achieving structural transformation toward a pyramidal model. The dia- gram below summarizes the issues addressed in these sections regarding the trigger events, barriers to transitioning, and organizational contexts that facilitated or hindered the adoption of pyramidal structures.
I. Trigger Events 1. Generational transitions 2. Market uptick: Fund raising,
scale, and growth 3. Strategic changes
• Geographic expansion
• Stages of investment
II. Barriers to Transitioning 1. Costs to the firm
• Imperiling returns
• Endangering firm culture
• Weakening firm reputation 2. Market downturn
3. Internal and external resistance
III. Organizational Context 1. Past firm performance 2. GP backgrounds
3. Compensation arrangement
ORGANIZATIONAL STRUCTURE AND
However, some of the patterns in the pyramidal industrial firms of past research may not hold in PSFs. Compared to capital-intensive firms, PSFs provide clients with services that are largely intangible and difficult to
‘‘inventory,’’ their businesses are subject to information economies, and their core assets are the people who work in them – the proverbial ‘‘elevator assets’’ (Maister 1993). These knowledge-intensive firms include such PSFs as investment banks (Eccles and Crane 1988), law firms (Gilson and Mnoo- kin 1989; Sherer 1995), management consultants (Maister 1993), and ven- ture capital firms (Gompers and Lerner 1999). Even compared to other service organizations, which use a large base of fixed assets to deliver rel- atively standardized and simple products to clients and customers, the products of PSFs are relatively complex and usually feature ‘‘entrepreneur- ial problem solving’’ and customized solutions (Morris and Empson 1998;
Lam, 2000). From an economic perspective, PSFs are formed to share risks by pooling expertise (Gilson and Mnookin 1985). The key input in these firms is the expertise of a firm’s employees (Prahalad and Hamel 1990;
Drucker 1993), and the emphasis in such firms is on esoteric (or ‘‘tacit’’) expertise over widely shared (or ‘‘explicit’’) knowledge (Polanyi 1966). As a result, these firms ‘‘present particular problems of organization and man- agement.’’ (Blackler 1995:1028) For instance, they rely on apprenticeship relationships because tacit knowledge has to be conveyed through strong personal ties between the source and recipient (Hansen 1999), and the junior staff must acquire necessary tacit knowledge via mentoring and socialization (Nonaka 1994;Lam 2000).
Early in their lives, the most striking structural characteristic of these PSFs is the fact that many are not structured as pyramids (Wasserman 2002). Instead, they are often structured as ‘‘upside-down’’ pyramids, with multiple people at the top of the organization and fewer people at each successive level down. In short, the people at the top of these organizations decidenotto gain the presumed benefits of hierarchies, such as the increased efficiencies of delegation, the development of specialized expertise at differ- ent levels of the organization, and the use of promotion as an incentive.
However, in industries such as law, investment banking, accounting, and management consulting, firms transitioned away from these structures and toward large pyramidal structures. This chapter examines an emerging transformation in the VC industry, both to gain a better understanding of the transformation itself and to begin to assess whether the VC industry will follow in the footsteps of these other industries.
Gaining a better understanding of these organizations is particularly im- portant today, given the significant increase in similar knowledge-based Upside-down Venture Capitalists and the Transition Toward Pyramidal Firms 155
organizations within the economy (Starbuck 1992) and the important eco- nomic role played by venture capitalists (Gompers and Lerner 2001). It can also provide insights into the broader issue of transformational change (e.g.
Miller and Friesen 1980; Tushman and Romanelli 1985; Romanelli and Tushman 1994) helping us understand the factors that can either trigger or hinder the ‘‘revolutionary’’ changes that punctuate longer periods of ‘‘con- vergence’’ within organizations. Below, I describe the work performed by VCs and the structures historically adopted in their firms, my approach to studying the structural transformations within the industry, and the findings from my field-based research with almost two dozen VC firms from 1998 to 2002, including three months spent working as an associate inside a VC firm.
Venture Capital Firms
Venture capitalists are professional private-equity managers who invest capital in young companies. Before investing, VCs expend a lot of time and effort collecting information on each candidate investment, examining the company’s management team, its ability to develop products or services, its business model, and the market it is targeting. Much of this information is subjective, instinctive, and holistic. In collecting this information and mak- ing decisions about whether to invest in a company, VCs must rely heavily on their intuition, years of experience in working with young companies, and tacit knowledge about business and technology. Once this information has been assessed, they decide whether to invest in the company and, for those in which they invest, help the company grow and develop.
There are two major ways in which VCs try to manage the risks of in- vesting in such companies. The first is by building a portfolio of investments, in an effort to diversify risks across many companies in ways that an in- vestor in a single company cannot. The second is by performing extensive pre-investment due diligence in order to assess the quality of each potential deal. They assess the entrepreneur’s abilities (and those of her team), the chances of developing an operational product, the market need for such a product, how competitors might respond, and the potential responsiveness of the stock markets to an IPO of the company’s equity. Once they have decided to pursue an investment, the VCs negotiate the terms of that in- vestment with the entrepreneur. During negotiation over the terms of their investments, VCs seek to craft terms that both will provide entrepreneurs with incentives to build their company’s value and will protect the VCs from losing their entire investment.
Within these firms, general partners (GPs) are the senior leaders of the firm who raise capital from and sign funding agreements with the limited partners (LPs) who invest in venture firms. The GPs are responsible for crafting firm strategy, attracting and investigating business plans from high- potential start ups, and making the final investment decisions that imple- ment their chosen strategies. After investing in a company, they play an active role in helping shape and build the company, sometimes also serving on the company’s board of directors. Internally, GPs are incharge of VC- firm governance, and decide whether and when to hire additional (junior) staff to assist them with performing their jobs. These junior staff include both mid-level Principals and junior Associates. Principals are ‘‘GPs in training’’: younger, less experienced VCs who draw upon several years of experience to perform many of the tasks that otherwise would be performed by the GPs, but which can be performed by the Principals with only a small loss in effectiveness. Associates are recent graduates with little or no work experience, who work alongside one or more of the GPs or Principals, perform tasks delegated to them, and facilitate communication within the firm. They often bring with them technical or business/financial skills gained in school, and spend years working under more senior VCs to learn the business.2
Almost as a rule, VC firms are very small organizations, in contrast to the industrial firms of past research, which often needed to grow to a substantial size in order to have a significant economic impact. This is because PSFs can have a large impact even while consisting of only a few people (Baker and Smith 1998).3Therefore, the effects of size and growth may be particularly important to examine for these firms. As we will see below, the firm’s stage of development, capital availability, and the nature of the work performed within the firm all played key roles in the transition toward pyramids.
Structures within VC Firms
Consistent with the finding that the dominant type of knowledge in an organization affects organizational form (Lam 2000), a VC firm’s strategy and the associated predominant mode of knowledge have a powerful effect on the structure adopted within the firm (Wasserman 2002). Most impor- tantly, the stage of company on which the firm focuses its investments plays a pivotal role in its structuring. For ‘‘later-stage’’ VCs, who assess mature companies that have been in existence for several years and have a lot of historical performance data that can be analyzed, their tasks are more sep- arable and codifiable, which enables the GPs in these firms to delegate discrete subsets of their job to junior staff. For this reason, later-stage firms Upside-down Venture Capitalists and the Transition Toward Pyramidal Firms 157
are able to build structures that are more pyramidal and leverage the efforts of junior staff. In contrast, ‘‘early stage’’ investors assess young companies that have little or no history and must base their decisions on intuition and the pattern recognition that comes from years of working with young com- panies. In these firms, VCs’ jobs are holistic and based on tacit knowledge that either cannot be codified or would suffer from being codified, so the GPs are not as able to separate their job into discrete tasks that can be delegated. Because junior staff are of little use to these GPs, early-stage firms rely predominantly on GPs and cannot use many junior people.
To illustrate the difference in structure between early- and late-stage VC firms, the chart below shows how, for 2000, these different types of structures were distributed in my large-scale dataset.4Firms whose struc- tures were GP-only made up 38% of the dataset, with the other firms split between majority-GP (39%) and majority-non-GP (24%) firms. Non- pyramidal structures were particularly dominant in early-stage VC firms, but less prevalent in late-stage firms.
GP-only
Majority GP
Majority
non-GP Total firms % of firms
Shading Key
Early stage 44% 37% 19% 78 24% 41-50%
41% 40% 19% 132 40% 31-40%
32% 39% 28% 82 25% 21-30%
Late stage 29% 34% 37% 35 11% 11-20%
Total firms 123 126 78
% of firms 38% 39% 24%
In quantitative terms, we can use the metric of structural leverage to refer to the degree to which firms are GP-only versus pyramidal. Structural lev- erage is the ratio of the number of lower-level staff to the number of higher- level staff, and indicates the extent to which organizational leaders try to use the efforts of lower-level employees to achieve the organization’s objectives (Sherer 1995). The higher the structural leverage, the more pyramidal the organization; GP-only firms have structural leverage of 0 (a ratio of 0 non- GPs to the number of GPs), while pyramidal firms have structural leverage of greater than 1 (more non-GPs than GPs). The chart below shows the distribution of structural leverage across the firms in my dataset during 2000. While there are some pyramidal firms (i.e. structural leverage of 1.0 or above), non-pyramidal firms are much more common in the VC industry,
whether we compute structural leverage using all personnel in the firm (i.e.
including full-time support personnel and others who are not investment professionals) or using just investment professionals (i.e. GPs, principals, and associates).
Histogram of Structural Leverage (for 2000)
0 10 20 30 40 50 60 70 80
0 0.1 0.2 0.3 0.4 0.5
0 .6 0.7 0.8
0.9 1
1.1
1.2 1.3 1.4
1.5 More Structural Leverage
# of Firms
Investment Professionals All Personnel
While performing field research in the late 1990s to understand the dif- ference in structures between early- and late-stage firms, I found a small number of firms that were in the process of trying to transition from their long-standing upside-down structures toward pyramidal structures, consist- ent with the past transitions in other PSFs. As an emerging transition, studying the transformations within these firms promised to fill in many of the details that could not be examined in past PSF-transformation studies.
However, as I followed the evolution of these firms over time, it also became apparent that most of the firms were encountering strong barriers to tran- sitioning that imperiled such a major change. These barriers to change could prevent the firms in this industry from following in the footsteps of the
‘‘formerly cottage’’ firms in other PSF industries. Therefore, I spent the next couple of years trying to understand the events that were leading these firms to try to transition and the process by which they were trying to do so, but also delved into the barriers that might prevent such a change and the organizational contexts that might facilitate or hinder such a change.
An Overview of the Structural Changes
The first institutional VC firm, American Research and Development, was founded in 1946 by Harvard Business School professor General Georges Doriot and MIT president Karl Compton. Since then the non-pyramidal Upside-down Venture Capitalists and the Transition Toward Pyramidal Firms 159
organizational structure has predominated in the industry. Indeed, many VCs in firms I studied said that they still felt little pressure to change their long-standing structures. Their current approaches had been performing very well, their GPs were relatively young and planned to be active VCs for many more years, and they had not recently made any strategic changes. The following comment was representative of the thinking in such firms:
With the Sequoia guys, the inner sanctum of managing partners are all in their early 40s, with no interest in going anywhere.yBringing in Associates isn’t good if you do it too quickly, when you don’t need to make a generational transition. You have to do it only when you want, in 4 or 5 years, to have developed a full-fledged GP. {Principal in large California firm}
However, other firms were undergoing fundamental changes. Rather than making small, incremental changes on a person-by-person basis, firms were changing their approaches and structural models in ways that signaled a fundamental shift in how they performed their work as VCs. The people in these firms insisted that this new model had become necessary as the industry matured.
This is a cottage industry in its infancy – it will mature and move into the organizational form of more-mature industries. {GP in early-stage California firm}
In the ‘‘traditional’’ VC arrangement, each GP typically performs all tasks for each of the potential and actual investments for which the GP serves as sponsor. The same person performs due diligence, negotiates terms of the deal, and works with the company after investing in it. However, several firms I studied decided to make a dramatic shift in the GP’s job. They split the job into multiple, discrete tasks, and hired specialists to perform some of them. For instance, some firms hired junior staff to whom a GP could delegate analysis tasks, while other firms brought in ‘‘venture partners’’ to sit on boards of directors instead of the GPs. Other firms hired functional specialists, such as executive recruiters or turnaround specialists, to work with portfolio companies on specific tasks that used to be performed by the GPs. As a result, these firms added a relatively large number of non-GPs, thereby making a fundamental shift in both their structures (toward py- ramidal organizations with functional specialists) and their work processes (toward discrete tasks).
At firms like Crescendo and Battery, they aren’t just supplementing the orthodox model with a couple of discrete tasks that can be handled by support staff. They are entirely
revamping the way that VC firms operate by relegating [to them] some of the vital GP functions – domain expertise and assisting companies. {Industry analyst}
For instance, one Boston firm, which was comprised almost solely of GPs 5 years ago, hired eight Associates in 2000–2001 and made plans to transition to a classic pyramid over the next two years.
We’re now talking about building our ‘‘power pyramid.’’yWe’ve had a lot of dis- cussion about ‘‘how steep should the sides be?’’ We’re thinking that 1:2 would be too much for us, just given the senior partners we have and the limits on their abilities to take the time to mentor junior people, but we’re looking to go to 1:1.5 in the near term. Our plan is to go to 8 investing GPs plus the MP and COO, 12 Principals, and 20 Associates.
{COO of Boston firm}
Instead of being a ‘‘one-man show,’’ GPs in these firms now played more of a coordination role in which they performed tasks that only GPs could perform, but spent the rest of their time facilitating the efforts of the junior or specialized personnel working for them.
The tasks that these VCs separate and delegate to junior staff seem to share four main characteristics (Wasserman 2002). First, the inputs into the tasks and outputs out of the tasks are well defined, which facilitates the interactions between the people performing the tasks and those performing related tasks. Second, the processes required to perform the tasks that can often be codified and formalized, enabling the firm to provide detailed guidance to the junior staff and to check the quality of their work. Third, the people performing the tasks can become more productive by developing specialized expertise in them. Fourth, having an Associate or Principal per- form the tasks would not harm the relationship that a GP has with the entrepreneurs or LPs with whom the GP interacts.
In addition to splitting up the job, many of these VCs also broadened the scope of their work by bringing some tasks in-house, hiring their own people to perform them instead of outsourcing. In some firms, these were pre- investment analytical tasks that they used to ‘‘farm out’’ to investment bankers, while in other firms they included such post-investment tasks as executive search, which had been outsourced to external executive search firms. Some of these post-investment tasks included those which GPs used to perform themselves, but which specialists – even those with fewer years of experience than the typical GP – could perform with higher quality. For instance, one Boston firm hired mid-level people who specialized in helping turn around portfolio companies that encountered major problems as the market turned down. The firm’s MP stated, ‘‘We now push our problem Upside-down Venture Capitalists and the Transition Toward Pyramidal Firms 161
children to our specialists and let them handle them.’’ Similarly, a New York firm hired a team of mid-level specialists:
We have an in-house consulting firm now. For example, if company has an issue, we have a couple of Director-level people who’ve been CFOs in troubled situations who come in to help. {Principal in large New York firm}
Other firms tried to broaden the range of services they provided to their portfolio companies, in an effort to become ‘‘full-service providers.’’ Firms that used to focus on delivering a particular type of value to their portfolio companies, such as technical guidance, added specialists, marketing con- sultants, and in other areas.
This is meant to be a selling point at a time when cash is a commodity, and firms are driven to differentiate themselves to get the best deals. {Industry analyst}
Once again, these shifts resulted in the hiring of more junior level or spe- cialized staff, broadening the pyramidal structure of the firm.
It is important to note that the transition from being GP-only or ‘‘upside down’’ to a pyramid could take different paths. For instance, in the Salta case (Wasserman 2002), the firm moved from being GP-only to being upside down (hiring a couple of non-GPs), to have an hourglass shape (many GPs, many Associates, almost no mid-level Principals), to pyramidal (as some people from the initial wave of Associates have moved into mid-level po- sitions), before regressing toward a less-pyramidal structure (and parting with the COO who had been hired to lead the transformation toward a pyramidal structure). Other firms skipped the ‘‘hourglass’’ stage by hiring mid-level people from the outside at the same time as they were hiring Associates. At the same time, another firm first built a hierarchy within its GP team, by creating a Managing Partner position and a small management committee at the top of the GP team, before beginning to build a pyramid at the bottom of the organization. Therefore, while the initial starting point and the target ending point for these firms is similar, their interim transi- tional structures may differ.
We can use my quantitative dataset of VC firms to explore the structural changes on a larger scale. To examine structural changes between 1997 and 2000, I selected the firms that were in the dataset throughout those 4 years, and then calculated summary statistics of how they changed their structural leverage between 1997 and 2000. As shown in the histogram below, with regards to the structural leverage within each firm, there was a wide range of changes across the industry. Overall, the firms increased their structural leverage by an average of 0.031 between 1997 and 2000. However, 110 of the