there are two basic types of companies. One company is focused on making a profit as soon as possible and growing slowly to allow the founder to gain the skills and experience necessary to lead a growing business while retaining power and control. The other is focused on using outside money and attracting outside talent so the business can grow as fast as possible and make the founder rich but at the expense of power and control. Growth at all costs is the focus of most business books and success stories and shapes what most founders envision when they think of success, but it is not the story for most small businesses that favor power and control over growth.
By choosing power and wanting to remain king, founders make decisions that enable them to lead the business often at the expense of increasing its long-term value.
By choosing wealth and rapid growth, founders opt to give up more equity to attract investors and/or highly skilled talent in a quest to build a more valuable company but are often sidelined along the journey when investors and/or a board of directors take away their leadership position and control over major decisions.
In all but a few exceptions, you can’t have both, wealth and power. The balancing act between wanting to remain king and having the potential to become rich is the essence of the Founder’s Dilemma.
Choosing between money and power during the early stages of a business allows entrepreneurs to come to grips with what success will mean to them. Founders who want to manage empires will not believe they are successful if they lose control, even if they end up rich. Conversely, founders who understand that their goal is to amass personal wealth and simply give birth to a business will not view themselves as failures when they step down or are forced out of the top job.
What is more important to you as the founder, having all the power and control or wealth and rapid growth?
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