Ownership dynamics within founder teams: The role of external financing

• Author: Dan H. Vo,Chloe Tergiman,Thomas F. Hellmann,Paul H. Schure
• Date: 01 September 2019
• Published date: 01 September 2019
• DOI: http://doi.org/10.1002/sej.1328

SPECIAL ISSUE ARTICLE

Ownership dynamics within founder teams: The

role of external financing

Thomas F. Hellmann

1,2

| Paul H. Schure

3

| Chloe Tergiman

4

|

Dan H. Vo

5

1

Saïd School of Business, Oxford University,

Oxford, UK

2

Saïd School of Business, National Bureau of

Economic Research, Cambridge,

Massachusetts

3

Department of Economics, University of

Victoria, Victoria, British Columbia, Canada

4

Smeal College of Business, Penn State

University, University Park, Pennsylvania

5

School of Management, California Lutheran

University, Thousand Oaks, California

Correspondence

Thomas F. Hellmann, Saïd School of Business,

Oxford University, Park End Street, Oxford

OX1 1HP, UK.

Email: thomas.hellmann@sbs.ox.ac.uk

Funding information

Social Sciences and Humanities Research

Council, Grant/Award Number:

410-2010-0905

Abstract

Research Summary:This paper examines how founders

within start-up teams dynamically readjust their relative

ownership stakes. It leverages a unique dataset from British

Columbia, Canada, which contains detailed information on

founder ownership over time. Two trade-offs between effi-

ciency and fairness are identified, one at the time of

founding, the other as the venture develops. Teams with a

preference for fairness at the start, as revealed by an equal

division of the founder shares, also exhibit a dynamic pref-

erence for fairness, as witnessed by their reluctance to

change the ownership structure over time. Relative founder

stakes are more likely to change when a company raises

investments. Larger rounds and lower valuations are associ-

ated with bigger changes in relative founder stakes.

Managerial Summary:Splitting the equity stakes among

founders involves a delicate trade-off between efficiency

and fairness. This trade-off is made when founders deter-

mine their initial division of equity, and also as the venture

develops. We find that teams with a preference for fairness,

as revealed by an equal split of their original founder equity,

are also unlikely to change their relative stakes over time.

We also find that changes in the division of founder owner-

ship often coincide with external financing rounds,

suggesting that renegotiations within teams are more easily

settled in the presence of outside investors. Overall, the

evidence suggests that although notions of fairness inhibit

changes to the relative founder equity stakes, the stakes

Received: 14 August 2017 Revised: 2 February 2019 Accepted: 9 June 2019 Published on: 5 August 2019

DOI: 10.1002/sej.1328

© 2019 Strategic Management Society

256 wileyonlinelibrary.com/journal/sej Strategic Entrepreneurship Journal. 2019;13:256–287.

are not set in stone, and financing rounds provide opportu-

nities for recalibration.

KEYWORDS

external financing, fairness, founder shares, founder teams,

ownership change

1|INTRODUCTION

In recent years entrepreneurship researchers have developed a growing interest in understanding entrepreneurial

teams (Klotz, Hmieleski, Bradley, & Busenitz, 2014). Considerable progress has been made in understanding the ori-

gins of founder teams, and the importance of founder team characteristics for start-up growth (Åstebro & Serrano,

2015, Colombo & Grilli, 2005, Ruef, 2010; Ruef, Aldrich, & Carter, 2003). Of particular significance is the work of

Beckman and Burton (see Beckman, 2006; Beckman & Burton, 2008; Beckman, Burton, & O'Reilly, 2007; Burton,

Sørensen, & Beckman, 2002), which looks at how founders put an imprint on their ventures, and how this affects the

subsequent evolution of companies. The work of Baron, Burton, and Hannan (see Baron, Burton, & Hannan, 1996;

Baron, Hannan, & Burton, 2001; Hannan, Burton, & Baron, 1996) further underscores the long-term implications of

original founder teams and their culture. Their interest lies mainly in understanding when companies undergo organi-

zational changes, and how the initial imprint affects these dynamic changes. A related literature looks at how founder

teams are augmented and sometime replaced by professional managers (Ewens & Marx, 2018; Hellmann & Puri,

2002; Wasserman, 2003).

While the importance of the skill sets of individual founders and the composition of the founding team has now

firmly been established, much less is known about the organization and incentives of individual founders within a

team. In this paper, we look at an important determinant of the incentives of individual founders and the relationship

between them, namely the division of the founder shares among the founders. The allocation of founder shares

directly impacts the financial returns to individual founders, and hence their incentives, which are key in the entre-

preneurship literature (Åstebro, 2012). In addition, the initial ownership choice and the willingness (or lack thereof)

to subsequently change ownership speak to the internal dynamics of founder teams.

Hellmann and Wasserman (2017) provide a theory, and empirical analysis of the initial allocation of shares among

founders. Their analysis suggests a fundamental trade-off between an “efficiency”logic, based on efficient bargaining

(Binmore, Rubinstein, & Wolinsky, 1986; Nash, 1953), which typically pushes founder teams towards unequal split-

ting of share ownership, and a “fairness”logic (Adams, 1965; Dawes, Fowler, Johnson, McElreath, & Smirnov, 2007;

Deutsch, 1975; Fehr & Schmidt, 2006; Skott, 2005) that pushes teams toward equal splitting.

1

Wasserman (2012)

further examines case studies of how initial ownership within founder teams changes over time. However, to date

there has not been any systematic study on the dynamics of founder ownership.

This paper focuses entirely on the founder team itself. The main research question is how the relative allocation

of shares among the members of the founder team changes over time. The relative allocation of shares involves

important yet delicate decisions. It determines the relative rewards to, and incentives for entrepreneurial activity, as

well as the social dynamics and status of the members of the founder team. Founder teams can, in principle, change

their relative ownership at any time. However, any adjustment has to be agreed upon, and a change may be viewed

as an alteration of the original agreement that was forged at the start of the company.

2

The motivation for our analysis is the fundamental trade-off between efficiency and fairness. Hellmann and

Wasserman (2017) derive and empirically test a formal theory that explains how an efficiency logic encourages foun-

der teams to choose an unequal split of the founder shares at founding, whereas a fairness logic encourages equal

HELLMANN ET AL.257

splitting. In this paper, we extend this logic by expanding our horizon beyond the initial founder agreement and ana-

lyze how founder ownership changes over time. A dynamic efficiency logic encourages teams to continuously recon-

sider their relative ownership stakes, reflecting new insights and changing circumstances that affect the efficient

allocation of relative founder shares. By contrast, we conceptualize a dynamic fairness logic as encouraging teams to

maintain whichever was their initial relative share allocation. That is, if they stick to dynamic fairness, founder teams

do not go back on the relative ownership shares they originally agreed upon, even if circumstances change. Under-

standing the drivers of this dynamic trade-off between efficiency and fairness is the core objective of this paper. We

consider our analysis exploratory in the sense that there is neither any established theory, nor any established prior

empirical work to guide the analysis.

We exploit a unique dataset from the Canadian province of British Columbia (BC) where start-ups disclose their

legal share registries to an administrator as part of a tax credit program. The dataset contains accurate and detailed

information concerning share ownership over time. Our dependent variable measures the degree of change in rela-

tive ownership within founder teams. The analysis primarily focuses on two important antecedents, namely (1) the

initial split of shares within the founder team and (2) external financing events.

The first antecedent concerns the team's initial allocation of founder shares. A key question is whether teams

that adopt a “static”fairness logic at the start, are also more likely to adopt a “dynamic”fairness logic as their venture

develops over time. The first main empirical finding is that when teams initially choose an equal equity split, they are

indeed less likely to subsequently change their relative founder ownership. We also find that equal splitters have sig-

nificantly fewer financing rounds compared with unequal splitters, are less likely to raise venture capital, and have

lower premoney valuations. Moreover, when equal split companies receive founder investments, it is more likely that

the founders contribute identical amounts, thus preserving the equal distribution of shares. Of further note is that

teams that start with an initial division of shares that is close to equal, but not exactly equal, fundamentally behave

differently than the equal splitters.

The second antecedent concerns external financing events. A large prior literature notes that external investors

play a key role in the internal structuring of start-up companies (Hellmann & Puri, 2002; Sapienza, Manigart, & Ver-

meir, 1996). While founders may grapple with the trade-off between efficiency and fairness, investors likely have a

different perspective. They are much less encumbered by the internal social dynamics within the founder team and

are usually primarily motivated by the financial success of the venture. External investors may therefore push foun-

ders to adjust their ownership stakes toward greater efficiency. Investors do not only have the incentives, but often

also the required level of influence and control to effectuate change (Gorman & Sahlman, 1989; Kaplan & Strömberg,

2003). We find indeed that changes to the relative founder ownership are larger in the presence of external inves-

tors. We also find that larger external financing rounds, as well as lower premoney valuations, are associated with

larger relative founder ownership changes.

The remainder of the paper is structured as follows. In Section 2, we discuss the relevant prior literature. In

Section 3, we present our data. Section 4 contains the empirical analysis. In Section 5, we discuss and extend our

main results and provide an outlook on future research. Section 6 concludes.

2|RELATED LITERATURE

In this section, we discuss the related prior academic literature. Our starting point is that founder teams face impor-

tant choices regarding the allocation of ownership among themselves. The ownership allocation choice can be

governed by two very different types of logics. A first logic is an economic calculus that is based on “efficiency,”and

holds that the division of ownership is mainly driven by a negotiation that is based on the founders' productivity,

incentives, and outside options. The efficiency logic that we refer to here is concerned with the overall maximization

of the company value, as well as with the individual utility maximization in a bargaining context. A large economic

bargaining literature examines such division problems. Some of the early seminal contributions assume cooperative

258 HELLMANN ET AL.