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Updated July 11, 2012, 11:50 a.m. ET
A Fight in Silicon Valley: Founders Push for Control
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By JOANN S. LUBLIN And SPENCER E. ANTE
There's a power struggle underway in Silicon Valley. At stake: Power itself.
One of the most influential venture-capital firms in Silicon Valley, Andreessen Horowitz, is turning the usual rules of start-up investing on its head as it's telling entrepreneurs it prefers situations where the founders, such as Facebook's Mark Zuckerberg, have controlling stakes. Spencer Ante reports. (Photo: AFP/Getty Images)
Over the past two years, one of the most influential venture-capital firms has turned the usual rules of start-up investing on its head. Andreessen Horowitz is telling entrepreneurs it prefers situations where the founders have controlling stakes, reckoning that they'll be better able to resist outside distraction and focus on making great products.
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The firm—which controls a $2.7 billion war chest and invested in Facebook Inc., Zynga Inc. and Groupon Inc., —has naturally won support from entrepreneurs. One of its champions includes Jason Goldberg, the co-founder and CEO of online design retailer Fab.com Inc., which raised $40 million in an investing round led by Andreessen in December.
But Andreessen's approach is also exposing a rift in Silicon Valley, where a group of young and relatively untested entrepreneurs have maintained control over their rapidly growing companies. For now, venture investors are relatively content with the arrangement, as they've made immense sums along the way. The growing worry is that the setup leaves investors little recourse if a highly empowered CEO goes off track.
Craig Walker, co-founder and CEO of Firespotter Labs, a technology incubator, said it feels unnatural to bestow so much voting power on one executive. "That's the reason you have a board," Mr. Walker explains. "We both win if we work together.''
In the early days of venture capital, when money was scarce, entrepreneurs often gave up control of their company in exchange for their first investment funds. In 1957, computer maker Digital Equipment Corp. gave up 70% of the company to American Research & Development Corp. in exchange for $70,000 in venture capital and a $30,000 loan from the early venture firm.
In the 1990s Internet boom, easy money helped founders maintain more control early in a company's evolution, but founder CEOs without voting control often got replaced by a professional manager ahead of an IPO.
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This time around, technology entrepreneurs are being more assertive. Facebook went public in May with two classes of stock that give founder and Chief Executive Mark Zuckerberg about 57% of the voting power even though he only owns about 28% of the shares. Zynga went public last December with three classes of stock. Groupon went public in November with two classes of stock.
Google Inc. ignited the current trend by adopting a dual-class voting structure before its IPO in 2004. Founders Larry Page and Sergey Brin and Executive Chairman Eric Schmidt now control nearly 66% of the voting power. Last month, the company won shareholder approval to create a third class of shares —one with no votes.
About 14% of the technology firms that have held initial public offerings between January 2011 and the end of June 2012 went public with at least two share classes—more than twice the 6.4% that did so in 1999 and 2000, according to an analysis for The Wall Street Journal by Jay R. Ritter, a finance professor at University of Florida's business school.
Mark Siegel, managing director at venture capital firm Menlo Ventures, which has managed more than $4 billion since 1976, said it's a matter of supply and demand. There is so much money chasing hot deals that founders are able to command better terms, he said.
Sometimes it makes sense to insulate entrepreneurs from pressure to make money while they build their products, Mr. Siegel said. But he said the pendulum has swung too far, making it harder to change faltering CEOs if necessary for the good of the company.
"That's why you have a board," he said. "Most people want to know management is accountable."
Venture capital is increasingly becoming a winner-take-all business, with the top 10 firms raising 69% of funds in the first half of 2012, according to Dow Jones VentureSource, which like The Wall Street Journal is owned by News Corp.
Marquee investments in companies like Facebook make a big difference when firms are out building their war chests, putting pressure on them to get in on hot deals.
When seeking new investment, founders negotiate over control and the value put on their companies. Andreessen Horowitz has muscled its way into the top ranks of VC firms since its 2009 debut in part by being generous on both fronts.
"We are encouraging all of our companies to put in place a dual-class share structure if and when they go public,'' said Marc Andreessen, a general partner at the firm, which has taken stakes in 156 tech enterprises over the past three years.
Mr. Andreessen said he used to see things different. Netscape and Opsware, which he helped found, went public with single-class share structures in 1995 and 2001, respectively. But the dramatic rise of activist hedge funds, pressure from short sellers and the risk of disruptive hostile takeovers gradually changed his mind.
"It is unsafe to go public today without a dual-class share structure,'' Mr. Andreessen said. When Andreessen Horowitz invests in a technology company run by the founder, "I feel better if another investor can't topple that person,'' said Ben Horowitz, Mr. Andreessen's co-founder.
Critics often acknowledge that view, but they also warn the setup insulates management in a way that could hurt shareholders at key moments like takeovers, when executives' interests and investors' interests may not be perfectly aligned.
"We have seen the damage that this share structure can cause over the long run,'' said Anne Sheehan, head of corporate governance for California State Teachers' Retirement System, a big public pension fund.
Succession is another area where CEOs and shareholders could find themselves on opposite sides, said Greg McAdoo of venture capital firm Sequoia Capital. "Shareholder voting power in more traditional capital structures affords shareholder considerable protection against these situations," he said. "Dual-class structures can substantially reduce (if not eliminate) these protections."
Fab's Mr. Goldberg doesn't currently have control over the company, but he's negotiating for it now. The company is out raising money again, and Mr. Goldberg said his investors, including Andreessen Horowitz, support creating a new dual-class voting structure that gives him control after the round closes as long as he stays CEO.
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Associated Press
Marc Andreessen, left, and Ben Horowitz in November 2010,
"We have an agreement from investors to support us on creating a dual class structure," he said.
Founders can't demand such concessions unless their companies are doing well. In just a year of operations, Fab has signed up nearly 5 million members, sold 1.8 million products as of June, and this year expects to do $140 million in sales.
Not all of Andreessen Horowitz's companies hope to create a dual class structure. Aaron Levie, co-founder and CEO of online storage provider Box Inc., said he is in favor of the idea but it isn't a priority.
Last October, Box announced it raised $81 million in venture capital from a number of firms including Andreessen Horowitz. Mr. Levie believes the jury is still out on whether dual class structures are a good idea.
While in theory founder control can add a lot of efficiency to decision making, the risk for shareholders is that the CEO then makes the wrong call.
"I don't think we've seen it enough in practice to know the real value," Mr. Levie said.
Write to Joann S. Lublin at joann.lublin@wsj.com and Spencer E. Ante at spencer.ante@wsj.com
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