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Many business owner-managers who have dealt with venture capitalists (VCs) may find themselves agreeing with their “vulture capitalist” characterisation. While VCs often argue that in selecting their high-risk investments they are backing people rather than products, recent research by Cass Business School has shown that when the needs of the investee business move on, or relationships with their VC funders sour, owner-managers should not expect too much mercy.

The study looked at 350 hi-tech companies funded by VC and found a startlingly high casualty rate among owner-managers: about 10 per cent were replaced or forced out in the first 20 months of the business’s life, rising to 40 per cent in the first 40 months and 80 per cent in the first 80 months.

VCs face the challenge that they are often backing technologists with exciting business ideas but no track record in managing start-ups. These innovators can turn out to be the wrong people to commercialise a business, but this may not be apparent immediately; their management skills are often difficult to assess at the outset. Therefore, VCs may claim that after detailed due diligence they are still, in the end, relying on a gut feeling for what can be extremely risky investments. A statistically-based strategy for assessing owner-managers might, therefore, be useful.

Survival of the fittest?

Given the frequency of manager replacement, a natural question to ask is: why do some owner-managers survive while others don’t? Unsurprisingly, our research showed that innovators who prove their ability to add value – for example, by producing commercially useful patents – are more likely to be spared the chop. Likewise, VCs who operate a “hands-on” approach, by putting more effort into monitoring how the business is run, incur more costs in continuing the relationship and are more likely to replace the founder when incremental return to replacement exceed these costs.

The so-called beta-testing stage of a product is also a crunch time for many owner-managers. Our research found that at this point – when the business shifts its focus from research and development to pilot marketing – 32 per cent of all owner-managers were removed and replaced by outsiders. Good performance to date, therefore, does not necessarily save them. How well they will take the business forward counts for more; in many cases, they are simply deemed to have outgrown their usefulness.

We found also that replacement rather than a transfer within the organisation tends to be the dominant strategy – relationships are often so soured by alleged underperformance or by conflicting objectives that there is little point in the CEO staying. Finally, our research concludes that although a certain degree of ruthlessness is required in the replacement decision, VCs need to be careful not to kill the golden goose: owner-managers will likely have the best understanding of their products and technology, particularly in the early stages of a business, so that forcing them out too early could mean a crucial loss of knowledge affecting both owner-manager and VC alike.

VC experience matters

Inevitably, the replacement of owner-managers is influenced not merely by the quality of these individuals but also by the experience of the VC making the decision. According to parallel research conducted with my colleague Sven Remer, the average level of VC experience tends to decrease during boom periods as the total supply of venture capital outpaces available expertise (the latter is something taking time to acquire). Our research found that globally, the average experience of a VC (measured by the cumulative number of investments made), fell 30 per cent between 1995 and 2000, as the peak of the VC bubble approached. Moreover, this pattern was consistent for both general and specialist experience measured across all investment sectors and stages. The implication is that in a buoyant IPO market, more venture capital investment decisions tend to be made and more investment monitoring tends to be done by relative novices in this area. Inevitably, novice VCs are more likely to fire owner-managers too early or too late; getting the timing right requires that (missing) experience.

A model approach to owner-manager replacement

It would appear, therefore, that VCs could benefit from a more systematic approach in assessing the skills of owner-managers. In turn, fine-tuning this assessment and the timing of any replacement should translate into improvements in value.

To achieve this, I developed a statistical model in conjunction with Thomas Hall of the University of Alabama. The model was intended to help VCs both to identify underperforming owner-managers and to decide the best time to replace them.

Our model is based on the assumption that while the intrinsic quality of an owner-manager is difficult to measure, his performance can be calibrated. For example, the VC investor can monitor the manager’s skill in heading up the company’s research, in running its board meetings, in managing difficult colleagues or in marketing its products. The VC can then progressively learn about the manager’s performance and infer whether he is up to scratch.

With the aid of this model, the performance of owner-managers can be scored against a set of questions that assess skill levels in key areas. Average scores are measured against an optimal performance hurdle updated round by round; if, in any funding round, the owner-manager’s performance falls below the current hurdle, it is time to consider severing the relationship.

Importantly, then, the level of cut-off the VC uses varies with the evolution of the business. This allows VCs to take into account not only current manager performance (embodying the learning process) but also to weigh decisions according to the stage of product development and the financial impact of retaining or replacing the owner-manager.

While the original research was based on technology companies, we believe the model is, with adjustments, useful for VCs in any industrial sector.

Lessons for owner-managers

Despite their ruthless profile, not all VCs believe that getting rid of business founders and inventors is the best strategy. Some describe the relationship as a marriage – a joint venture with inevitable ups and downs but which often pays off if the parties work hard at it. An alternative to replacing an owner-manager altogether may, therefore, be to have a frank conversation to convince her to stay as chief technical officer, while bringing in a more commercially-minded chief executive. However, the fact that ousted individuals frequently walk away with limited financial reward or compensation suggests that business founders seeking venture capital financing should tread warily and be suspicious of marriage guidance counsellors offering quick fixes.

Venture capital is often critical in giving a business first-mover advantage over competitors, but owner-managers should also be openly asking what expertise a VC will bring to their business. With the experience of the VC often crucial to their ability to make the right strategic decisions, it is only sensible that owner-managers should seek out the better VCs among those available. However, market conditions may well be a limiting factor in determining what range of choice there is.

Research recently conducted with Prof Remer for the European Commission showed that market conditions have a major effect on the venture capitalists’ willingness to invest in a venture, the financial resources offered, conditions attaching to that finance and the subsequent relationships the VC has with the company. Specifically, when markets are buoyant, there may be a range of VCs willing to offer money, the amounts may be generous, the advice from may be good and the tendency to conflict with owner-managers over company strategy minimal. However, a significant change in market conditions may alter all of these things dramatically. In particular, since VCs are themselves often agents of other investors (such as pension funds) a major downturn in the market may lead a VC – anxious to demonstrate a successful track record for future fundraising – to focus much more on short-term issues and to replace or drive out the owner-manager should there be resistance to his ideas.

Robert Cressy is professor of finance at Cass Business School

Copyright The Financial Times Limited 2017. All rights reserved.
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