The Quality of Management Teams: Looking Beyond Experience

The Quality of Management Teams: Looking Beyond Experience
by Brian Anderson BA Search Group

Everybody knows that venture capitalists rate the quality of a company’s management team as the most important factor when weighing an investment decision. Is that really so? And, what does, quality, mean in the context of an entrepreneurial growth company. If you look closely, you recognize that entrepreneurial experience and a venture capital track record are the reflections of more fundamental capabilities. What are they, and what can you do to build and present a more fundable team?

The Experience Advantage

The link between the entrepreneurial experience of a company’s team and the attractiveness to a VC has become axiomatic. As one venture capitalist asserted a few months ago:

"Management teams are very different today than they were several years ago, they’re better at solving problems, they’re better skilled in organizational development. The number one factor in deciding whether to invest in a start-up or early stage company is the quality of the management team".

The conventional wisdom is that serial entrepreneurs are advantaged in obtaining venture capital, because their heightened human capital (business building skills) and social capital, (access to resources through personal networks) reduces investor risk. Not surprisingly, empirical evidence supports this assumption. Serial entrepreneurs are roughly 25% to 30% more likely to receive venture capital funding than novice entrepreneurs. However, it also seems that diminished investor risk translates into commensurately higher pre-money valuations. According to work by David Hsu, now at Wharton, serial entrepreneurs having had success with their previous ventures receive a pre-money valuation boost of 45%.
So, investors make trade-offs. On the one hand, experienced entrepreneurs reduce risk, but that reduction in risk comes at a significant cost to the investor. Hsu references a study of investment theses from actual VC investment memoranda that summarized the perceived strengths and weaknesses of early stage investment opportunities. In 60% of the cases, the experience of the management team was mentioned as a reason for investing. In other words, management experience is an important? but not always the principal factor in evaluating an investment opportunity.

Problem Solving Capacity as a Measure of Entrepreneurial Quality
Entrepreneurial experience is a proxy for a more fundamental capability, the ability to learn and adapt in the face of ambiguity. Business researcher Amar Bhidés study of different categories of business initiatives underscores how relatively high levels of ambiguity characterize venture-backed companies and differentiate them from the majority of businesses. Mathematician-turned-sociologist Duncan Watts notes, Unlike uncertainty, which one can think of as random draw from a known distribution, ambiguity reflects what decision makers do not know. Planning in the context of venture capital, doesn’t connote prediction. Rather, a realistic business plan identifies the limits of the known and strategies. Jeff Shuman at The Rhythm of Business observes that entrepreneurs simply can’t know in advance all of the important aspects of matching their business model to evolving customer needs. The process of entrepreneurship is a process of learning. A great entrepreneur is somebody who can learn, and solve problems in real time.
Easier said than done. There are significant barriers to learning in the real world of business. The business world doesn’t readily accommodate controlled experiments; there are delays and dynamic complexity. Furthermore, we’re hindered by selective perception and our tendency to protect our personal sense of competence. In his classic work, Chris Argyris explains how defensive reasoning inhibits learning by the smartest people.

So, one would expect investors to look for evidence that an entrepreneur can learn and adapt. it’s a proposition that fits with the experience of Rob Ryan, the founder of Ascend Communications . He made a lot of money for his venture capital investors through a systematic process of experimentation and adaptation.

It (Really Does) Takes a Team
It’s fashionable to talk about the importance of a management team, but that doesn’t stop us from lionizing founders. Is it possible that a really strong founder is all that’s really required?
In a word? no.

Having a founder who is skilled at learning and adapting is a necessary, but insufficient condition. The notion of team is more than a fad, it’s a structural requirement for problem solving in an ambiguous environment. More from Watts:

When solving complex problems in ambiguous environments, individuals compensate for their limited knowledge of the interdependencies between their various tasks, and uncertainty about the future by exchanging information, knowledge, advice, expertise, and resources with other problem solvers within the same organization. Ambiguity, in other words, necessitates communication between individuals whose tasks are mutually dependent. And when the environment is rapidly changing, so too are the problems, hence intense communication becomes an ongoing necessity. The problem of coping with chronic ambiguity is therefore equivalent to the problem of distributed communication. Firms that are bad at facilitating distributed communications are bad at solving problems, and therefore bad at handling uncertainty and change.

The lack of hierarchy found in successful venture-backed companies isn’t the result of collectivist, politically correct thinking. It’s an adaptation to ambiguity. Hierarchies require that the founder serve as the central information router, but an individual’s ability to route information isn’t scaleable. A robust information-processing firm, one that can effectively distribute information in a variety of environments, has the characteristics of a multiscale network. In a multiscale network, most horizontal communication occurs within the core of the management team, but a significant amount of horizontal communication occurs in the periphery as well. That is, people in line functions actually talk to each other in order to solve problems. Furthermore, in multiscale networks, there is significant vertical communication between the core and periphery. As Watts concludes, The superior robustness of multiscale networks also conveys better scaling properties and can grow to larger sizes before suffering failure. Many founder-managed companies exhibit hierarchical tendencies. After all, multiscale networks are less efficient than hierarchies in the sense that distributed communications places a burden on people with production responsibilities. If your people are in meetings, they aren’t making sales calls, providing customer service, or delivering the company’s product or service. Nevertheless, hierarchies aren’t robust, and will almost certainly fail when faced with growth and ambiguity.

Various research and anecdotal evidence suggests that there exist organizational attractors around group sizes of 7, 60 to 80, and 150 that seem to be a function of social grooming (i.e., the cost of building and maintaining social relationships). Given an average revenue per employee per year of about $160,000 in the U.S. (a ratio that varies widely across industries), a 60 to 80-person firm corresponds roughly to $10 million in sales. Perhaps not coincidentally, that's about the minimum size for a company to be considered eligible for growth capital. It may be that private equity investors have learned that a baseline indicator of requisite organizational problem-solving capacity tends to be demonstrated at this range of employee size. Prior to the 60 to 80-employee level, it may be possible for a talented entrepreneur to muscle results out of a hierarchy, even though such results aren't sustainable as the company continues to grow.

In sum, in the context of venture capital, an organization that has a team composed of good to very good individuals who really communicate both horizontally and vertically within the organization is better than a hierarchy dominated by a single, very capable founder. Quite simply, heterarchies are less vulnerable to failure, are better at recovering from catastrophe, and are more scaleable in the face of ambiguity than are hierarchies.

It Takes a Network
Having a strong core team, however, is also insufficient. The resiliency of a firm is very often a function of informal and serendipitous relationships among employees in all levels of a company and their professional peers, customers, and suppliers. Others have documented the anatomies of such communities of practice. For purposes of this discussion, I’d like to focus on the continuing importance of geography. Collaborative technologies do, indeed, make it easier for us to create and maintain social relationships across distance. A new generation of social networking software is beginning to help us search our social networks more easily and effectively. These technologies are particularly helpful in regard to relationships based on more narrowly construed professional affinities. However, as the relevant dimension of relationships changes, geographic proximity often re-asserts itself as a delimiting factor.
No matter how capable and motivated your core team, the adaptability of your company may be diminished to the extent that it is located far from the centers of relevant communities of practice. On balance, the benefits of your company’s location may outweigh the negatives. Nevertheless, be aware of the need to build and maintain bridges to the broader business world. For example, recruiting, training, travel, and branch office strategies, augmented by collaborative technologies, can all help. It’s also becoming clear that encouraging and training your employees in the use of their social networks to solve problems works better than forcing them to build, contribute to, and maintain centralized, knowledge-bases.

How to Present the Quality of Your Team
Assuming that you are among the majority, that is, you are not a serial entrepreneur with a track record of venture capital success, there are a number of things you can do to strengthen the perception of the quality of your team:

Cover the basics. Of course investors look for evidence that your team is composed of smart people who have meaningful and complementary domain expertise. Furthermore, capability without commitment is meaningless. To the extent possible, document competencies and commitment.
Demonstrate your capacity to learn. Investors want you to be an expert. But, they need experts who have the capacity to learn and adapt. Your plans should be presented as the limits of what is known, not what is knowable. Be honest about the gaps in your knowledge, and be clear about your strategies to fill those gaps. Be ready to provide examples of how you have adapted in the past in order to achieve a goal.
Be a team. An organization chart isn’t a team. Be prepared to demonstrate your teamwork when challenged by VCs during due diligence. If all eyes turn automatically toward the founder at every point, you are in trouble. On the other hand, a demonstration of team rapport shouldn’t give the impression of management by committee. After all, learning requires iterative decisions and actions, not just group discussion and contemplation. Finally, it’s necessary and efficient for one person on your team, most likely the CEO, to be the fund raising point person. However, don’t confuse efficiency with effectiveness. Include your core team when appropriate. Absent evidence of a compelling track record, the VC?s safe bet is to assume that you don’t have much of a team.

Demonstrate links to communities of practice. Your location shapes the benefits and weaknesses of your company’s collective connectivity to potentially important communities of practice. Be forthright about how you are going to leverage your strengths and mitigate the weaknesses in your employees, networks. How are you going to build and maintain necessary relationship bridges?

Push prospective investors regarding their ability to add value. Work to reach a shared understanding with prospective investors regarding the strengths and weaknesses of your team. Push VCs hard on how they can, and will, act to bolster your company’s capabilities. Rest assured that the term sheet will reflect the venture capital firm’s self-assessment of its value-add. Make sure that you are going to get what you are paying for. If you are the weak link in your team, it’s best to know that upfront. Whether or not you cede control to your investors, you owe them, and the rest of your shareholders, a shared commitment to a value creation and realization strategy.

Brian Anderson is the principal founder of BA Search Group an executive search, coaching and consulting practice in the Naperville, Aurora, IL market.
http://www.basearchgroup.com/