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How Venture Capital Professionalizes a Firm

February 2001

STANFORD GRADUATE SCHOOL OF BUSINESS—Many factors come into play when a startup morphs into a modern corporation. Yet relatively little is known about exactly how this "professionalization" takes place. Cisco, Intel and Yahoo—seeded with venture capital—developed extremely quickly from startups to large, complex organizations. Although a crush of money earned in the bull market of recent years has flowed into venture capital, little is known about its effects on the development of a firm. What role, if any, do financiers like venture capitalists play?

To answer that question, Graduate School of Business faculty members Thomas Hellmann and Manju Puri examined how venture capitalists influence startup companies. Is there a relationship between venture money and the internal organization of firms, particularly the building of the management team? In a traditional financial relationship, investors are involved on the financial side of the business but not on the human resource side. "Generally, people in Silicon Valley think venture capital makes a difference-that it's more than money," says Puri, who is associate professor of finance. "It provides a number of services besides financing, but until now we have not really had any systemic evidence on this."

First, Hellmann and Puri looked at the question of who gets to be chief executive officer: the founder or an outside professional. As a rule, founders don't last as long in the executive chair if they have venture money. The researchers quantified for the first time that founders are more likely to be replaced by an outsider as CEO if they obtain venture capital and that venture-backed companies make leadership changes faster than other companies.

Second, they analyzed the timing of certain milestone events that are key indicators of professionalization. These included development of a stock option plan, which formalizes the incentives between owners of a firm and employees, as well as the hiring of a vice president of sales and marketing, a critical position responsible for pushing the commercial orientation within a startup. The researchers found that venture-capital-backed firms are more than twice as likely to adopt stock option plans than startups without venture money. And they found firms with venture investment hired a vice president of sales and marketing faster than other startups.

Finally, they examined whether venture capitalists played the same role in all companies or whether their role was tailored to the phase that a startup is in. They divided their sample of companies into those that had gone public, those that had a product on the market, and those that had no clear sign of success yet. They found that venture capital is particularly important for attracting a CEO to companies that had no signs of success yet, still important for companies with a product, but no longer important by the time the company had gone public.

Data on venture capital is scant, so Hellmann and Puri tapped into a unique source of information that has been developed at the Business School over the last five years: the Stanford Project on Emerging Companies (SPEC). The endeavor has tracked the organizational development of 173 startup companies in Silicon Valley. Using SPEC findings, new surveys, interviews, and public information, Hellmann and Puri constructed a data set that allowed them to observe financing histories, if and when startups obtained venture capital, internal organization of the companies, the date of arrival of an outside CEO, the recruitment process of senior executives, and the adoption of stock option plans. "The strength of the data is that it allows us to examine the role of venture capital by looking at a variety of issues," says Hellmann, who is assistant professor of strategic management.

Hellmann and Puri's latest research is part of a growing academic literature known as "the theory of the firm," which sheds light on a question that has received surprisingly little attention. That is: How are resources stitched together to create a company? The paper is also relevant to issues of corporate governance, or control. Signifying the growing importance of this research, Hellmann and Puri recently received National Science Foundation grants to conduct two more studies on the effects of venture capital, including one on the difference between bank-backed and independent venture money. They have already completed several other studies including one that showed that venture-capital-backed companies with first-of-a-kind products were faster to market with their products than similar companies with other types of financing (see Stanford Business, June 1999).

With the surge of venture capital flowing into economies everywhere, there is a need to better understand how it works. "There's more interest today than there might have been 15 or 20 years ago," says Puri. "It's not just in the U.S. but the world over. Governments are trying to figure out how to jump-start nascent industries and venture capital. Right now, we don't have a large number of answers, so we need more research."

Related Information

A Theory of Strategic Venture Investing, Thomas Hellmann, Journal of Financial Economics (Vol. 64, No. 2), May 2002

Research Papers

Venture Capital and the Professionalization of Start-up Firms: Empirical Evidence, Thomas Hellmann and Manju Puri, GSB Research Paper #1661, September 2000