In Venture Capital, it Takes an Entrepreneur to Know One

Among blue chip venture capital firms, finance pros may rule the roost but seasoned entrepreneurs are the star performers. Pity that so few of them are in the VC business

The essentials

Venture capitalists with an entrepreneurial background have a markedly positive impact on the performance of venture capital firms (VCs), even stronger than those with finance or general business experience. According to a study, VCs that employ a greater fraction of former entrepreneurs had a higher share in the Initial Public Offering market and better performance in taking portfolio firms public, says Merih Sevilir of the Kelley School of Business at Indiana University. The study showed that only 14 per cent of venture capitalists were entrepreneurs before becoming a VC. Sevilir presented the study’s findings at Queen’s School of Business’s Economics of Entrepreneurship and Innovation Conference in June 2013.

There is a mystique surrounding venture capital (VC) firms and their role in the creation of new companies. Sure, they fund precious few start-ups — under 1 percent in the U.S. — and the number of VCs and their pool of money are actually dwindling. But many are still seen as shrewd judges and nurturers of business potential. What separates the best of these VC firms from the also-rans? The answer: Having plenty of former entrepreneurs on the VC team.

“We opened the black box of venture capital and tried to understand what makes a good VC firm,” says Merih Sevilir, an associate professor at the Kelley School of Business at Indiana University. “We found that entrepreneur venture capitalists (EVCs) add value to the firms they work at. They know the process of entrepreneurship and work with other entrepreneurs in a more efficient way.” 

Sevilir studied the performance of EVCs with fellow researchers Ye Cai (Santa Clara University) and Xuan Tian (Indiana University). She presented their findings at the Queen’s School of Business’s Economics of Entrepreneurship and Innovation Conference in June 2013.

The researchers based their study on a sample of some 300 top venture capital firms (measured by reputation score). They hand-collected the names and biographies of individual venture capitalists at these firms, and matched their backgrounds — be they entrepreneurial, finance, or general business — with their firms’ performance. (EVCs were defined as those who had founded at least one firm before becoming a venture capitalist.)

The entrepreneurial “dividend” was unmistakeable. The researchers found that those VC firms employing a greater fraction of former entrepreneurs had a higher share in the Initial Public Offering (IPO) market and better performance in taking portfolio firms public. These firms were also more likely to show up on the Forbes list of top 100 venture capital firms.

By contrast, no such bump was found for those with a Wall Street or Main Street background.

The Entrepreneur's Advantage

According to the researchers, the positive impact of former entrepreneurs was strongest for smaller, younger venture capital firms and for VCs specializing in early-stage investment and in high-tech industries.

“This result is consistent with the idea that EVCs’ advantage in understanding and nurturing entrepreneurs might be greater for high-tech and early-stage start-ups where VCs’ ability to communicate with entrepreneurs is more critical for success,” says Sevilir.

Despite the star performance of EVCs, Sevilir and her colleagues found that only 14 percent of venture capitalists in their sample had entrepreneurial experience, a much lower percentage than those with a finance or general business background.

Why are there so few former entrepreneurs in VC ranks? Sevilir offers two possible explanations. “We may not have an infinite supply of those talented individuals,” she says. “And the business of entrepreneurship is different from the business of venture capital. I may be a very successful entrepreneur and understand that language, but I may not have any interest in the venture capital business.”

For high-flying venture capital firms, the answer isn’t to stack the deck with former entrepreneurs. The researchers found that firms with a diverse team drawn from entrepreneurs, finance professionals, and non-finance professionals perform best. The trick is to get the right mix. “Bringing in people with different skill-sets creates synergies,” says Sevilir, “and helps enhance the performance of the firm.”

Alan Morantz

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