As I mentioned in my first article “The Art of VC: Picker or Builder?” the decision of whom you hire as CEO is the single most important decision you will make post investment when you serve on the board of directors. While I stand by this statement, in reality the decision making process starts pre-investment. When you first make an investment, your assessment of the current CEO/founder typically falls into one of three categories.
The first category is the successful entrepreneurial CEO who is battle scarred, “has been there, done that, got the T-shirt” and yet still retains the desire to build his next successful company. If the company fails, it won’t be for lack of leadership or effort. For VCs this is the dream scenario but the intersection between i) an experienced entrepreneurial CEO ii) still having the passion and drive and iii) willing to take money from you and not their previous happy investors is not a null set but close to it so unless you are a well established fund with many repeat entrepreneurs this is likely to be a rare event.
The second category is the CEO/founder who has passion and drive but lacks the depth of experience or self awareness to develop into a strong leader who can navigate the company through the inevitable highs and lows. They could be a brilliant engineer who sees the world through a purely rational lens and cannot handle the complexity of “irrational” real world decisions outside of the lab environment. They could be a stellar sales executive who has a demonstrable track record of successfully selling many products to demanding customers, but who hasn’t been exposed to the process of productizing a technology. If a VC comes to this conclusion then they should have this discussion with the incumbent CEO/founder and see if they have the same self assessment. If they don’t, then you should not invest. If they do, then you should hire a CEO concurrent with closing the financing. It’s not surprising that many CEOs/founders say they are prepared to step aside for the right candidate, but still have great trouble doing so. Using the financing as a forcing function may seem brutal, but it’s a good acid test of the CEO/entrepreneur’s true intent.
The third and largest category falls between these two ends of the spectrum. The CEO/founder has some general management experience, either launching a product or running a P&L while managing a group of people. Perhaps they have run a business unit within a larger organization. Perhaps they have managed an engineering group with a large diverse product portfolio. They communicate articulately, display emotional stability and have demonstrated team building. They have not yet run an entrepreneurial venture but there is enough evidence for you to believe that they can grow into being a successful entrepreneurial CEO. For a VC this category requires the most commitment and acute judgment. This can be where a VC can earn the often said but rarely validated description of “value add”, so let’s explore this process more deeply.
Identifying the Entrepreneurial CEO
There is no substitute for an open mind and dedicating time in trying to understand whether an entrepreneur has the potential to become a successful entrepreneurial CEO. To my mind there are very distinct differences between an entrepreneur (someone who spots an opportunity and can identify and galvanize some of the resources needed to attack it before anyone else) and an entrepreneurial CEO (someone who can galvanize and manage all the resources needed to monetize the opportunity after it is identified). It is rare for an individual to be able to span these two roles. You can starting identifying the entrepreneurial CEO from the very first meeting.
· Behavioral patterns
In addition to being critical about the content of an investor pitch, you can also tell a great deal from how they pitch their company. You can judge whether they are a good listener and adjust their pitch to your questions. You can judge how self assured they are by challenging their position. You can judge how they treat their team either by letting them answer questions or by interrupting them (the eye rolling is a big tell). At the end of the first meeting I always ask myself the gut question “would I want to embark on an arduous 5 year journey with this person?”
· The Crucible of Experience
At subsequent meetings I like to delve into their formative experiences, especially those experiences which involved a substantive leap such as functional change or big step up in responsibility. As Benjamin Franklin said “Experience is a dear teacher, but fools will learn at no other." As a potential investor I want to understand what the CEO has learned on other people’s dimes. What aspects of their increased responsibility did they find the most surprising or the hardest? What would they do differently if they could turn back the clock? Are their aware of their weaknesses? How have their successes and failures impacted the way they now judge and mitigate risk? Good CEOs are able to evaluate a situation through multiple lenses – financial, strategic, operational, engineering, marketing, sales – but in times of stress it is human nature to revert to just one preferred lens. Understand which lens your CEO will rely on and evaluate their skills of synthesis.
Mentoring the Entrepreneurial CEO
If after assessing both the current behavior and formative experiences of the CEO, you conclude that you are prepared to place your capital risk in their hands, then the time has come to initiate the mentoring process.
· The CEO-Investor Contract
Before the financing has closed, it’s appropriate to have an explicit conversation with the CEO where you outline why you are prepared to back them as CEO even though they have not yet had success as an entrepreneurial CEO. You commit to continuing to support them if the business progresses and they continue to develop as a CEO. The more specific you can be with regards to the business progress (engineering, sales and financial milestones) and the behavior (team building, decision making, information flow) you want to see, the clearer the contract. Making this verbal contract explicit helps build the all important quality of trust in the nascent CEO-investor relationship.
· Regular consistent board feedback
Most VCs aren’t shy about voicing their opinions so most venture backed CEOs don’t suffer from a lack of feedback. However, much of this feedback can be confusing for a first time CEO. What should I listen to? What should I ignore? What should I be doing differently? For first time CEOs I advocate a structured feedback process once a year (and maybe twice a year for very early stage companies) where all the board members provide developmental feedback on the CEO’s performance on four dimensions: i) development of the strategy and objectives of the company ii) execution and structure of the company iii) leadership and development of the management team and iv) relationship with the board. On each of these dimensions, the participants are asked to grade CEO performance as either i) outstanding (awarded 3 points) ii) good (awarded 2 points) or iii) needs improvement (awarded 1 point). The CEO is then presented with minimum, median and maximum grades on each dimension along with the anonymous written feedback from each board member that articulates what they need to see to justify improved scores. This simple yet highly effective process helps the CEO calibrate how they are perceived by the board and where they should be directing their efforts for improvement. It takes the emotion out of the feedback process and filters out the random, context free feedback that is often the bane of a startup CEO’s experience.
· Independent information flow
In addition to the board’s mentoring responsibility, the board also has a fiduciary responsibility to monitor the CEO’s performance. A trap many boards fall into is relying on the CEO as the only information source to judge the company’s performance. No matter how persuasive the CEO, board members should supplement the CEO’s perspective with two other data sources – the management team and the market. In the best companies, CEOs do not limit access to their teams. A board member should be free to meet with the management team provided of course that the CEO is informed such conversations are taking place. It is also appropriate for board members to meet with customers and elicit their views on product performance and future requirements. Many enterprises have financial viability concerns about buying from a startup so there is often an opportunity to ally these concerns through direct board-customer interaction.
The Inevitable Decision Point
If the board has committed time to identifying entrepreneurial traits, mentoring CEO development and monitoring the CEO’s performance in a structured way, then the hardest decision a board will ever have to make becomes somewhat easier. However, no matter how good you are at talent spotting and coaching, it’s likely that the board will need to transition a CEO more often than not. If you’re batting greater than 0.500 (to borrow a baseball analogy – my English friends are cringing as they read this) in backing first time entrepreneurial CEOs you are either very lucky or very very good.
As a startup encounters its first major setback such as a delayed product release or a competitive loss and the specter of transitioning CEO looms, a board can make many mistakes in handling this delicate situation
· Support or transition; no third choice
I have seen board members behave in a passive aggressive manner with CEOs, neither providing them their full support nor being able to move towards a transition. They cross inappropriate operational boundaries in second guessing the CEO without the experience or the data to support their opinions; they meet with management without informing the CEO; and they undercut the CEO’s authority in front of their team. Board members need to understand there is no third option. Either support the CEO, while providing thoughtful advice and critique, as they have a hard enough job anyway; or make a decision to transition the CEO and bring in a new executive.
· It’s never a good time
Sometimes when it’s patently clear that a CEO needs transitioning because they have not responded to mentoring and they are displaying behavior detrimental to the success of the company, boards still do not act because they fear for the stability of the company under the stress of an impending event such as a product launch or customer deployment. However, if its become apparent to the board that the CEO’s performance is hindering the company, then it’s more than likely that this has already become apparent to the management team, the employees and, worse still, the customers. Pick your favourite awful movie (mine is Heaven’s Gate with the unbelievable Isabelle Huppert) and I bet you that the film crew knew it was lousy before the studio executives did. The reality is it’s never a good time to change a CEO so don’t fall into the trap of avoiding a hard decision.
· No silver bullet
This is probably the easiest, and also the most common, mistake for boards to make – believing that changing the CEO will lead to a magical transformation in the company’s fortune. Board’s should keep in mind Warren Buffett’s delightful aphorism "With few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains in tact”. Board’s should evaluate whether they have the basis for a good business first, before making a decision on the CEO.
Developing entrepreneurial talent is an imperative for a VC wanting to be successful in early stage investing, both to increase the pool of potential investments and to earn a reputation for having a good “entrepreneur UI”. Hopefully by exposing my thought process, I can contribute to the rebuilding of trust between VCs and entrepreneurs which has been on the wane over the past 5 years. We are different animals, with different motivations, different thought processes and different languages. The more we understand this, the better we shall be able to collaborate. I’ll write more about these differences in a future post.