I regret to say that I've personally served on a dozen boards of venture backed companies that have replaced CEOs. It's usually not a good sign. It doesn't mean those start-ups were doomed; but it does mean drastic change was needed.
The decision to replace a CEO is never taken lightly. Replacing any CEO is difficult enough. Replacing a founder/CEO is even more traumatic and fraught with risk.
Although I have never seen a case in which a CEO, even a founder, is indispensable, over the years, my partners and I have formed a strong preference for founders.
Most founders have never been a CEO. Some may have never even had a corporate job (Mark Zuckerberg, for example). Yet we prefer to work with them as they learn on the job.
I won't get into why we prefer founders (not the main topic of this post) but I'd recommend checking out these articles discussing the merits of founder CEOs:
- I first wrote about our preference for founders three years ago: Ousting the Founder
- Ben Horowitz wrote this more recently: Why we prefer founding CEOs
- Steve Jobs' Law: Why Founders Make the Best Leaders
When my partners and I first got started more than 15 years ago, we replaced CEOs quite often (though I'd esimate it was about average for the VC industry as a whole. I'll share actual data later in this post). In contrast, my eight most recent boards have yet to replace a CEO.
One data point which reflects the presence of founder CEOs in venture portfolios is CEO ownership. When we tell people that the typical CEO in an Altos backed company owns more than twice the equity of a typical venture backed CEO, they assume it's because we invest less money (resulting in less dilution). While this is true, the bigger factor is that most of our CEOs are founders.
On average, the minute a board replaces a founder/CEO, that company's CEO ownership percentage drops. For example, when Eric Schmidt was hired at Google, the CEO ownership stake dropped to 4%, far lower than Larry Page's stake.
Another reason we replace CEOs less often is selection bias. We are less likely to invest in the first place if we believe a new CEO will be needed. I'm always surprised when a VC submits a term sheet that calls for the retained search for a new CEO from day one.
We'd rather not make an investment, if we don't know who the CEO will be. As the saying goes, "go with the devil you know versus the devil you don't." We must believe, at least in the beginning, that the person we're backing can develop into a great CEO.
In the case of backing a "professional CEO" we must believe that the person has what Warren Buffett calls "owner mentality" (it might not be as good as founder mentality, but it's better than most).
Of course, this does not mean that we will never fire a founder or replace a CEO. We make plenty of mistakes. To see if we might learn from them, I decided to look at some data from our current and past funds.
After studying a data set of more than 60 companies, I found that the probability of a CEO change increases dramatically with each new round of financing, unless a company is already profitable. A CEO who can control her own destiny is much less likely to get replaced.
Given that the companies in this data set have raised more than a billion dollars from over a hundred different venture firms, I suspect that there is a similar pattern for the entire VC industry, even if specifics vary from fund to fund.
In the chart below, each bar represents a group of companies based on how many rounds of funding were required to get to profitability or exit. The height of each bar represents the percentage of companies that replaced CEOs.
In companies needing only one or two rounds to get to profitability or exit, CEOs were replaced less than 14% of the time. At the other extreme, if a company needed four rounds or more, the replacement rate sky-rocketed to 85%. For companies that required three rounds, the rate was 53%, which is about average for the industry (see article below).
Given this data, I'd advise start-up CEOs to get their companies to profitability sooner. Control your own destiny. Otherwise, deliver an exit before you run out of money and have to raise another round.
When a CEO is replaced, the rationale is usually quite subjective. "The team has lost confidence" or "lack of leadership" are typical quotes from board members considering a change.
For me personally, I've learned that my stress level about any particular company goes up and down with confidence in the CEO, regardless of how the company is doing. Let me try to explain.
Even if a company is doing really well, if I do not have confidence in the CEO, I tend to worry a lot because things might fall apart; and sooner or later, the shit usually does hit the fan.
In contrast, even if a company is struggling, if my confidence in the CEO is high, I stress less because I know there is a smarter and more capable person staying up at night not only worrying about things but doing something about it.
That said, other than obvious reasons such as lying, cheating or stealing, I believe the following are other, more objective, factors correlated with change in CEOs:
- Time - eventually, all CEOs retire, die or get fired.
- Lack of growth - a flat profitable business might be OK for some but not for VC backed companies that promised high growth to investors.
- Employee turnover - higher than normal turnover happens for two reasons: great people are hired but are repelled or mediocre people are hired and must be replaced. Successful companies typically have turnover rates that are significantly lower than industry averages.
- Burn rate relative to cash balance (key metric we track is months of cash remaining)
The following article has some interesting statistics. Out of 50 high-profile VC-backed companies in 2010, 54% had replaced founder CEOs: "Do VCs usually fire founder CEOs?"
I'd also recommend checking out these questions on Quora for more info and discussion:
- On average how often do founding CEOs get replaced by a VC controlled BoD?
- How do VCs eventually come to the conclusion that they need to replace the CEO?
- What skills does a CEO of a growing company need that a founder CEO might not have?
I'd like to emphasize that the data points out a strong correlation, not causation. For example, it's possible that VCs are more likely to replace CEOs in companies that run out of money and have to raise more rounds. It's also possible (and very likely) that start-ups that hire professional CEOs tend to raise more money and go through more rounds of funding.
Founders are much more sensitive to dilution compared to professional management that are granted more options if a company goes through a massively dilutive round. Founders also want to maximize control. The biggest fortunes have been amassed by founders who have been able to retain quite a bit of control over their companies, sometimes decades after the IPO.
The punchline of the article should be "get profitable" rather than "avoid the 4th round."