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E-MailJesse Fried is the Dane Professor of Law at Harvard Law School and Brian Broughman is Professor of Law at Indiana University. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Renegotiation of Cash Flow Rights in the Sale of VC-Backed Firms, by Jesse Fried and Brian Broughman (discussed on the Forum here).
Startup founders, who typically must cede control of their firms to obtain VC financing, are widely believed to regain control in the event of an IPO. This view is reinforced by the media salience of prominent founders such as Facebook’s Mark Zuckerberg, Google’s Sergey Brin and Larry Page, and Snap’s Evan Spiegel. Trevor Kalanick’s loss of the CEO position before Uber’s anticipated IPO seems to be the exception that proves the rule.
Indeed, the possibility of founder control-reacquisition via IPO underlies an influential theory for why venture capital requires a robust stock market (Black & Gilson 1998). On this theory, an IPO-welcoming stock market makes possible a VC exit that can return control to founders, enabling VCs to implicitly give founders a valuable “call option on control” that they can exercise if successful. VCs’ ability to offer this call option, this theory claims, makes VC financing more acceptable to control-loving founders and can thereby spur more founder-VC “deals.”
But we know little about the likelihood of founder-control return via IPO, and the extent and duration of such control. In short, we know little about the ex ante value of this call option at the time founders agree to accept VC financing. Prior work has, in passing, reported the frequency of founders being CEO at IPO (e.g., Baker & Gompers 2003, Kaplan et al. 2009). But the samples are small, non-random, and old. And because these studies had a different focus, they did not consider the voting power of founder-CEOs at IPO, the extent and duration of founders’ control post IPO, and the ex ante likelihood of founder-control return via IPO.
In a paper recently posted on SSRN, Do founders control start-up firms that go public?, we seek to investigate the ex ante value of founders’ call option on control via IPO by collecting a sample of over 18,000 startups that received first-round VC funding during 1990-2012 (“financing vintages” 1990-2012), and then investigating, within a random sub-sample of these firms that conduct an IPO, two measures of founder control: serving as CEO and voting power. For each firm, we measure founder control at three points: upon completion of IPO (“at IPO”), one year after IPO (“IPO+1”), and three years after IPO (“IPO+3”).
We start by measuring the frequency of founder control ex post (i.e., conditional on IPO). A founder is considered to have “weak” control if she is CEO (“founder-CEO”) and “strong” control if she is CEO and, along with co-founders, has a voting interest of at least 30% (“founder-CEO/blockholder”). At IPO, most founders lack even weak control: the frequency of founder-CEO is only 41%. The frequency of founder-CEO/blockholder is much lower: about 7%. Moreover, for either type of control, founders’ control is not “durable” (lasting at least three years). By IPO+3, the frequency of founder-CEO drops from 41% to 21%, and the frequency of founder-CEO/blockholder drops from about 7% to 2.5%. Even if a startup is successful enough to reach IPO, the probability that a founder will exercise a call option on control and enjoy some form of control for three years is only 2.5%-21%, depending on the degree of control.
We then use the 11,104 firms in financing vintages 1990-2002 to investigate the ex ante likelihood of regaining control via IPO. We find that, as of initial VC financing, the likelihood is extremely remote. The main reason: most VC-backed firms—including many of the most successful—exit not via IPO but via M&A. In these financing vintages, only about 6% of founders take their firms to IPO as CEO, and 1% take their firms to IPO as CEO/blockholder. Because of the high rate of post-IPO control attrition, the ex ante likelihood of obtaining durable control is even lower (3% for founder-CEO and 0.4% for founder-CE0/blockholder).
We also investigate whether control return via IPO is a carrot to reward the most successful founders—those generating the highest returns for VCs. Since IPO exits are on average more profitable for VCs than M&A exits, and only an IPO can return founder-control, founders reacquiring control via IPO likely generate above-average returns for VCs. But the “carrot” hypothesis might also be expected to apply within IPO exits: founders of IPO firms should be more likely to retain control as IPO profitability for VCs increases. Yet we find no evidence that VC returns are positively correlated with control reacquisition. Indeed, we find the opposite in some models; higher VC returns are associated with a lower frequency of founder control.
Our paper contributes to the literature on founder exit from the CEO position in VC-backed startups. Most prior work focuses on firms where VCs exit via M&A (Broughman & Fried 2013, discussed on the Forum here) or have not yet exited (Wasserman 2003; Wasserman 2012; Conti & Graham 2016; Hellmann & Puri 2002). This work finds that founders often exit the CEO position (e.g., Broughman & Fried 2013; Broughman 2010), many times involuntarily (e.g., Wasserman 2012). Baker & Gompers (2003) and Kaplan et al. (2009) report the frequency of founder-CEO at IPO only in passing, as their focus is not the arc of founder control. Our work is the first to systematically examine founders’ propensity to remain CEO in VC-backed firms that are successful enough to go public. Our results suggest that this propensity is surprisingly low. Our paper is also the first to systematically measure founder voting power at and after IPO, which is important for understanding how control of VC-backed firms evolves over time.
Our paper also sheds light on the plausibility of the Black & Gilson (1998) control-reacquisition theory. We show that the ex ante likelihood of founders reacquiring control via IPO is extremely low, especially when we focus on control that is both strong (founders have enough voting power to ensure they remain in the saddle) and durable (control lasts at least three years). Our findings thus call into question the premise that founders negotiating with VCs weigh heavily the possibility of control-reacquisition via IPO, which in turn suggests that stock markets are not as important for VC investment as is widely believed.
The complete paper is available for download here.
