Money Matters

Research: What Happens to a Startup When Venture Capitalists Replace the Founder

(Source: hbr.org)

When a startup founder seeks external funding, they may worry about losing control over their company — with good reason. Between 20% and 40% of startup founders are replaced at the behest of their investors. But what happens to the company after the founder is ousted? An initial look at the data reveals that startups where a founder is replaced are less likely to have a successful exit, but that may be because founders are more likely to get replaced when a startup is struggling. Noncompete clauses may also make it tough for investors in some states and industries to find a good replacement CEO. A closer look at the data shows that when it’s easier to find a replacement CEO — in a state that has banned noncompetes, for example — replacing the founder actually improves the startup’s chances for success.

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GABRIEL BOUYS/Staff/Getty Images/Hayon Thapaliya

Entrepreneurs often seek external capital to accelerate their growth. This is especially true in hotly contested markets where fast growth can be the difference between success or failure. And yet this outside funding may come with strings attached, which can (and perhaps should) give entrepreneurs pause. Founders will likely find their influence diluted, in terms of both financial equity and their control over the board of directors. They may even find themselves out of a job if their investors decide to fire them and find a replacement.

Between 20% and 40% of founders do not remain in their original role (according to several academic estimates), typically replaced by a more-seasoned executive who might seem better positioned to scale the company and prepare it for the acquisition or IPO market. One would assume venture capitalists are rational actors who would not replace founders if it were not in the best interest of the company — at least in terms of its ability to go public or be acquired — but it could also be the case that VCs overestimate the importance of their own role in “professionalizing” the company. When founders are replaced, how do their startups fare?

To explore this question, we assembled data from Venturesource, which tracks rounds of funding by venture capitalists, and hand-collected employment histories of founders for startups founded between 1995 and 2008, including how their initial roles changed over time. This data lets us see when founders are replaced. (When a new executive joins the company with the title that a founder used to have, we assume the founder has been replaced.) We then checked whether the founder stayed at the company (usually in a diminished role) or left following replacement. We followed these companies through the summer of 2017 to ascertain the connection between founder replacement and startup performance.

We found that approximately one-fifth of founders in venture-backed companies are replaced, which roughly matches findings by other studies, and is roughly similar to replacement rates in public companies. Replacements become more common as the startup ages and investors have time to assess the performance of the founder(s), and replacement rates seem consistent across various types of VCs. As a next step, we correlated replacement with whether the startup achieves an IPO or an “attractive” exit, defined as the company being sold for more than 150% of capital raised.

At a first glance, it might appear that founder replacement drives poorer performance, as those startups where at least one founder was replaced have worse outcomes. However, this result may be because underperforming startups are simply more likely to have their founders replaced. In fact, it may be that replacing founders actually helps performance in general, but this selection of replacement in low-quality startups confounds the analysis. How can we tell whether replacement is helping or hurting performance?

We addressed this question by assessing the connection between replacement and performance in a situation where it suddenly became more (or less) difficult to find a replacement for a founder who has left or was demoted or fired. Ideally, the replacement founder would be a senior executive with relevant industry experience. But such candidates are likely bound to their firms by a noncompete agreement. Research suggests that 70% of executives at public companies have signed noncompetes and that these contracts discourage them from taking jobs in the same industry.

In the U.S., noncompete agreements are governed at the state level. In states that have made noncompetes harder to use, it should be easier to recruit replacement executives with industry experience, and vice versa. During our sample period, 14 states changed their noncompete policies, enabling us to test our hypothesis rigorously. Importantly, for these state-level changes to have an effect, it must be the case that replacement executives are usually recruited from within the same state. We found that there is indeed significant “home bias” in startup executive replacement hiring: Startups are twice as likely to hire from within the state than would be predicted if executives were selected randomly from any U.S. location.

We found that when state-level shifts in noncompete policy makes it easier to recruit replacement executives, the rate of replacement indeed rises. When policy makes it harder to recruit replacement executives, the rate of replacement falls. And when policy makes it easier to replace founders, the outcomes of startups where a founder is replaced improve — they’re more likely to go public or have a successful acquisition. When it’s harder to recruit, the likelihood of achieving an IPO or successful acquisition falls.

Therefore, we conclude that founder replacement, although it typically takes place among struggling startups, is beneficial on the whole. In our estimates, a 14% increase in the probability of a founder being replaced (one standard deviation) predicts a 25% higher probability of a successful exit.

Finally, we consider when founder replacement makes the biggest difference. One perhaps unsurprising finding is that the replacement of founders with C-level titles is more consequential than those serving in VP-level roles. More interesting is what happens when a founder remains at the company, or doesn’t. It might seem ideal for the founder to step down but remain with the company, but in fact startups perform better when the replaced founder leaves the company. We speculate that this might be because a deposed founder’s sticking around may lead to confusion among the remaining employees, or the founder may even (attempt to) undermine their replacement, although we lack direct evidence on this point.

In sum, founders are right to worry that by raising external funding, they also raise the risk of losing their job. Although that fact had been previously established, the effect on performance of the venture had not been. Our results suggest that founders might worry a bit less about being replaced — at least from a financial perspective — because their diminished role in the company may be rewarded with a higher value for their equity.

More Info: hbr.org

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