I asked for, and received, some critical feedback from Bill Reichert at Garage Technology Ventures regarding my recent essay on the quality of management teams.  He thought I made some good points in my previous piece, but—given Bill’s perspective as an early stage investor and boutique investment banker—he thought I missed a key issue:

[VCs] are investing in the brilliance of the value proposition.  But before they write the check, they want to make sure that the team can execute the business model.  So the team side of the equation is a “necessary but not sufficient” analysis.  Is the team good enough?  That’s the core criterion when analyzing the team.

The key investment analysis, however, is focused on the value proposition.  No one would look at a business plan and say, “Is the value proposition good enough?”  Venture investors want a value proposition that is extraordinary, and a team that is competent.  No one is interested in a value proposition that is just adequate even if the team is extraordinary…

The most important factor, however, is performance.  You don’t really address this in your piece…It takes months of living with the team to get comfortable making an investment.  Our primary evaluation of a team is based on what they have accomplished thus far.  Even with the earliest seed stage startups, you can evaluate what has gone before, and you can watch over the weeks, or even months, of interaction with the team how they perform vs. what they say…Give me a scrappy team that is going to succeed whether or not they get venture capital, not a team that can rest on its laurels because they’ve “done it before.”

Points well taken.  I believe that Bill's prioritization is correct.  Growth is predicated upon a compelling value proposition.  Managerial capacity is just one of a number of factors required to achieve the value creation and realization thresholds of early stage venture capital investments.  In the early stage of a company’s life—when market validation in the form of sales is, by definition, limited—the value story needs to be eye-popping.  It’s only after that box is checked that an analysis of the sufficiency of the management team to execute comes to the fore.

Learning, Smarts, and Performance

One point of clarification is called for regarding my emphasis on learning capacity as a metric of managerial capacity.  I’ve come to understand execution or performance to be equal to learning in the sense advocated by The Rhythm of Business and others.  A management team performs to the extent that it understands customers’ needs and satisfies those needs profitably faster and better than the competition (which includes the status quo).  From this perspective, learning isn’t just a function of abstraction and analysis—it’s the result of attempting to sell and deliver real products to real customers.  One must think and do.  Work in your business and work on your business.

Consider the “OODA” or Boyd loop.  Our plans (our orientation) guide our decisions; our decisions determine our actions; and our actions (interactions with the real world of business) generate observable information that, in turn, leads to a re-orientation.  (It’s the very process that Bill describes regarding assessing a management team, for example.)

In a very practical sense, there is no learning devoid of action [1].  The evidence of learning is performance.  So, a key assumption underpinning my previous comments was that a team’s capacity to learn over time is equivalent to its capacity to perform.  Note though, a team’s capacity to learn is not equivalent to how “smart” it is, as Bill commented upon a while back in an interview [2].  Very often, people who know a lot aren’t very good at adapting to rapidly changing environments—the kind that are commonplace in the world of venture investing.  Nevertheless, all things equal, it’s desirable to have a team of smart people who can learn—good enough, cheap enough, and fast enough to get the job done.

It’s the Result, not the Input, that Matters

I appreciate Bill’s perspective.  Entrepreneurs aren’t well served to enter into a relationship with an investor with the notion that “management is the most important factor.”  In the context of venture capital, the most important variable is the result—a competitive rate of return.  Management skill is an important input variable (as evidenced by the considerable time and effort Bill and his colleagues invest in assessing management teams).  Nevertheless, management skill is but one variable.

That’s not to suggest, however, that assessing a management team should be considered a trivial task.  No investor should feel too comfortable about settling for an insufficient team under the assumption that it can be “fixed” later.  I know from personal experience that changing management in midstream can be a difficult, risky, disruptive, and expensive task.  That’s true even in large, established companies.  As The Economist magazine noted last week, at least one study concluded “outside chief executives do very well in the early part of their tenure and very badly in the latter part.”  Research by Inc. magazine showed that over a 15-year period, the founder played an important continuing role in 80% of the hundreds of instances of new entrants to the Fortune 500.  Some material degree of management continuity seems to matter.

On the other hand, management teams who live in fear of the prospect of a managerial “bait and switch” by venture capitalists, would be well served to consider a question by Trevor Loy of Flywheel Ventures: “Do you value your ownership stake in the company more, or do you value your job and your role?”  If you are considering a venture capital investment, your honest answer should be the former—even as you must be prepared to demonstrate that your current team is up to the task of executing the plan.

Venture Dynamics™—Accelerating the Managerial Assessment Process

To the extent that “It takes months of living with the team to get comfortable making an investment,” the management assessment process is a time-consuming and expensive one—for both investor and management.  Laura Black, Don Greer, and I are in the process of adapting a set of proven methods and tools (including system dynamics modeling and simulation) to the task of improving investment due diligence.  We believe we can help venture capitalists and private equity investors, on the one hand, and management teams, on the other, develop a shared understanding of, and commitment to, an actionable value creation and realization strategy—prior to closing.  The idea, in the context of this particular discussion, would be to provide a forum and focus in order to systematically explore a company’s value proposition in a manner that allows investors to observe managerial problem solving in real time.  The expected result is time saved, and time is the VC's scarcest resource.

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[1] The cycle was articulated by John Boyd, a fighter pilot who asserted that his ability to “fly inside the loop” of his opponents was the reason that he lived and they died.  Survival is a pretty fundamental metric of performance.

[2] Teaching Smart People How to Learn by Chris Argyris offers  a classic explanation of why smart people have trouble learning and, consequently, aren’t always the most effective entrepreneurial performers.