I am going to try to address a complex problem in a concise way.

Here is the big problem with investors – they dilute the founders’ ownership in the company.  Is this actually a big problem?  Well, that answer depends on your point of view.

Let’s cover some basics:

1.  It is impossible to issue stock to investors without existing shareholders (founders, employees and prior investors) being diluted.
2.  It is impossible to do a stock for stock business combination without existing shareholders being diluted.  But now the diluted shareholders own a smaller piece of a larger pie hopefully.
3.  If you have issues with dilution then raising outside investment will give you heartburn every time.  That is not a good situation to endure.

Given the basics, here is one key subjective data point that I always like to keep in mind:  what exit value is going to make the founders happy?.  The answer to this question is a function of (i) how much of the company do the founders own at time of exit and (ii) the exit value.   For example, a company may sell for a relatively small amount, say $18 million.   Are the founders happy?  Well, if they own 50% of it they well might be.  Typically, 50% ownership would mean that the company only has raised 1 or, at best, 2 rounds of equity funding.  Alternatively, if the founders own only 15% then they might not be too happy with an $18 million exit.   But they might be really happy with a $100 million exit.

Here is another basic truth:  the more a company raises, particularly in tough times when projections are not being met, for example, the greater the likelihood of real tension between the investors and the founders.  As investment dollars increase, founders ownership decreases.  And if dollars are raised in challenging times then valuation and other terms will favor the investors compounding the tension.  VCs deal with this situation most of the time.  The “up and to the right” valuation scenario is not at all common (unfortunately!) or only comes after millions and millions of investment.

It is up to the investors and founders to acknowledge the tension, discuss it and come up with solutions that dissipate it.  Often times, investors face situations where they must support a company that is going through growing pains.  These are tough times for the investors and founders.  It is up to the founders and investors to make sure that the founders stay motivated.  But it is up to the founders to acknowledge the situation the company might be in, particularly if sub-optimal.  There are ways to keep management teams motivated – additional stock option grants and management carve out plans are probably the 2 most common.  But the investors and founders need to have direct face to face open and trustworthy discussion.

The motivations of founders and investors are highly predictable and usually aligned (maximize company value!), which should make the discussion easier.   Luckily, the motivations are not political – I have been watching House of Cards recently…….

I have written quite a few posts on the topic of Boards of Directors.  Just put in “board of directors” into the search bar.  As a quick review, it is the Board of Directors or “Board” that literally by law makes all critical decisions for the company.  The Board has to vote on issuing stock, approving the annual budget, setting the company’s strategy, changing the company’s by-laws and certificate of incorporation, selling the company, merging with another company, hiring officers like the CEO, shutting the company down, etc.  The list goes on and on.  Good corporate governance is critical at startups and other companies alike!

The importance of the Board is why institutional investors (like VCs) often get a seat on the Board after an investment.  The Board discusses and agrees on strategy.  Discussion is critical.  But don’t be fooled, there is an element of control as investors want a say in critical decisions.  This is pretty natural if you think about.  VCs typically do not want to control the board vote, they just want a seat at the decision table.

When CVF invests we often take a board seat (probably 95% of the time) and when we don’t we take an observer seat (5% of the time).  If the board is already large and we are coming into the company later in its stage of growth, then an observer seat might be fine.

One situation is really scary though.  Sometimes at the seed stage, the company founder insists that he/she be the only board member and that once more financing is raised that the board composition will be normalized (code word for “adding more members”).  From my perspective, this is typically a sign of paranoia.  

I have now done 2 deals where there has been a lead investor (not CVF) who did not mind the “founder as sole board member” trap.  We followed in line with the lead investor and went along with the structure.  This was a HUGE mistake that I will never make again.  Both companies have since failed for different reasons:  one had no product market fit after 3 years of trying.  And one gave up prematurely.  Regardless, had there been an actual board of directors with 2 or 3 members I am pretty confident that the end result would have been better.

Never again.