Striking a Balance between Entrepreneurs and Investors
In Do Entrepreneurs Want Control? And Should They Get What They Want? A Historical and Theoretical Exploration (NBER Working Paper 31106), Naomi R. Lamoreaux and Jean-Laurent Rosenthal develop a model of startup financing in which founders and outside investors compete for control of the firm. They apply their framework to study how companies’ outcomes, in particular subsequent innovations, are influenced by which group has the upper hand.
The researchers find that no simple corporate governance rule fits all circumstances. Entrepreneurs want a company to fund their vision of continued technological development. Investors want to earn favorable returns on the funds they invest in an entrepreneur’s project. Because entrepreneurs can personally gain from some innovations even when investors lose money, the two groups may disagree about which projects to fund. Disparate views are particularly likely with regard to projects that are more difficult or have lower expected returns.
Outside investors are more likely to wrest control of a firm from its founders if its early financial performance is weak, a development that may inhibit founders from following their innovative vision.
Ultimately, either the entrepreneur or the investors must control the firm. In a firm governed by a one-share-one-vote rule, control is dependent on the firm’s history. If the firm’s initial project earns a high enough return to satisfy investors, the entrepreneur will remain in control as the firm matures. If the firm’s initial project generates low returns, control will switch to outside investors. Under different governance rules, however, the entrepreneur can choose to lock in control, and the researchers’ model suggests that the choice is affected by the firm’s opportunity cost of capital.
The researchers suggest that established firms controlled by entrepreneurs are likely to be an important source of technological innovation. As long as the firm makes enough money after its launch to compensate its investors, the founding entrepreneurs will be able to fund further projects and potentially even more difficult projects than the initial one without consulting the investors.
The researchers review the history of business governance structures in Europe and the United States to illustrate how circumstances and corporate structures affected the choices of some famous entrepreneurs. Although the general incorporation statutes in England and France that developed during a period of relatively low capital costs gave corporate founders considerable leeway to preserve entrepreneurial control, the one-share-one-vote arrangements that emerged in the US, where capital costs were higher, gave greater control rights to external financiers. The researchers cite several examples of entrepreneurs who launched firms based on one innovation only to discover that their investors did not share their enthusiasm for further innovations. In the late 1800s, Elihu Thomson, an inventor who founded a firm devoted to arc lighting, could not persuade his Connecticut funders to support a range of further product innovations. He left and launched a new firm, the Thomson-Houston Electric Company, which became a forerunner of today’s General Electric. Chemist Herbert Dow encountered a similar situation at the Midland Chemical Company, which he had founded to produce bromine using an electrolytic process. When investors balked at funding his attempt to apply similar technology to make chlorine, Dow resigned, forfeiting his intellectual property. He subsequently found another group of investors who funded a new research-oriented firm that became the Dow Chemical Company.
In a more contemporary illustration, the researchers point to the experience of Google in the early 2000s. At a time when the US cost of capital was low, Google’s founders sought to keep control of the company while raising more capital. In an unusual move, they went public in 2004 with multiple classes of shares that enshrined their control. Although this gambit was controversial, the firm was so profitable that investors were willing to ignore this violation of the golden rule of US IPOs: control must be surrendered to the market. The founders retained control and have been able to pursue their vision for research and innovation to this day.
— Linda Gorman
The NBER's Bulletin on Entrepreneurship, Entrepreneurship Working Group, and related initiatives are supported by the Ewing Marion Kauffman Foundation.
