Why Startups Should Embrace Radical Transparency

After high-profile startup failures like FTX or Theranos, investors, employees, customers, and lawmakers are left wondering what could have been done differently to ensure accountability and prevent mismanagement. But startup founders should join that list: It’s in their best interest to embrace transparency and accountability, especially toward their investors. This advice goes against some common misconceptions among startups, namely that it is in the founder’s interest to accept as little oversight as possible. In fact, to maximize the growth and impact of a startup, founders must take on the responsibility that comes with raising external funding. It will make your company stronger and more reliable.

There’s a lot of hand wringing and belly button gazing in start land with the unraveling of two of the biggest scandals the industry has ever seen: Theranos’s Elizabeth Holmes (sentenced to 11 years in prison for fraud) and FTX’s Sam Bankman-Fried ($32 billion worth vaporized through bad fraudulent management and accounting).

Yes, investors should do more careful due diligence. Yes, startup employees should be more vigilant in reporting when they see bad behavior. Yes, boundary-pushing founders, spurred on by a permissive “fake it till you make it” and “move fast and break things” culture, need to be more accountable.

But here’s what’s not being talked about: founders are actually the ones who should be embracing more transparency and accountability. It is in your interests. And the sooner the founders understand this reality, the better off we all will be.

Rich and King/Queen?

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

• Set up “party rounds” where no investor is the lead and therefore you are in a position to hold the founders accountable.
• Keep a tight rein on your directory. In fact, ideally, don’t allow any investors to sit on your board.
• Insist on “founder-friendly” terms that would reduce investor information rights and weaken controls and protection provisions.
• Avoid sharing information with your investors for fear that it will leak to your competitors or the press. Also, your investors could use the information against you in future funding rounds.

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

Many years ago, my former colleague at Harvard Business School, Professor Noam Wasserman, articulated a “rich and king/queen trade-off,” in which founders had a fundamental choice between going big but giving up control (rich ) or maintain control but aim for smaller (remain king/queen). Wasserman stated: “The founders’ choices are simple: do they want to be rich or king? Few have been both”.

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

Entrepreneurs as agents of their shareholders

The managers of a corporation are agents of its shareholders. In Michael Jensen and William Meckling’s famous scholarly article from 1976, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure”, point out that corporations are legal fictions that define the contractual relationships between the owners of the company (shareholders) and the managers of the company in terms of decision making and cash flow allocation.

This principle has been weaponized and politicized more recently due to the tension between the purely defined capitalist shareholder (see 1970 seminal by Milton Friedman New York Times Magazine Article) and a more progressive view known as stakeholder capitalism (see BlackRock CEO Larry Fink’s report). Annual Letter 2022).

But wherever you fall into this debate, the fact remains that as soon as a founder raises a dollar in funding in exchange for a claim on his cash flow, he’s accountable to someone other than himself. Whether he believes his duty is solely to investors or instead to multiple stakeholders, they then 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 also work on behalf of their investors and must act in accordance with this fiduciary duty.

The advantage of accountability and transparency

Some founders only see the downside of the accountability and transparency imposed on them as soon as they take in 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, while fraud in the startup arena is very rare, those stories are a large minority of the thousands upon thousands of positive case studies of investor/founder relations. Many founders are realizing the tremendous advantage that accountability brings.

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 and leaders they can trust, and transparency in all communications and meetings with everyone is a critical component in building and maintaining that trust. Customers want to buy products from companies they can trust, ideally companies that publish and adhere to their product roadmaps. Partners want to collaborate with startups that actually do what they say they’ll do.

The impact of accountability and transparency on future investors is obvious: investors want to invest in companies they understand and where they have visibility into internal operations and value drivers, both good and bad. When US regulators made visible the fact that Chinese companies they were not as revealing as their American counterparts prior to public listings on the NASDAQ or NYSE, it naturally deflated the valuation of those companies.

There is an equally compelling reason for good accounting practices. Provides reliability and control. Researchers have frequently shown that greater transparency, whether between countries or companies, leads to greater credibility and therefore 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.

The Triple-A Rubric

Beyond improved ratings and increased trust between partners, there’s an added benefit to being more accountable. My partner, Chip Hazard, recently wrote a blog post on the importance of monthly investor updates and articulated the “Triple-A rubric” of alignment, accountability and access. The founders report that external accountability and the habit of sending detailed monthly updates can be a positive force feature. As one of our founders said: “The practice of sitting down to send an update is based on internal responsibility.”

By being more transparent and accountable, founders can ensure that their employees and investors are fully aligned and in a position to be of service. If you’re upfront with your investors about the state of affairs and your “stay awake issues,” you’ll be 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 culture of direct and honest practice is practiced in all communications. his book, Beginningexpands radical transparency and this general business and life philosophy.

The founders should take a page from Dalio’s book and embrace radical transparency with all their stakeholders, especially their investors. Some defenders of the Theranos and FTX founders say they may have been exaggerated and inept rather than corrupt. Whatever the case, today’s founders can not only avoid similar pitfalls, but more importantly, drive greater alignment, opportunity, and bottom line value by simply embracing responsibility and transparency as stewards of others’ capital. By doing so, they will be in a better position to build valuable and lasting companies that have a positive impact on the world.