Followers of this blog won’t be surprised that I much prefer investing in founder-led companies. I will admit I am very biased when it comes to founders. I have started a couple companies myself, am a member of Entrepreneurs’ Organization, and tend to love all things related to entrepreneurship. I believe companies led by their founders often have intangible assets that are nearly impossible for a professionally managed company to replicate.
How many times have you heard a hired CEO describe the company as their baby? Probably never. But I have heard many entrepreneurs describe their own companies this way. Loving a business like it’s your own child doesn’t guarantee you’re a good CEO, but that obsession can make up for a lot of faults.
“To succeed, a CEO needs a detailed knowledge of the organization, its culture, products, finances, personnel, customers, and competitors. He must also command the respect of his subordinates and the board. The necessary skills, knowledge, and authority can best be obtained working within the company; they are very difficult for someone outside the company or the industry to acquire.”
This quote, from The CEO Pay Machine, was talking about the advantages of promoting a CEO from within the company as opposed to hiring an outsider. But a founder takes this whole “working within the company” part to the max. The founder/CEO (especially of a small company) was either directly or indirectly involved in hiring every employee, getting every big client, and appointing every director. If the company is performing well there’s almost no chance of the founder getting kicked out.
On top of this, founder/CEOs almost always own significant amounts of stock and CEOs with lots of stock have been shown to outperform those with little or no ownership. One reason for this outperformance is the job security that comes with owning 10%+ of a company’s shares. Job security allows the CEO to focus on the long-term future of the company, which is required to grow a company in the right way. Professional CEOs generally own far less stock (that was gifted to them via options) and know they could be fired at any moment. Because of this, professional CEOs are more incentivized by their annual bonus than how the company will maintain its competitive advantage twenty years from now.
My main takeaway from The CEO Pay Machine is that a good pay structure is basically impossible. The authors gave great examples of why the standard CEO pay structure (high salary, annual bonus, long-term options) is bad for shareholders. If you have ever done a discounted cash flow analysis, you know that most of a company’s value comes from the distant future—how much money it can make ten or twenty years from now. Therefore, the only way a CEO is ever truly aligned with shareholders is if they are motivated to grow the business over that long of a timeframe. And the only way a CEO is going to care about the next twenty years is if they’re confident they will still be there in twenty years. Finally, the only way they will be confident in their long-term job security is if it’s their own company, they hired every employee and director, and/or they have a significant share of the vote—preferably all three.
A Purdue University study tried to delve into why founder-led companies outperform all others. The only significant difference they found is that founder-led companies spend more money on R&D and file more patents than non-founder-led companies. There have been numerous studies that have found a positive correlation between R&D spending and long-term stock outperformance. Founders are able to spend more on R&D because they have more job security and thus are more likely to be around in five or ten years to reap the rewards of that R&D. R&D is inherently a long-term spend, which is less suited for hired CEOs with less job security. Interestingly, this study found that when a founder/CEO leaves the company, R&D spend and patents filed drop off dramatically. This suggests that newer CEOs (with less job security) take fewer risks.
Finally, there are several “softer” benefits that make me prefer founders over hired CEOs. All things being equal, I think just the fact that a founder is still running their company means they’ll be better than most comparable CEOs. Starting and growing a company from nothing to even $10 or $20 million in revenue is an incredibly difficult task. Founders wear a ton of different hats and that person is likely to be good at a wide variety of tasks. Someone who has moved up the company ladder over twenty years is less likely to have those skills.
I think founders are also more likely to be contrarians and independent thinkers. Starting a business is a risky adventure and carving out your own position in a market from nothing means you had to be doing something different. As a small piece of evidence on the contrarian front, I’ve noticed founder-led companies seem to give guidance far less often than others. Of the founder-led companies that I either own or follow, only one of them gives guidance. Refusing to play Wall Street’s guidance game is a contrarian trait I always like to see in CEOs.