In my first “Upside-down VCs” post, I asked for input on “upside-down” org structures in VC. Thank you to Jeff Barson and to two anonymous commenters (one of whom provided an excerpt from the “Understand the Math” part of this post from Seth Levine) for contributing their thoughts. Their comments are excellent starting points for the next stage of this discussion.
Jeff and the quote from Seth highlight VCs’ economic disincentives to hire junior people: that GPs pay their junior hires out of their “overhead” or management fees, and thus may make more careful hiring decisions. I absolutely agree that economic considerations are a factor. However, this economic structure is consistent across VC firms, yet we still find structural differences across those firms, so on its own, economic structure can’t be the full story. Picking up on this, the second anonymous commenter suggests that important differences across firms affect whether it makes sense for each firm to hire junior people, but doesn’t delve into what those differences are.
My “deep dives” into almost two dozen VC firms and subsequent quantitative analyses of more than 300 VC firms showed several systematic differences that affected their internal structures. Those differences affected whether each firm built a “pyramidal” structure (with lots of junior people) or an “upside-down” structure (with few or no junior people). The most important difference was the stage of investment targeted by the VC firm: does the VC firm target “early stage” start-ups (i.e., the firm consistently invests in the proverbial “two guys in a garage”) or does the firm target “later stage” (i.e., more mature) companies? I found that, compared to later-stage investors, early-stage investors are much more likely to be upside-down.
Quantitatively, for a prototypical VC firm with 10 GPs, I found that a typical late-stage VC firm had hired almost five more (more precisely, 4.8 more) non-GPs than did the typical early-stage VC firm, even after controlling for a wide variety of other differences between firms.
Methodological Note: Although the graphic above shows 2 prototypical structures (“upside-down” and “pyramidal”), internal structures vary considerably in how “flat” they are. To capture this variation, my quantitative measure of internal structure is a continuous measure of structure, structural leverage (e.g., Sherer 1995 on law-firm structures), that varies from 0.0 (no junior staff) to more than 1.0 (more junior staff than GPs).
Why do later-stage firms hire more junior people? Part of the quote from Seth Levine hints at a relevant decision rule: that a junior person will be hired only if he or she increases the firm’s investment returns enough to justify the junior person’s cost.
All of this suggests the following question: Why are junior hires more valuable to later-stage investors than to early-stage investors? (In terms of Seth’s decision rule, why can a junior hire in a later-stage VC firm increase the firm’s investment returns more than a junior hire can increase returns in an early-stage VC firm?)
Looking forward to getting your next round of thoughts….
Seems to me that the process of getting a deal done is different in the two models. In early stage investing, deals are driven almost instinctually: how big do I think this emerging market can get, how well do I think these entrepreneurs can execute. To make those decisions well requires good investing instincts and judgement honed through years of experience and deep industry expertise, and you just can’t get that from junior folks. Also, deal flow is driven almost entirely through firm reputation and personal relationships. The late stage biz is different, and is increasingly resembling the investment banking world (ie, highly paid and glorified salesmen). Need to do a fair bit of financial modelling and nowdays even pitch books. The deals are generally more competitive processes where there’s a fair amount of grunt work which might ultimately end in a lost deal. Outbound calling is the norm. These are all areas where you can get a ton of leverage out of junior talent, and the payoff is obvious.
I was essentially going to write what Amir already did so I will simply say I agree with his assessment. The later stage firms definitely do more smiling and dialing to get deals and they do work with financial models and other paperwork which is exactly why they need to hire more junior folks. Early stage firms are absolutely more instinctual in terms of making investments so GPs with experience are most in need.
This post highlights a key area that is often overlooked in VC firms, the pyramid structure. Different from the way many other companies operate with interim goals as milestones along the road to an ultimate goal, VC success is difficult to demarkate along those lines. From this view, there is another way of looking at the difference in a junior person’s role and why early stage firms hire fewer people. The investment required for training a junior person may greater in an early stage firm than a later stage firm. This is because the nature of the training period may be so much longer in light of the longer period of investment, and thus “early stage” of the companies.
Great comments above- and I agree. I would add that later stage firms may also have larger fund sizes (= more fees) and can afford a larger junior staff. Moreover, the type of guidance and support portfolio companies need in early and later stage deals is different - early stage deals tend to need more executive or long-term strategic leadership, and entrepreneurs will most likely want to engage with more seasoned (senior) investors. Later stage deals tend to already have a full mgmt team in place and the ‘value-add’ is more financial / market driven. Avg. hold time for later stage deals is 3-5 years while early stage deals is 5-7.
The data might be masking another form of leverage. For the reasons already mentioned, early stage VCs don’t get their leverage through junior people (as compared to later stage private equity shops). However, they do get leverage in other ways, for example with “venture partners,” “special partners,” “entreprenurs-in-residence,” etc. Instead of hiring one junior person, they’ll hire a “fractional senior person.” A lot of the the people that would show up in your data as a “senior person” are not in fact full time or compensated like a partner.
You’re absolutely right that those “fractional people” are an important part of the story, Furqan, especially in recent years. Because of that, the quantitative models included measures that both included and excluded those people, to make sure that the results were robust to both measures. (I also did extensive robustness tests for several of the other key metrics — e.g., various measures of how “early stage” each firm was, of the size of each firm, etc.)You do raise an interesting related question about whether early-stage firms can/do make more use of those “fractional people” than do later-stage firms, or vice versa. So: Anyone have any thoughts or observations regarding why the use of those people would differ between early- and later-stage firms?
I’m a partner at a for-profit incubator. We’ve found that younger people’s lack of expereince is a terrible handicap in early stage firms. The founders are often groping, and may be throwing away a business plan every month or so. In this unstable climate, a seasoned voice can be a great help to the founder. This is a contrast to the freshly minted MBA, who knows theory but no customers, and who knows something about financial engineering, but his skills don’t work too well in a pre-revenue company. The experinced person, if they know something of the target market, potential corporate alliance targets, and/or technology, knows the real world. One of my partners is fond of quoting the story of Aristotle’s horse. His students attempted to debate whether a horse rose to its feet by standing on it’s back or front legs first. They had wonderful arguments. The great teacher refused to disucss it, and told them to find a horse and watch what it did. The seasoned startup person has seen the horse, and the new MBA has not.
Forgive my naiveté, but what is unique about investment firms that makes the answer to this question different than for any other type of firm?I agree with what everyone else has said. As a junior person myself, I can attest to the fact that we’re wrong more than we’re right. In early-stage ventures, you need to be right more often to gain momentum, while in later-stage firms, the flywheel is already turning, so being wrong is less harmful. But then again, because of my junior status, I am probably missing something ;)
Hello Noam,Very interesting conversation.I have a hypothetical for you. Two gentle start a project 4 years ago. They put a tremendous amount of work into in regards to research, and developing a business model at a tremendous personal expense to both of them plus they were successful getting through all the government red tape. The natural resource required for the project went up to an Expression of Interest from the government and they made a submittal for the resource and it looks as though they are the winning Proponent.5 months ago they asked another gentleman to join their founders group and whereas he had more experience as a CEO in larger Corps. than either of the other two founders did they thought it best for him to take over a CEO. The 3 them done the Proposal for the Expression of Interest.Three of them signed a Founders Agreement giving them 3 equal shares of the company pre-investor.Now the new CEO is insisting that the two original founders give up more of their founder’s shares to compensate him as CEO before they take on investors. Even though the two original founders have put much more time and personal expense into the project than the new CEO did.My question is:Should his CEO compensation package be done now (pre-investor) or after investors are taken on???Should the new CEO get more founders shares than the original founders?? If so, what amount is fair??Any commitments would be appreciated.ThanksTerry
Hiring junior people means hiring managers for junior people. Hiring self-led/experienced individual contributors - although each is more expensive on the front end - means not having to pay people/hours to manage/mentor/teach/train the juniors, which is a luxury early-stage startups can't afford. Experienced hires are capable of more output/$ and develop traction immediately, speeding time to market.At some point, hiring juniors becomes not only reasonable, but desirable. There's a shift of economy. This date drops differently in each startup. We can afford to spend time, attention and money developing junior talent. Importantly, now that the sr. people have made all the errors themselves and self-corrected(more quickly than juniors could), they actually have concrete knowledge to transfer. At this point, you have a critical mass of senior talent and it's more cost-effective to hire juniors for new positions than it is to add on more experienced hires.I deal with this a lot in recruiting for startups & emerging firms. As you can imagine, there are a host of variables affecting exactly when this shift occurs: model, management style, capital availability, hands-on vs. strategic work needed, etc.One thing is for certain: the ability to see this even on the horizon and act accordingly is a key contribution to making startups successful.