The role that investors play in replacing chief executive officers of startup companies has been the subject of heated debate in the investing community, and it remains controversial whether investors in startups do better by replacing incumbent CEOs. Our recent working paper, available here, provides for the first time causal evidence showing that the likelihood of startup-CEO replacement rises as more prominent investors participate in financing. Our paper also demonstrates that successor CEOs are drawn disproportionately from a particular talent pool – outsiders with prior startup-CEO experience – and, critically, that prominent-investor led CEO replacements produce large and robust startup performance improvements.
We became interested in these questions after noticing investors taking very different positions on when, and indeed whether, to replace startups’ CEOs. Describing the venture capital financing model, a founding partner of Beta Group investors observed, “The person who starts the business is seldom the person who can grow it, and that person is seldom the one who can lead a much larger company. Thus it is unlikely that the founder will be the same person who takes the company public.”
But when Marc Andreessen announced the launch of the Adreessen Horowitz investment firm in 2009, he expressed a contrary view, that the firm was “hugely in favor of the founder who intends to be CEO.” Explaining further, his partner Ben Horowitz noted that the “most controversial component of our investment strategy [is] our preference for founding CEOs. The conventional wisdom says a startup CEO should make way for a professional CEO once the company has achieved product-market fit [but] we prefer to fund companies whose founder will run the company as its CEO.”
This suggestion that Andreessen Horowitz screens its investments accompanies Andreessen’s acknowledgement of a monitoring role: “We cannot guarantee that a founder can be a great CEO, but we can help that founder develop the skills necessary to reach his or her full CEO potential.” Similarly, a general partner at Khosla Ventures stated that “[g]reat VCs do not want to replace a founder as CEO. Period.” While there is no consensus view, this last comment – by distinguishing “great” VCs from others – suggests that differences in investor quality may be a relevant factor when investigating CEO replacements in startups. Our paper builds from this last notion by distinguishing prominent investors from others.
In our paper, we empirically examine CEO turnover in startup companies, providing evidence on the cause-and-effect relationships among prominent investors’ participation, CEO replacements, and their ex post firm performance implications. Using a large dataset of investors, startups, executives and their characteristics, we focus on how the participation of more prominent investors affects CEO replacement in startup companies, identifying the conditions associated with these leadership transitions and relating CEO replacement to ex post financial and innovative performance in startups. In a series of qualitative interviews with professional financiers, we investigated when and how investors replaced CEOs in their portfolio companies, and discovered a set of explanatory investor attributes. Because these include longer investing experience, superior reputation and deeper sector-specific relationships in finance and startup industries, our “prominence” measure reflects prior investing relationships with other financiers, and captures participation in prior startup-financing deals.
While existing studies have shown mere correlations between investor participation and particular outcomes without overcoming selection concerns, we implement a statistical matching approach to separate ex ante selection from ex post monitoring effects, thus generating causal evidence that prominent-investor participation in startups induces an increased likelihood of CEO replacement. Additionally, we show that, contrary to suggestions in earlier scholarship, the involvement of venture capital firms (in and of itself) is not the primary driver of CEO replacement in startups. Instead, replacement is produced by the participation of more prominent investors, regardless of their type. This finding is provocative, especially considering the exclusive focus on VCs in much of the entrepreneurial finance literature.
Because startups are often founded and initially led by technologists who lack business experience and management training, we also use the same techniques to investigate the relationship between prominent investor-led CEO replacement in startups and the characteristics of the individuals chosen to supplant incumbent CEOs. Since investor motives for replacing a CEO may differ from case to case, it is not a priori evident which individual traits may matter. Using prior literature as a guide, we examine characteristics related to managerial skill and experience and, alternatively, whether the successor was promoted from inside the firm. Specifically, we determine whether the successor CEO (i) was hired from outside the firm (“outsider”) rather than promoted internally (“insider”) and (ii) had previously acted as CEO to another investor-funded startup (was “experienced”). Our results show a causal relationship between the participation by prominent investors in startups and successor CEOs combining both characteristics, whom we call “experienced outsiders.”
Our paper also explores whether prominent investor-led CEO replacement varies depending on the maturity of the portfolio startup. Prior literature suggests that in more mature startups, prominent investors may generate a bargaining advantage by inducing their portfolio startups to compete against one another for financing, thereby securing for the investors a larger share of the value available to be distributed in the deal. However, the effect from prominent investors’ superior monitoring ability may cut the other way: investors may participate and induce a CEO replacement early, “buying low” in early stages when uncertainty is highest, and “selling high” after building value in the startup over time. Our results provide causal evidence of the latter, demonstrating that the involvement of prominent investors induces a higher likelihood of CEO replacement in relatively immature startups, supporting the notion that prominent investors take advantage of their monitoring advantages beginning in the earlier stages of their portfolio companies’ development.
We also examine startup characteristics related to the quality of firm governance. Relying on prior research relating strong governance to investor outcomes, we use information on startups’ boards of directors to generate a proxy for weak governance and investigate how prominent investor-led CEO replacement is related. Our analyses show that the involvement of prominent investors is more likely to induce a CEO replacement in startups exhibiting relatively poor governance, implying that prominent investors may have advantages in monitoring when startups have weak governance structures in place.
Given these findings, the last questions we investigate are fundamental ones: Does startup CEO replacement contribute to ex post financial and innovative performance, and does the participation of prominent investors independently induce a performance premium? Again, in light of the disparate motives prominent investors may have for replacing existing CEOs, it is not clear that hiring new management would necessarily result in better startup outcomes. We provide causal evidence that CEO replacement produces superior ex post performance in startups, and that these dividends are strongly driven by “experienced outsider” CEOs. Additionally, we find strong support for the positive, distinct role played by prominent investors. Our results provide evidence of large increased performance effects produced by CEO replacements that are directly induced by prominent-investor participation in the startup.
We stress that, in light of the increasing evidence that young firms propel economic development, it is desirable to improve our collective understanding of how the involvement and actions of financial intermediaries increase the odds of startups succeeding. Taken together, our findings highlight the role of prominent investors in making the operation of startups more professional thorough the replacement of their existing CEOs. Importantly, the results also emphasize the large, independent effects that prominent investor-led CEO replacements have on a startups’ financial and innovative performance.
 Bob Zider. “How venture capital works.” Harvard Business Review, Nov-Dec, pp. 131-139 (1998).
 Marc Andreessen. “Introducing our new venture capital firm Andreessen Horowitz.” http://blog.pmarca.com/2009/07/06/introducing-our-new-venture-capital-firm-andreessen-horowitz (7/6/09).
 Ben Horowitz. “Why We Prefer Founding CEOs.” http://www.bhorowitz.com/why_we_prefer_founding_ceos (4/29/10).
 Andreessen, footnote 2.
 Keith Rabois, Comment. https://www.quora.com/How-do-VCs-eventually-come-to-the-conclusion-that-they-need-to-replace-the-CEO/answer/Keith-Rabois (7/15/10).
This post comes to us from Annamaria Conti, an assistant professor of strategic management, and Stuart Graham, an associate professor of strategic management, at the Georgia Institute of Technology’s Scheller College of Business. It is based on their paper, “Prominent Investor Influence on Startup CEO Replacement and Performance,” available here.