VCs Need to Focus on How the Jockey Rides the Horse

Horse_and_jockey Last week in PE Hub Dan Primack reported on a recent white paper, “Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies”.  In this paper, Professors Steven N. Kaplan (University of Chicago), Berk A. Sensoy (USC), and Per Stromberg (Stockholm Institute of Financial Research) survey 50 VC-backed companies that completed IPO’s in 2004.  They conclude the following:

“The results call into question the claim that “a great management team can find a good opportunity even if they have to make a huge leap from the market they currently occupy. . . . firms that go public rarely change or make a huge leap from their initial business idea or line of business.  An initial strong business, therefore, may not be sufficient, but appears to be almost necessary for a company to succeed.  On the other hand, it is common for firms to replace their founders and initial managers with new ones and still be able to go public, suggesting that VCs are regularly able to find management replacements or improvements for good businesses.  We interpret our results as indicating that, on the margin, VCs should spend more time on due diligence of the business rather than management.”

The authors wisely note the limitations of their small sample size and that 44% of the companies in their survey were life sciences companies.  They also point out that they are unable to access data on companies that experienced exits through acquisition (the vast majority of VC-backed companies) because this data is unavailable.  It is unfortunate that the value of much of the academic research conducted on our field is severely limited by the lack of access to relevant data.  This is clearly the case when one reflects on the conclusions of this report.  In my view, debating this aspect of the Horse vs. Jockey argument isn’t particularly useful to VCs or to entrepreneurs.

A more interesting line of related questions could begin with “Why do so few VC-backed firms succeed, period?”  "Is it endemic to venture capital investing that roughly 10% of investments will account for the vast majority of returns?"  "Can VCs do something to improve these statistics and therefore increase the return profile of the entire industry?" 

As the authors point out, VCs do, indeed, know how to replace management teams, and this occurs quite regularly.  More importantly, the human capital side of founder and management transitions is by no means optimized in our industry. In my opinion, the absence of consistent processes in many VC-company management transitions is the Achilles heel that spells failure for many companies—and this suggests that dysfunctional personal dynamics between VCs and founders may actually lead companies with solid business models to fail.

Start-ups experience accelerating rates of change, both internally and externally, as they develop.  The convergence of changing markets, evolving product lines, and frequent employee hires and replacements in a resource-constrained environment leads to extraordinary and stress inducing rapid rates of change in fledgling companies.

Through collaborative work on identifying governance best practices, the group of VCs and other industry professionals who have formed the Working Group on Director Accountability and Board Effectiveness conclude that having process and internal controls in place allows investors and the senior management team to better identify and calibrate problems, to determine the next course of action, and to reposition the company for success.  The outcome may involve changes to the team, to the business model, or both.

Process and controls form an important framework for management self-help in decision making.  Without process, it’s much easier to flounder and get caught in sub-optimal decisionmaking.

While VCs should certainly avoid investing in weak business models, in contrast to Professors Kaplan, Sensoy, and Stromberg, I would suggest that, at the margin, we should spend more time identifying and applying best practices and processes to our companies to improve our set of potential outcomes.  Assuming that we can identify strong business models, we should focus on maximizing the potential for our management teams to succeed in order to boost the VC industry’s collective returns for our investors. 

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