Why startups should rely on radical transparency

After high-profile startup failures like FTX or Theranos, investors, employees, customers, and policymakers wonder what could have been done differently to ensure accountability and prevent mismanagement. But startup founders should join this list: it is in their best interest to accept transparency and accountability, especially to their investors. This advice goes against some misguided ideas that have become popular among startups – namely, that it’s in a founder’s best interest to accept as little oversight as possible. To maximize a startup’s growth and impact, founders should accept the responsibility that comes with raising outside funding. It will make your company stronger and more trustworthy.

There’s a lot of hand-wringing and navel-gazing going on startup country with the resolution of two of the biggest scandals the industry has ever seen: Theranos’ Elizabeth Holmes (sentenced to 11 years in prison for fraud) and FTX’s Sam Bankman-Fried ($32 billion evaporated through mismanagement and fraudulent accounting).

Yes, investors should conduct more careful due diligence. Yes, startup employees should be more vigilant when pointing out bad behavior. Yes, founders who push the envelope — fueled by a permissive culture of “fake it until you make it” and “act fast and break things” — should be held more accountable.

But the following is not talked about: Founders are actually the ones who should embrace more transparency and accountability. It is in their interest. And the sooner founders grasp this reality, the better off we’ll all be.

Rich and King/Queen?

Unfortunately, during the boom times of the last few years, founders were given pretty bad advice when it came to fundraising and investor relations. Special:

  • Run “party rounds” where no investor takes the lead and is therefore able to hold founders accountable.
  • Maintain tight control of their board of directors. Ideally, don’t allow investors on your board.
  • Insist on “founder-friendly” conditions that would limit investors’ information rights and weaken controls and safeguards.
  • Avoid sharing information with your investors for fear it will leak to your competitors or the press. In addition, your investors could use the information against you in future funding rounds.

Each of these decisions can maximize founder control, but at the expense of long-term value potential and ultimately success.

Many years ago, my former Harvard Business School colleague, Professor Noam Wasserman, articulated an “empire vs. king/queen tradeoff” in which founders had a fundamental choice to grow big but relinquish control (rich), or die Keeping control but aiming smaller (King/Queen staying). Wasserman asserted, “Founders have simple choices: do they want to be rich or do they want to be kings? Few were both.”

But when money is cheap and the competition to invest in their startups is fierce, founders suddenly had the opportunity to be both. Many of them seized this opportunity and thereby harmed themselves by abandoning a fundamental principle of capitalism: agency theory.

Entrepreneurs as representatives of their shareholders

Managers of a corporation are agents for their shareholders. In the famous 1976 scholarly article by Michael Jensen and William Meckling “The theory of the company: management behavior, agency costs and ownership structure”, They point out that companies are legal fictions that define contractual relationships between the company’s owners (shareholders) and the company’s managers in relation to decision-making and the allocation of cash flows.

This principle has been used more recently because of the tension between purely defined shareholder capitalists (cf Milton Friedman’s seminal 1970 New York Times magazine Article) and a more progressive view known as stakeholder capitalism (see BlackRock CEO Larry Fink). Annual letter 2022).

But wherever you fall into this debate, the fact is that as soon as a founder raises a dollar of funding in exchange for a claim on their cash flow, they are accountable to someone other than themselves. Whether you feel their duty is solely for investors or instead for multiple stakeholders, at that moment they become agents acting on behalf of their shareholders. This means that they can no longer make their decisions based solely on their own interests, but must now also stand up for their investors and act in accordance with this duty of loyalty.

The benefits of accountability and transparency

Some founders only see the downside of the accountability and transparency imposed on them once they take someone else’s money. And, to be fair, there are plenty of horror stories about poor investor behavior and incompetent boards ruining companies. Fortunately, in my experience, just as fraud is very rare in startup land, these stories are in the vast minority of the thousands and thousands of positive investor-founder relationship case studies. Many founders recognize the tremendous benefits that accountability brings.

Accountability is an important part of a startup’s maturing process. How else can employees, customers and partners trust a startup to deliver on its promises? The brightest people want to work for startups and leaders they can trust, and transparency in all communications and meetings is a critical component of building and maintaining that trust. Customers want to buy products from companies they can trust—ideally, ones that publish and follow their product roadmaps. Partners want to work with startups that actually do what they promise.

The impact of accountability and transparency on prospective investors is obvious: Investors want to invest in companies they understand and where they have insight into the internal workings and value drivers, both good and bad. As US regulators exposed the fact that Chinese companies were not as open as their US counterparts prior to the public listing on the NASDAQ or NYSE, this naturally detracted from the valuation of these companies.

There is an equally compelling reason for good accounting practices. It offers reliability and control. Researchers have frequently shown that greater transparency – whether between countries or companies – leads to greater credibility and therefore more value. For example, in a Research work 2005 that countries with more transparent tax practices have more credibility in the market, better tax discipline and less corruption.

The triple-A rubric

Aside from improved ratings and greater trust among affiliates, there is an added benefit of being more accountable. My partner, Chip Hazard, recently wrote a blog entry on the importance of monthly investor updates and articulated the “Triple A rubric” for Alignment, Accountability and Access. Founders report that external accountability and the habit of sending detailed monthly updates can be positive coercive features. As one of our founders put it, “The practice of sitting down to send an update builds internal accountability.”

By being more transparent and accountable, founders can ensure their employees and investors are fully aligned and empowered to be helpful. When you’re open with your investors about the state of play and your “staying awake issues,” you’re in a better position to access their help—whether it’s for strategic advice, sales leads, talent referrals, or partnership opportunities.

Founders and radical transparency

Bridgewater’s Ray Dalio famously coined the phrase “Radical Transparency” as a philosophy to describe his operating model at the company, where a direct and honest culture is practiced in all communications. His book, principlesexpands radical transparency and this comprehensive philosophy of business and life.

Founders should take a page from Dalio’s book and embrace radical transparency with all of their stakeholders, especially their investors. Some defenders of the Theranos and FTX founders claim that they may have been overwhelmed and inept rather than corrupt. Whatever the case, today’s founders can not only avoid similar pitfalls, but more importantly, achieve greater alignment, opportunity, and value if they would simply embrace responsibility and transparency as stewards of others’ capital. By doing so, they will put themselves in a better position to build valuable, enduring businesses that make a positive impact on the world.

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