Follow Up To Venture Business Dogma Post

As a follow up to my post on what is the most important element when evaluating high growth startups, a study performed by Steve Kaplan, Berk Sensoy and Per Stromberg, researchers at University of Chicago is very apropos.  Steve is also the Academic Dean of the Kauffman Fellows Program and is at the tippy top of the pyramid of academic researchers focused on private equity markets (and is a great guy and a friend).  Kaplan et. al. performed academic research on whether its best for VCs to bet on the Horse (product / market axis in my post) or on the Jockey (the management team).  It was a pretty rigorous piece of academic research and they had access to 50 business plans of companies that went public after having received venture backing.  To mitigate sample selection issues they also then analyzed the evolution of every company that performed an IPO in 2004.  The findings strongly indicated that the Horse is more important than the Jockey.

To organize the data, they took company information at three measurement points:

• BP, or Business Plan, which is the point in time where they received venture financing

• IPO, where they took information out of the IPO prospectus

• AR, or the third Annual Report after the IPO, which would occur between 2 and 3 years after IPO (e.g. for an IPO in July 1999, the AR point was the 2001 annual report)

A few money shots came out of this research, organized into 4 different areas

• Core Business

• Of the 50 venture backed IPOs, only 1 changed its core business.  Or to put it another way only one management team successfully re-tooled the business and still made it to IPO.
• Of the 106 relevant IPOs in 2004 (relevance is defined in the paper, but in general  they eliminated REITs, holding companies, spin-offs, JVs and the like), not one of them changed their core business in the 5 years prior to IPO, and only 8 changed their core business at any point in their corporate life.
• Conclusion: Backing an "A" team with a "B" plan does not lead to IPO exits. You have to start with "A" plan.
  

• Differentiation from competitors (determined by self-reported questionnaires completed by management)
  • Unique product or technology (which would be the Horse)
    • At BP, 100% of companies ranked this as a key differentiator
    • At IPO, it was 98%
    • At AR, it was till 92%
  • Management expertise (which would be the Jockey)
    • At BP, only 45% of companies ranked this as a key differentiator
    • At IPO, it had plummeted to 14%.
    • At AR, it was at 13%
  • Conclusion: At all points in the company lifecycle, the Jockey's themselves believe that the Horse is significantly more important than the Jockey

• Management Stability
  • Starting at BP and running through AR, only 50% of the CEO’s remained the same and only 25% of the top 5 executives remained the same.
  • Conclusion: For companies that make it to IPO and beyond, the team will change, but the business plan will not.  So if you have an "A" plan, you could start with a "B" team because the team will get rebuilt over time anyway.
    

• Ownership
  • In a sample limited only to the VC-backed companies in the study, average CEO ownership immediately prior to the IPO was 10%.  There had been a similar CEO-ownership study conducted on VC-backed companies going public between 1978 and 1987, or roughly 20 years earlier, and the average CEO ownership immediately prior to IPO in that study was found to be 19%.
  • Conclusion: The relative contribution by the Jockey, as reflected in the amount of economic value the Jockey owns, has been nearly cut in half over the last twenty years. I would postulate this phenomenon as being driven by supply and demand; the scarce resource is no longer the Jockeys so Jockeys command less economic value.  That’s not to say that Jockeys per se have decreased in importance, its just that they have increased in supply relative to the supply of Horses so the relative price of Jockeys to Horses goes down. Referencing my previous post, some of the factors driving this are the Flat World phenomenon and the incredible influx of capital into the venture asset class.

Having ruminated on this for a while I have to clarify that I believe this data would only be relevant to companies in the classic venture capital mode, i.e. companies attempting for high organic growth.  In the Private Equity business and/or platform roll-ups the quality of the Jockey is much more important because the Horses have all been vetted over many years of operating results so there is less variance in different investors analyses about what is a good Horse and what isn’t.  So in the PE / LBO business value accrues to those investors who can analyze Jockeys and/or have the best relationships with the best Jockeys.  And 20+ years ago venture capital was probably more similar to that model.  But my anecdotal experiences, and this academic research shows that venture capital no longer operates on that model.

By no means am I disregarding the value of great management teams...especially because I'm now back on the operating side of the business myself! But as an operating executive I'm really trying to objectively analyze what is most important and prioritize allocation of resources most appropriately.

This is a fascinating piece of research for anyone with a stake in high-organic growth companies.  I've made lots of generalizations here in the interest of brevity and clarity of point.  For those interested in learning more, I encourage you to download the research paper and powerpoint presentation that summarizes the paper and read it yourselves and blog it at your sites or come back to comment here if the spirit moves you.

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