The founders of home decor company Umbra chose to put a tight limit on the number of shareholders in order to stay nimble and maintain control, president and co-founder Les Mandelbaum says. This structure has worked for Umbra.
But, as a guide to success, Harvard Business School Professor Noam Wasserman asks private businesses the ultimate pressing question: “Do you want to be king? Or do you want to be rich?”
“If you want to be king, don’t get active shareholders,” says Thomas Hellmann, professor at University of British Columbia’s Sauder School of Business. “Pick a bunch of shareholders that will do whatever you want. But you’re not going to get any value out of them because you set it up so that they can’t do anything. And you’re going to be king.
“But if you want to get rich, if you want to build a really great company, you have to give up control. You bring in strong shareholders, you may allow other people to manage and you get a smaller share of a bigger pie.”
But increasing numbers of shareholders can also present conflicts.
“Not all shareholders are the same,” says Martin Kovnats, partner in the legal firm Aird & Berlis LLP in Toronto. “They come with different expectations.”
For instance, partners at similar ages and with similar family circumstances may start a private business with similar expectations, he says. But if one partner dies and his or her children take shares, expectations can clash: for instance, the elder partner wants to preserve capital, the younger ones want to grow and take risks.
If circumstances change and one of the shareholders wants out, it’s not so easy, says Sauder’s Dr. Hellmann. “In a public company, an unsatisfied investor can sell, but it’s more difficult in a private company, because there is no liquidity to the stock.
“As an investor, you have a choice of exit or voice. If you are unhappy, you leave, or you try to change it. In a private company context, you really don’t have the exit option, so you are left with voice.” In other words, voicing their dissatisfaction.
Other investors can also present difficulties. If shareholders want the company to grow, they may have to turn to outside help, such as strategic investors, or to venture capitalists.
Strategic investors may offer financial aid, and also know-how, technology, management skills, marketing techniques, clientele and a sense of direction. But Mr. Kovnats says they will be invested in the private business as a sideline to their own business. But if the private company makes a decision that conflicts with the strategic investor, the latter may start seeing his or her investment become a competitor, he says.
Venture capital investors want to drive value as quickly as they can, and then make a bountiful exit. They will structure the agreement to ensure they get their money back. They’ll negotiate rights, and some of them will be aggressive – they may insist on the right to appoint management, Dr. Hellmann says.
“If you find that you are losing control after you take on venture capital, either you are living in some delusionary world or you just have to wake up. But that is what their business is,” he says.
They’ll want a guaranteed IRR (internal rate of return, used to measure the profitability of investments). If they don’t get this guaranteed rate of return on the balance sheet, they may put the company up for sale, Mr. Kovnats says. They could force the owner to buy them out to get the guaranteed rate.
“If a [private company] relies heavily on research and development and long-term investment to grow, then having short-term shareholders like venture capitalists might not be a good idea,” says Kai Li, professor of finance at the Sauder School of Business.
Sometimes the transition from a founder to a professional manager is important to the success of a company. For instance, Google would never have grown to what it is today had it remained in the hands of its two founders, Dr. Hellmann says.
Success can kill a business, too, Mr. Kovnats says. If a company doesn’t have enough working capital, it can’t take orders, and can’t build the business. If a company has a very large client, it may ask the client to become a partner, if it can’t get the money elsewhere.
Umbra’s Mr. Mandelbaum does not want the distraction of outside investors, who often simply care about return on investment. “I want the interest of the company to come first,” he said.
Mr. Mandelbaum has sold or granted shares to management executives as an extra incentive “to make sure they have the interest of the company first in mind, rather than their personal interest,” he says.
The shares, called phantom shares, are a form of compensation by which the company promises to pay cash at a future date in an amount equal to the market value of the shares. The recipient is not an actual shareholder, however, and does not have the rights even of a minority shareholder.
“We do phantoms all the time,” says Mr. Kovnats. “The limit of what you do is the limit of your imagination.”