To anticipate likely sources of misalignment in any company, it’s useful to distinguish between three concepts:
• Ownership: who legally owns a company’s equity?
• Possession: who actually runs the company on a day-to-day basis?
• Control: who formally governs the company’s affairs?
A typical startup allocates ownership among founders, employees, and investors. The managers and employees who operate the company enjoy possession. And a board of directors, usually comprising founders and investors, exercises control. In theory, this division works smoothly. Financial upside from part ownership attracts and rewards investors and workers. Effective possession motivates and empowers founders and employees—it means they can get stuff done. Oversight from the board places managers’ plans in a broader perspective. In practice, distributing these functions among different people makes sense, but it also multiplies opportunities for misalignment.
To see misalignment at its most extreme, just visit the DMV. Suppose you need a new driver’s license. Theoretically, it should be easy to get one. The DMV is a government agency, and we live in a democratic republic. All power resides in “the people,” who elect representatives to serve them in government. If you’re a citizen, you’re a part owner of the DMV and your representatives control it, so you should be able to walk in and get what you need.
Of course, it doesn’t work like that. We the people may “own” the DMV’s resources, but that ownership is merely fictional. The clerks and petty tyrants who operate the DMV, however, enjoy very real possession of their small-time powers. Even the governor and the legislature charged with nominal control over the DMV can’t change anything. The bureaucracy lurches ever sideways of its own inertia no matter what actions elected officials take. Accountable to nobody, the DMV is misaligned with everybody. Bureaucrats can make your licensing experience pleasurable or nightmarish at their sole discretion. You can try to bring up political theory and remind them that you are the boss, but that’s unlikely to get you better service.
Big corporations do better than the DMV, but they’re still prone to misalignment, especially between ownership and possession. The CEO of a huge company like General Motors, for example, will own some of the company’s stock, but only a trivial portion of the total. Therefore he’s incentivized to reward himself through the power of possession rather than the value of ownership. Posting good quarterly results will be enough for him to keep his high salary and corporate jet. Misalignment can creep in even if he receives stock compensation in the name of “shareholder value.” If that stock comes as a reward for short-term performance, he will find it more lucrative and much easier to cut costs instead of investing in a plan that might create more value for all shareholders far in the future.
Unlike corporate giants, early-stage startups are small enough that founders usually have both ownership and possession. Most conflicts in a startup erupt between ownership and control — that is, between founders and investors on the board. The potential for conflict increases over time as interests diverge: a board member might want to take a company public as soon as possible to score a win for his venture firm, while the founders would prefer to stay private and grow the business. In the boardroom, less is more. The smaller the board, the easier it is for the directors to communicate, to reach consensus, and to exercise effective oversight. However, that very effectiveness means that a small board can forcefully oppose management in any conflict. This is why it’s crucial to choose wisely: every single member of your board matters.