The risks that are different in founder-led companies

First published in Livewire Markets, 6 October 2021.

Not magnified, but certainly different. Founder-led investing presents a unique set of risks that investors need to be cognisant of. The strategy is built upon the thesis of hunger and alignment so there is a need to monitor these behaviours to ensure they remain true into the future.

Direction of founder ownership matters more than absolute level

The absolute holding percentage is relevant, but more importantly the key is to observe the direction of the founder’s shareholdings. With what velocity is the founder selling or acquiring shares? Founders will offer a plethora of logical reasons they may be selling, but investors need to remember – actions speak louder than words. Founders that offload a large portion of their holdings present a clear red flag.

Companies will issue ‘statement of changes in beneficial ownership of securities’ – this is known as Form 4 in the US, or similarly ‘change in substantial holding’ in Australia. Investors need to stay on top of these updates.

If you sense there is a significant change in founder motivation, then look elsewhere. Globally there are plenty of motivated founders (several thousand founder-led companies worldwide). There’s no need to be wedded to any one founder, especially if motivations change.

Interestingly, founders may not sell at the optimal time. Founders of Afterpay, for example, left plenty of cash on the table having sold down in 2020. Even though they’ve lost out in the short-term, it remains a red flag over the long-term – the fact is, the strength of alignment with investors has been weakened. Another example is Facebook – since 2020, Mark Zuckerberg has sold a significant amount of Facebook shares. The lesson for investors is to watch the velocity of ownership changes closely. It matters over the long-term.

Motivation to continue pushing boundaries

The advantage of founders is they don’t accept the status quo. Their success is driven by questioning long-held traditions and pushing new frontiers, which is why they present such compelling investment opportunities. The risk is some founders can become complacent and lose their hunger over time, choosing instead to ride off into the sunset by setting their companies to cruise control. There are several telltale signs:

• High base salaries and low expenditure on R&D and capex
• Increasing extracurricular activities – typical examples are overly extravagant property or car purchases, or increasing business interests outside of the company
• Over self promotion and marketing – the focus becomes about them, not the company

Due diligence on intercompany transactions

Investors need to monitor and watch related party transactions and ensure they make financial sense. In the past, plenty of founders have used outside entities to extract value to the detriment of shareholders. Investors can do their due diligence as annual reports will outline related party transactions. For example, many investors could have sidestepped the WeWork fiasco if they had done their due diligence on the disclosed related party transactions.

Succession planning

This is a very real risk for older founders. Their influence has led to their success, but yet at a certain age they will need to develop a transition plan. I met with a Korean founder-led company in Seoul and through conversations with the management team, discovered the founder’s daughter was more interested in becoming a K-pop star than succeeding her father. Investors need to understand it is possible, but rare, for sons and daughters to emulate the same success as their parents. The key is to see founders maintain their influence and establish a company culture that permeates beyond their time as manager. This is possible. Apple is a testament to how Steve Jobs’ succession plan emphasised company culture; even resonating beyond his lifetime.

Investors who don’t have access to management will need to rely on desktop research, but another way to mitigate this risk is to invest in younger, hungrier founders with a longer runway for success.

Mitigating portfolio risks

The risks I’ve mentioned relate to individual companies but for investors looking to build a portfolio of founder-led companies, there are other portfolio construction risks that need to be considered. I’ve written about how to mitigate these portfolio risks separately.