WSJ Article re Control Capital Structure in Silicon Valley

By Cydney Posner

Here is yet another article, this one from the WSJ, on the new prevalence in Silicon Valley of Class A/Class B common capital structures that allow founders to retain control.  (See also my posting of 7/5/12.)

This article reports that some VCs are advising entrepreneurs that they prefer that founders retain controlling stakes, the rationale being that the founders will "be better able to resist outside distraction and focus on making great products." One VC argues that the control structure is helpful given the "dramatic rise of activist hedge funds, pressure from short sellers and the risk of disruptive hostile takeovers…. 'It is unsafe to go public today without a dual-class share structure.'"

But apparently, this 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." Critics also worry about the effect over the long run, warning that "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." Another potential area of conflict is CEO succession, where the CEO and shareholders may be on opposite sides.

Historically, founders have often given up control in exchange for their first investment funds. But, over time, even as founders were able to retain more control, the absence of clear voting control sometimes allowed founder/CEOs to be replaced by professional managers ahead of IPOs. Now, technology entrepreneurs are being more assertive, with Google having "ignited the current trend by adopting a dual-class voting structure before its IPO in 2004…. 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… a finance professor at University of Florida's business school. "

One VC commented for the article that "it's a matter of supply and demand. There is so much money chasing hot deals that founders are able to command better terms….

Sometimes it makes sense to insulate entrepreneurs from pressure to make money while they build their products, …. 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….Most people want to know management is accountable.'" Of course, only companies that are doing well can easily command these concessions.

According to the author of the article, 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….Marquee investments … make a big difference when firms are out building their war chests, putting pressure on them to get in on hot deals." The article suggests that some VCs have "muscled" their way into the top ranks by "being generous" in negotiations with founders over control and value.

Nevertheless, some successful companies are still taking a wait-and-see approach: "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…'" said one founder.

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