Why Startups Should Embrace Radical Transparency

After the failure of high-profile startups like FTX or Theranos, investors, employees, customers, and policymakers are all asking what they can do differently to ensure accountability and prevent mismanagement. But startup founders should join the list: It’s in their best interest to get transparency and accountability, especially regarding their investors. This advice runs counter to some of the misguided ideas that have become popular in startups – namely, that it’s in the founder’s best interest to receive as little oversight as possible. In fact, to maximize startup growth and impact, founders must embrace the accountability that comes from raising outside financing. It will make the company stronger and more reliable.

There was a lot of handwriting and navel-gazing going on starting land with the denouement 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-Goreng (evaporated $ 32 billion of value through mismanagement and fraudulent accounting).

Yes, investors should do more due diligence. Yes, startup employees should be more vigilant about blowing the whistle when they see bad behavior. Yes, founders who push their limits – reinforced by a permissive culture of “fake it till you make it” and “move fast and change things” – need to be held accountable.

But here’s what they don’t say: Founders are actually the ones who need to embrace more transparency and accountability. This is for their benefit. And the sooner we grasp this fact, the better off we all will be.

Rich and King/Queen?

Unfortunately, during the boom years of the past few years, founders received some bad advice about fundraising and investor relations. Specifically:

  • Raise a “party round” where no one investor is leading and therefore in a position to hold the founders accountable.
  • Maintain strict control of their board of directors. In fact, ideally, do not allow any investors on your board.
  • Insist on the term “founder friendly” which will reduce the information rights of investors and weaken the controls and protective provisions.
  • Avoid sharing information with your investors for fear of leaking it to your competitors or the press. Furthermore, your investors may use the information against you in future financing rounds.

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

A few years ago, my former Harvard Business School colleague, Professor Noam Wasserman, said “Rich vs. King / Queen tradeoff,” where founders have a fundamental choice between going big, but giving up control (rich), or keeping control but intended. small (still king/queen). Wasserman emphasized, “The founder’s choice is straightforward: Do they want to be rich or king? A little bit of both.”

But when money is cheap and the competition to invest in their startups is fierce, founders suddenly have the option to be both. Many of them seized this opportunity and, in doing so, inflicted self-harm by abandoning the basic principles of capitalism: the theory of institutions.

Entrepreneurs as Agents for their Shareholders

A corporation’s managers are agents for its shareholders. In a famous 1976 scientific article by Michael Jensen and William Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” they pointed out that the corporation is a legal fiction that defines the contractual relationship between the firm’s owners (shareholders) and the company’s managers regarding decision-making and cash flow allocation.

This principle has more recently become weaponized and politicized due to the tension between pure defined shareholder capitalists (see Milton Friedman’s seminal 1970 New York Times magazine article) and a more progressive perspective known as stakeholder capitalism (see BlackRock CEO Larry Fink’s 2022 Annual Letter).

But wherever you fall in this debate, the fact that as soon as the founder raises a dollar in financing in exchange for a claim on cash flow they are accountable to someone other than themselves. Whether you believe that their duties are only for investors or not for various stakeholders, at that point they become agents acting on behalf of their shareholders. In other words, they can no longer make decisions based solely on their own interests but must now work on behalf of their investors as well and must act in accordance with this fiduciary duty.

Advantages of Accountability and Transparency

Some founders only see the downside of accountability and transparency imposed on them as soon as they take outside money. And, to be fair, there are plenty of horror stories about bad investor behavior and incompetent boards ruining companies. Fortunately, in my experience, just as fraud in startup land is very rare, the story is in the vast minority of thousands and thousands of positive case studies of investor-founder relationships. Many founders are aware of the tremendous upside that comes with responsibility.

Accountability is an important part of the startup maturation process. How else can employees, customers, and partners trust a startup to deliver on its promises? The most talented employees want to work for startups with leaders they can trust, and transparency in all communications and all-hands meetings is an important component of building and maintaining that trust. Consumers want to buy products from companies they can rely on – ideally ones that publish and stick to their product roadmap. Partners want to collaborate with startups that actually do what they say they will do.

The impact of accountability and transparency for future investors is clear: Investors want to invest in companies they understand and where they have visibility into the deep operations and value drivers, the good and the bad. When the US regulator made visible the fact that Chinese companies not as disclosive as their US counterparts before public listings on NASDAQ or NYSE, it naturally deflated the valuation of those companies.

There are similar reasons for good accounting practices. It provides reliability and control. Research has often shown that greater transparency – whether between countries or companies – leads to greater credibility and thus value. For example, the IMF concluded in a 2005 research paper that countries with more transparent fiscal practices have more credibility in the market, better fiscal discipline, and less corruption.

Triple-A rubric

Beyond the increased appreciation and greater trust between partners, there is an additional upside to being more accountable. My partner, Chip Hazard, recently wrote a blog post about the importance of monthly investor updates and articulate the “Triple-A Rubric” of alignment, accountability, and access. Founders report that external accountability, and the habit of sending detailed monthly updates, can be a positive forcing function. As one of our founders put it, “The practice of sitting down to send updates builds on internal accountability.”

By being more transparent and accountable, founders can ensure that their employees and investors are aligned and in a position to help. If you’re honest with your investors about where things stand and the “stay-awake issues” you’ll be in a better position to access their help – whether for strategic advice, sales leads, referrals to talent, or partnership opportunities .

Founders and Radical Transparency

Ray Dalio of Bridgewater famously coined the phrase “radical transparency” as a philosophy to describe his operating model in a company where a culture of directness and honesty is practiced in all communications. the book, Principlesexpands on radical transparency and all of this philosophy of business and life.

Founders should take a page from Dalio’s book and embrace radical transparency with all stakeholders, especially investors. Some defenders of the founders of Theranos and FTX claim that they are probably more bigoted and incompetent than corrupt. Whatever the case, today’s founders can not only avoid the same pitfalls, but more importantly drive greater alignment, opportunity, and value if they simply embrace accountability and transparency as stewards of others’ capital. In doing so, they will put themselves in a better position to build valuable and sustainable companies that have a positive impact on the world.

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