Bet on the Horse

New research analyzes how companies evolve from early business plan to initial public offering to public company.

Some venture capitalists (VCs) believe a company’s product and market are the key determinants of its success, while others believe the company’s management team holds the key. This debate is often characterized as whether VCs should bet on the jockey (management) or the horse (product/market) when selecting their investments.

This debate is addressed in the new study “What are Firms? Evolution from Birth to Public Companies,” by University of Chicago Graduate School of Business professor Steven N. Kaplan, Per Strömberg of the Sweden Institute for Financial Research, and Berk A. Sensoy of the University of Chicago.

The authors study 49 companies financed by venture capitalists that subsequently went public. From business plan to public company, they classify and describe each firm’s financial performance, business idea, points of differentiation, nonhuman capital assets, growth strategy, customers, competitors, alliances, top management, ownership structure, and board of directors. They also assess which characteristics stay constant, change, or disappear as companies evolve.

The most striking and surprising result was the almost complete stability of firm business models. Only one company saw its core business change. Within the same core businesses, firm activities tended to stay the same or broaden over time.

Firms stressed the importance of proprietary intellectual property, patents, and physical assets in all three stages, and these characteristics became increasingly important over time. Though the human capital of the sample firms changed substantially, the uniqueness of the firm, nonpeople assets, customers, and competitors remained relatively constant.

The authors interpret the results as favoring the product/market (horse) view of VC investing more than the best-available-management-team (jockey) view. At a relatively early stage, the businesses were fixed and did not appear to change appreciably. At the same time, it appears that VCs were regularly able to find replacements for their management teams if they were not appropriate for the business. The authors do not find cases in which VCs invested in good managers and significantly altered the company’s business.

“The glue holding the firm together at a very early stage is composed of the patents, the stores, and the processes,” says Kaplan. “Except—perhaps—for raw start-ups, VCs should bet on the horse. We see the jockeys changing, but we don’t see the horse changing.”

Growth and Development

Kaplan, Strömberg, and Sensoy gathered their data from business plans collected from their previous studies. The final sample consisted of 49 companies that went public. For each company, the authors obtained an early business plan or business description at the time of a VC financing from which they identified early characteristics of the firms.

The authors also had detailed descriptions of the companies at the time of their initial public offering (IPO). When available, they collected the company’s annual report closest to 36 months after the IPO. Annual report descriptions were obtained from SEC form 10-K filings. The majority of the IPOs took place in 1998, 1999, and 2000, at the height of the technology boom. Sample companies were heavily weighted toward high-tech firms.

The extremely rapid revenue growth exhibited by the sample suggests that the companies were successful in supplying products and services to fast growing segments of the economy. Rapid revenue growth into millions of dollars per year is characteristic of the types of start-ups that VCs try to select. Despite increases in revenues, assets, employees, revenue per employee, and market capitalization, the median company did not become profitable by the time of the post-IPO annual report.

To differentiate themselves from competitors, the firms focused on delivering a unique product, with customer service becoming an increasingly important source of differentiation over time. Alliances and partnerships were of modest importance.

At the business plan stage, 45 percent of firms cited the expertise of their management and employees as a distinguishing characteristic. This claim declined to 14 percent at the IPO stage and 13 percent when the first annual report was issued. The result suggests that nonhuman capital plays a more important role for firms than specific human capital, particularly as companies mature.

Evolutionary Characteristics

For the companies in the sample, the median market capitalization increased sharply from $17.9 million at the business plan stage to $204.9 million at the IPO, then declined to $176.9 million at the annual report stage. The market capitalization figures indicate a roughly tenfold increase in value from business plan to IPO over a period of roughly three years. Despite being unprofitable, the companies were highly valued.

For each company, Kaplan, Strömberg, and Sensoy determined if the description of the business changed (for example, if the firm sold to a completely different set of customers) or if the firm markedly changed the products/services it offered. They also considered whether firms broadened, narrowed, or maintained their initial business model or line of business.

While the authors observed broadening or narrowing of business focus, only one of the 49 companies in the sample changed its line of business or basic business model. The authors did not observe any of the companies undertaking acquisitions unrelated to the original business. This suggests that the initial business lines and/or accompanying attributes of those businesses do not change.

Patents and physical assets became increasingly important from the business plan and IPO to the annual report. Intellectual property, whether patented or not, is substantially more important than physical assets.

Through the entire evolution of a company, the firms were focused on internal growth. The firms aimed to produce new or upgraded products, adding customers via increased market penetration or market leadership. The firms also planned to expand geographically. All three types of internal growth peaked at the time of the IPO.

External growth through alliances, partnerships, or acquisitions became relatively more important over time. Growth strategies tended to broaden between the business plan and the IPO stages. By the IPO, companies tried to grow along more dimensions than at the business plan stage. Surprisingly, growth strategies seemed to narrow between the IPO and annual report.

At the business plan stage, only 47 percent of the firms had customers. These figures increased to 90 percent at the IPO and 95 percent by the annual report. The majority of companies addressed a similar customer base, either business or consumer, during all three stages. The results suggest that the firms’ dramatic revenue increases were primarily driven by selling more to an initial customer type through increased market penetration or by selling additional products.

At the business plan stage, 84 percent of the companies faced competition in their target markets. All companies faced competition by the IPO stage. The type of competition remained fairly stable, with 56 percent of the firms claiming to face similar competitive threats during all three stages. Roughly 40 percent saw a broadening in the types of companies they competed with, while one company saw a narrowing.

The use of strategic alliances increased from the business plan stage to the IPO, and then was flat from the IPO to the annual report. Overall, only a median 20 percent of alliances at the business plan still existed at the annual report.

To assess the human capital aspects of the firm, the authors looked at the top five executives described in the business plan, IPO prospectus, and annual report. At the time of the business plan, 12 percent of the companies, mostly biotechnology firms, did not have a CEO, 42 percent listed a CFO as one of the top executives, and 38 percent listed sales or marketing executives. Consistent with the importance of technology for these firms, 77 percent of the companies listed a chief scientist, chief technical officer, or VP of engineering in their top five executives.

By the time of the IPO and annual report, the majority of firms listed a CFO as a top five executive. The importance of the chief technology officer or science officer remained stable at the IPO but declined substantially by the annual report.

Founders were heavily involved with the companies at the time of the business plan, but their involvement declined. CEO turnover was relatively low from the business plan to the IPO, with 84 percent of CEOs remaining in place.

The turnover of the CEO and five other top executives was more common after the company went public. From the initial business plan to the annual report, only 50 percent of the CEOs and 25 percent of the other top five executives remained the same.

The Glue

The study suggests that very early on in a company’s life it is the business that is most important for a new firm’s success. The authors stress this should not be interpreted as saying that specific human capital is unnecessary or unimportant. “Obviously, a specific person has to have the initial idea and start the firm,” says Kaplan.

Proprietary, but nonpatented, intellectual property is indeed critical to many firms. In contrast to nonhuman assets, however, the importance of specific people and initial expertise diminishes early in the firm’s life cycle. Once the firm’s nonhuman assets are established, it seems possible (and not unusual) to find other people to run the firm.

“Human capital is important, but the specific person appears less so,” says Kaplan. “When you have a business with strong nonpeople assets, you have something that is enduring, and you can start finding the right people to work with those assets.”