Pros and Cons of Founder Led Businesses On the Sharemarket

Founder-Led Companies: Benefits and Risks

Founder-led companies have gained significant attention in the investment world, with many investors viewing them as potentially lucrative opportunities. However, like any investment strategy, backing founder-led companies comes with both benefits and risks. This article explores the advantages and potential pitfalls of investing in such companies, supported by academic studies and real-world case studies.

Long-Term Vision and Commitment

Founders often have a deep emotional connection to their companies and a long-term vision for growth. This commitment can translate into better long-term performance, as traditional managers, due to their short tenure, tend to act and behave in a manner which supports earnings in the short term, whilst potentially sacrificing long term opportunity.

Importantly, founders with large “skin in the game” or inside ownership of the stock, are heavily incentivised to create long term compounding returns – often referred to as the “founder effect”.

In fact, a study done by Bain & Company established that founder led S&P 500 companies performed better than an aggregate of the remaining companies over a 15-year period.

Innovation and Adaptability

Founders typically bring an innovative mindset and the ability to adapt quickly to changing market conditions. There’s an endless list of global case studies whereby a business was founded on a premise or idea on how to improve a product or service. A great example is Reed Hastings, the founder of Netflix, who decided to create the company after being charged a $40 late fee at Blockbuster. Surely, there had to be a better way for people to borrow movies and television shows….

Over time as technology improved and the internet and streaming became a reality, Netflix was willing to invest and embrace this new frontier of product delivery for their business, whereas Blockbuster, the industry incumbent, failed to innovate and adapt leading to its eventual demise. Other great founder led stories come from Tesla, Meta, Apple, Microsoft and Berkshire Hathaway.

In Australia, we have outstanding examples of innovative founder led companies in their respective fields. Dr Sam Hupert continues to head Star Growth Stock Pro Medicus (PME), a pioneer in medical imaging software. Other founder led businesses include developer of the bionic ear implant Cochlear (COH), logistics software innovator Wisetech (WTC) and wealth management platform disruptor Netwealth (NWL) which continue to be led by father and son Michael and Matthew Heines.

Identifying Founder Led Businesses

To identify founder led businesses, investors can start with a simple Google search for the company and its founder. Then, use Stock Doctor’s Corporate Details tab to check if they’re still on the management team or board. You can also check for large shareholders to see if the founder has a significant holding.

But before considering investment, it is prudent to ensure that founder led businesses are financially healthy to minimise the risk of insolvency (GR1). In addition, it is important to look for companies with strong operating metrics including high operating efficiency and profitability (ROE, ROIC) and strong profit margins and earnings quality (GR2). Visibility on the future of these key financial metrics and active risks can also help investors understand whether the company can continue to generate strong return to shareholders (GR3).

Star Stock Case Studies

Pro Medicus (PME)

Dr Sam Hupert and business partner Anthony Hall have been at the helm of PME for over 30 years. The business was founded by Dr Hupert when he saw an opportunity to exploit evolving technologies in the practice of medicine. The business eventually found itself in the medical imaging space.

After listing in 2000, PME found some early success and Dr Hupert stood down as CEO in 2007 as the business was excelling its partnership with a global imagine software group known as Agfa. However, the partnership failed and by 2010 Dr Hupert went back into the role of CEO.

Everything changed in 2010 with the acquisition of Visage Imaging, a business which developed compression technology that allowed doctors to view high resolution images from any device. The PME team took that software, and invested heavily in further development, sales and distribution which led to it becoming one of the most successful founding stories on the ASX.

A learning we can take from it was the drive and passion the founding team had in exploring how technologies could enhance the medical industry and lead to better outcomes for doctors and care providers. Importantly, the character of Dr Hupert and willingness to embrace a high-quality Board and good governance practices has meant that PME has avoided significant agency costs, attracting investors who are willing to support it. The business was not an instant success, it took decades to find its footing and it was the acquisition of the Visage software that took it to the next level.

Netwealth (NWL)

Founded in 1999 by Michael Heine and his son Matt Heine, Netwealth was established with a vision to provide investors with a more accessible and flexible investment platform. Recognising the gap in digital solutions within the wealth management industry, the Heines saw an opportunity to build a company that could harness technology to empower financial advisors and clients alike. Listing on the ASX in 2017, Netwealth quickly gained attention as a disruptor, bringing a more client-centric approach to a traditionally conservative industry.

The Heines demonstrated a strong commitment to product innovation and customer service, which helped Netwealth differentiate itself and build a loyal client base. By continuously enhancing its platform’s capabilities, including sophisticated reporting tools and integration options, the business was able to keep pace with the evolving needs of financial advisors and investors. This focus on user experience has been pivotal to Netwealth’s success, contributing to rapid growth in funds under administration and a strong competitive position in the market.

A key takeaway from Netwealth’s story is the importance of staying attuned to customer needs while leveraging technology to innovate within established industries. The Heine family’s ongoing leadership and hands-on approach have fostered a culture of agility and a relentless focus on quality, which, combined with their robust governance practices, has instilled confidence in investors. Netwealth’s journey underscores how a founder-led company can sustain growth and relevance by embedding customer insights and innovation into its core operations.

Risks of Investing in Founder-Led Companies

As investors, we need to be mindful of the psychological biases we can face when analysing businesses with inspiring founder led stories and success. It can be easy to “fall in love” with these stocks, particularly if they have generated outsized returns for shareholders over time. This may cause investors to let their guard down and succumb to such biases such as confirmation bias and the endowment effect. As with any situation, there will always be certain risks that emerge which are heightened in companies with the founder effect.

The Founder’s Dilemma

Noah Wasserman is an academic professor and consultant who has worked with thousands of founder led businesses and conducted decades of research, culminating in his book “The Founder’s Dilemma”.

One of the greatest challenges founders led businesses face is the natural imbalance of power and control that a founder has in their business when compared to minority shareholders. After going public, Wasserman’s research found that four out of five founders were ushered out by investors due to these conflicts of interest and imbalances of power, also known as agency costs.

An example of this imbalance of power came from online jobs company Seek (SEK), whose founders, the Bassat brothers have been instrumental in disrupting the media industry and creating enormous wealth for investors. However, in 2021 Seek handed $1.7bn of capital to Andrew Bassat to invest in star-ups on behalf of its shareholders. According to analysts, these investments are now close to worthless.

Founder led business are also prone to elevated governance risks and recent scandals erupting from founder led businesses, Mineral Resources (MIN) and Wisetech (WTC) are clear examples of this.

Mineral Resources founder and chief executive Chris Ellerson is alleged to have spent a decade running a tax evasion scheme. The scheme involved selling machinery to Mineral Resources at inflated prices through a British Virgin Islands-incorporated vehicle, with the profits shared by Mr Ellison, former chairman Peter Wade and four other founding executives.

Meanwhile, Richard White was forced to stand down as chief executive of Wisetech Global, after his actions, which began of a personal nature, escalated into a governance crisis after it emerged that a former female director was bullied by Mr White.

Another example comes from retailer Harvey Norman (HVN), run by Gerry Harvey, which has long been affected by government issues, especially with regards to its lack of independent directors and opaque franchise structures.

Fortunately, the power imbalance and governance issues can be resolved. One of the key findings of Wasserman’s research is that founders which are willing to relinquish control early in their endeavour and invite co-founders and angel investors experience far greater success than those who decide to retain controlling stakes. Here is an extract explaining the dilemma.

“My research shows that a founder who gives up more equity to attract cofounders, nonfounding hires, and investors builds a more valuable company than one who parts with less equity. The founder ends up with a more valuable slice, too. On the other hand, in order to attract investors and executives, entrepreneurs have to give up control over most of the decision making.”

Founder led businesses can often generate strong returns for investors, both locally and globally, however, the greatest success stories tend to occur when the founder is willing to relinquish control and embrace best business practices, attract very high calibre talent and employees in working together to achieve a common goal.

Conclusion

Founder-led companies offer unique investment opportunities due to founders' long-term commitment, innovative drive, and significant ownership stakes, which often align their interests with those of shareholders. Successful examples like Pro Medicus and Netwealth demonstrate how a clear vision, combined with strong governance and adaptability, can lead to impressive growth and industry leadership. However, investing in founder-led companies also presents risks, including the potential for power imbalances and governance issues if founders retain too much control and make poor decisions.

Investors should approach founder-led stocks with a balanced perspective, recognising the potential for psychological biases such as overconfidence and confirmation bias. It’s crucial to assess each company’s governance structure and the founder’s willingness to share decision-making power, as success is often greater when founders collaborate with high-calibre teams. Founder-led companies may not be guaranteed winners, but with careful selection, they can provide exceptional returns and resilience over the long term.