In this week’s podcast episode 5 at Venture In The South, David and Charlie discussed one of the more challenging scenarios in early stage investing: management changes in invested companies.
Most angel investors don’t plan much about this. Angels invest in the founders – we “back the jockey not the horse” in the cliché – so do not seek management change. Most angel investors don’t “lead” deals, they aren’t responsible for, or can’t do anything about, who leads the company anyway.
For larger angel groups, and even more for later stage investors like venture capital and private equity funds, however, changing management is a common scenario. How common? In one study of 1,156 venture-capital-backed US IPOs from 1995 to 2013, 472 companies (41%) changed CEOs between the first round of funding and the IPO. Pretty frequent. 100% of VentureSouth portfolio companies that have gone public had at least one change in senior leadership.
I don’t know of comparable data for angel investing, but anecdotally my guess is this rate is lower, at least in the Southeast. From the VentureSouth portfolio, we only have a couple of companies (from 42 exited investment rounds at the time of writing this) that changed leadership before they were acquired. Even on our unsuccessful rounds, there are few examples. This is partly because of strategy and timetable: we are hoping for exits in 3-5 years, and not shooting for a 7-10+ year hold to an IPO, which means there is less time for change. Across our live portfolio, only a handful of founders have transferred the reins to new leaders.
Still, as this episode attests, management changes. Why are management changes necessary? There could be many reasons; some dramatic, some contentious, some amicable, some personal, some criminal. Too many to cover (which is part of the fun/torture of early stage investing!). The cause of the change usually dictates how the change occurs.
Are management changes “successful”? This is harder to answer. Selection bias complicates matters: generally changing management becomes a topic if a company struggles – and struggling companies are, obviously, less successful than successful ones! Companies that maintain their founders through a successful journey do somewhat better – like in this study that showed that companies with founder-CEOs had an almost 10% higher valuation at IPO, though that doesn’t seem much of an impact to me. The first executive often makes for the best executive. In the scenario in the podcast, the transition seems to have been the right move – but we can't ever know for sure.
What should we take away from this? Management changes can be complicated, messy, and unpleasant. Transparency, open dialogue, a trusting relationship between entrepreneurs and investors, and a lead investor with engaged board members all help. When early stage investing, evaluate the founding team and also who else is involved, just in case the founders aren’t the leaders in a few years.