Venture Capitalists (VCs) report that more than 50% of the time they have to replace the Chief Executive Officer (CEO) in a venture backed company before the investor exits. This process is often painful for the people involved and disruptive to the fledging enterprise. This paper explores the CEO leadership requirements for venture backed companies through in depth interviews with 10 venture capitalists. Specifically, we look at changing leadership requirements for CEOs in growing venture backed companies and explore whether there are signals that can help both CEOs and venture capitalists who fund their companies avoid being surprised by the need for leadership change. A theory and model for CEO leadership in venture backed companies is proposed.
The study of entrepreneurship has recently been defined in terms of two primary concerns--opportunity recognition and opportunity exploitation (Shane & Venkataraman, 2000). Entrepreneurs either discover or create new opportunities (Alvarez & Barney, 2006) and then move to build a company or create a strategy that will allow for the ability to obtain a profit from the opportunity. While the opportunity recognition process may be a solitary event, the opportunity exploitation process often involves building a team and a business over several years. These activities typically require capital. Thus, one of the key activities for opportunity exploitation is often the securing of capital to exploit the entrepreneurial opportunity.
According to PriceWaterhouseCoopers, 3,416 companies were funded by venture capital in 2006. These companies reflect a combined total investment of $25.5 billion in US businesses (www.pwcmoneytree.com). And, while there are many entrepreneurial ventures--in terms of numbers--that are not backed by venture capital, those backed by venture capital are like the racecars of early stage companies. They often represent some of the fastest growing entrepreneurial companies. In addition, the five year exit expectations of VCs who fund them demand that these companies focus on rapid growth and profitability. In short, unless the CEOs of these companies can promise and deliver results in a relatively short period of time they will lose favor with their boards and investors and face changing leadership.
Conversations with both sides of CEO leadership in these companies (venture capitalists and CEOs of venture backed companies) indicate an underlying frustration with the demands placed upon these leaders. At the end of the day, CEOs and their investors are people and people form relationships. When the intense demands of growing a venture rapidly lead to the need to change CEOs it is often painful for all those involved. The pain is not reserved for the investors and board who often have to deliver the news or even the CEO who must hear the difficult message, but often permeates into the company as employees find the leadership change disruptive and frightening. However, most agree that once a change has been made, it is often viewed as a "long overdue change."
Researchers such as Bruton, Fried & Hisrich (1997), Finkelstein & Hambrick (1990), Fried & Hisrich (1994), and Hambrick & D'Aveni (1992) have discussed the role the CEO plays in the success or failure of a new venture. Earlier studies on the reasons that venture investors change leadership in companies in which they invest have identified three key reasons for CEO dismissal: the CEO did not meet the expectations of the investors and board members; the poor financial performance of the firm; and, the CEO had developed an unhealthy sense of power (Fredrickson, Hambrick, & Baumrin, 1988; Fried & Hisrich, 1995; James & Soref, 1981; Gorman & Sahlman, 1989; Rosenstein, 1988).
While earlier studies did identify reasons for CEO dismissal, none looked at the stage of the new venture as a factor in the need for CEO change. We suggest that because venture backed companies often require intensely rapid growth in order to succeed, CEOs--and even at times their investors--are taken by surprise when milestones are not met and profits do not keep up with expectations and leadership changes are needed. Taking different stages of the new ventures' growth into consideration, this research paper explores the experiences of 10 VCs and attempts to describe a model of venture changes and CEO leadership.
In order to accomplish this, we rely primarily on the work of Greiner (1998) who contends that managerial problems are rooted in time and organizations can be conceptualized as moving through predictable stages over time. Moreover, he reasons that traditional management practices that might have been appropriate at one stage of company growth are no longer valid at a subsequent stage. Greiner maintains that the leadership and management practices that lead to success at one stage will often be the very practices that undermine success at the next stage. To develop our model more fully, we also rely on theories about the CEO behavior required at various stages of a firm's growth (Penrose, 1959: 35-41).
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Applying these theories to venture backed companies, we argue that rapidly growing companies such as those backed by VCs move through predictable stages and that both CEOs and VCs can reduce the disruption associated with CEO change by recognizing these stages and preparing for the changing leadership requirements at each stage. This preparation may include replacing the CEO or it may include mentoring and leadership coaching to help the CEO and his top management team and employees adapt to the changing needs of the venture.
Leadership in Venture Backed Companies
Leadership in a venture backed company differs from the more common owner-operator leadership position of early stage founder or debt funded firms where the entrepreneur maintains significant control and provides primary leadership for the venture (Bruton et. a1., 1997). In the venture backed company, investors provide funding in exchange for a significant ownership position in the firm. In order to better ensure the success of the investment, representatives from the venture company typically require a position on the board and also often require seats for other experienced entrepreneurs on the board of directors. Thus the VCs usually maintain significant control. This control often takes the form of providing direction to the leaders of the organization. Thus, leadership is shared by the board, which includes representatives of the investors, and the CEO of the venture (Bruton et. al., 1997). While the CEO operates the firm on a daily basis and provides leadership to the employees and top management team, he must answer to the board and take direction from the investors who maintain ownership control through their investments (Bruton et. al., 1997). Conversely, because the CEO is immersed in the operation of the business and the board is not, the investors are highly dependent upon the CEO for information about the status of the organization (Sapienza, 1992). Thus, the relationship between these venture backed company leaders--the CEO and his investors--is often intense and viewed as critical to the success of the firm.
As investors, VCs spend a significant amount of time supporting and tracking their investments (Gorman & Sahlman, 1989). However, when there is a strong bond of trust and confidence in the CEO, the VC is able to spend less time monitoring the organization and is willing to give up more control to the CEO (Bruton et. at., 1997). Because of this dynamic relationship, venture investors place a high value on the capability of management, and in particular the CEO, when making investment decisions (Tyebjee & Bruno, 1984). Thus, there is a commonly held and often stated rule that a VC would rather invest in a Grade A entrepreneur with a Grade B idea and are unlikely to invest in a Grade B entrepreneur with a Grade A idea (Bygrave & Timmons, 1992). In spite of this rule and the focus VCs place on choosing Grade A entrepreneurs, CEOs are frequently dismissed before the investor exit. The question then becomes, what changed from the early stages of the investment to the stage when the CEO no longer provided the leadership necessary for success?
There are two approaches to handling the need for new leadership. One tactic is to immediately replace the current CEO with someone who is perceived to have the necessary leadership skills. An alternative to this action however, may be to mentor and coach a CEO into the necessary leadership changes. This assumes that the CEO is open to being coached, and has the ability to grow and that the VC either has the talent or can acquire the talent to help the CEO meet the needs of the rapidly growing company. VCs coach CEOs on matters related to recruiting and retaining the right personnel; solicitation of suppliers and/or customers; strategic planning; and obtaining additional financing among others (MacMillan, Kulow & Khoylian, 1988). However, when this coaching falls short, the result is typically to return to the first alternative and replace the CEO.
Research on CEO leadership in venture firms suggests that a CEO of a venture backed company must be able to work seamlessly with the board of directors; attract, motivate and monitor employees; allocate resources...