Management Assessment Methods in Venture Capital: Towards a Theory of Human Capital Valuation
Geoffrey H. Smart, Claremont Graduate University
Legendary venture capitalist Arthur Rock said, Nearly every mistake Ive made has been in picking the wrong people, not the wrong idea (Bygrave & Timmons, 1992, p.6). His quotation illustrates the frustration that many venture capitalists experience when their investments achieve disappointing results due to weaknesses in the human capital that were not detected during due diligence. This study examines the methods that venture capitalists use to assess the senior managers of new ventures prior to making an investment decision. The lack of theory and empirical research in this area has led scholars to call for studies which examine the process of management team assessment in venture capital due diligence (Siegel, Siegel, & MacMillan, 1993; Timmons & Sapienza, 1992). This is the first study to heed their call that combines field research (N = 86 cases) with theory from psychology and economics to attempt to generate new theoretical and empirical insights. Human capital valuation is introduced as a term to describe the process of appraising the human capital (people) in a venture. An a priori conceptual model was tested that accounted for over 70% of the variance in the accuracy of human capital valuations. In addition, inductive analysis yielded several distinct typologies of venture capital approaches to the process of human capital valuation. Implications for researchers and practitioners are discussed.
When a venture capitalist makes a decision to invest in an entrepreneur, one of two outcomes is likely. The new venture will use the funding to grow, create jobs, and contribute to economic prosperity. Or the venture will eventually whither and die, waste the scarce funding dollars, destroy jobs, and fail to create value. Venture capitalists realize that they are often betting on people when they make investment decisions. They hope that their assessments of the people are accurate. How do venture capitalists assess people? Advancing our understanding of this important process of human capital valuation is the focus of this study. This study has three main research questions:
What methods do venture capitalists use to conduct human capital valuations?
What relationships exist between the methods that venture capitalists use and the resulting accuracy of their human capital valuations?
Why do venture capitalists
use certain methods?
Human capital, as it is defined it for this study, is the propensity of a person or group to perform behaviors that are valued by an organization. The term human capital was originally used by Nobel economist Gary Becker (1964) to refer to the stored value of knowledge and skills of members of the U.S. work force. The consensus among scholars is that human capital contributes to the performance of new ventures (Elango, Fried, Hisrich, & Polonchek, 1995; Cooper, Gimeno-Gascon, & Woo, 1994; Stuart & Abetti, 1990; Dubini, 1989; Stuteville, 1988; Kozmetsky, Gill, & Smilor, 1985; MacMillan, Siegel, & Narasimha, 1985). Human capital influences the behaviors that are performed by the members of an organization. These behaviors have economic value to the organization and market. Venture capitalists attempt to assess the degree to which the human capital embodied in the companys managers is likely to lead to the behaviors that are valued by the organization and market. The human capital valuation model is framed in the spirit of business valuation. Consider the parallels. Business valuation has to do with making projections of future cash in-flows and then figuring out what these expected future streams of cash in-flows are worth today. Human capital valuation has to do with making projections of future behaviors that human capital is likely to perform, and then estimating the present value of that future stream of behaviors. Business valuations typically use past financial performance as a guide in making estimates of future performance. Human capital valuations may use past behaviors as a guide in making estimates of future behaviors. An accurate human capital valuation is expected to help contribute to the overall accuracy of the business valuation and therefore help venture capitalists make better investment decisions.
Progress in this field has been plagued by one persistent problem. It is not clear how to accurately assess the human capital of a venture factor prior to making an investment decision. Scholars in neither the entrepreneurship field, nor the field of psychology, have provided models or methods for conducting human capital valuations in the context of venture capital due diligence. Perhaps one reason for this void in the literature is that human capital has been considered an intangible factor for many years by economists and finance scholarsmeaning that it cannot be accurately assessed during due diligence (Eskew & Jensen, 1992). Other scholars believe that it can be assessed accurately (Harvey & Lusch, 1995), but do not provide any theoretical models or methods to suggest how such an accurate assessment might take place. Stuteville (1988) suggested in Frontiers of Entrepreneurship Research thatalthough good management is so universally believed to be of paramount importance to new venturesour knowledge of how to accurately assess this factor is limited.
Assessing human capital is difficult for venture capitalists. Though no prior research exists to suggest what are venture capital accuracy rates when assessing human capital, anecdotal evidence suggests that this is the most troublesome factor to assess accurately (Harvey & Lusch, 1995; Dubini, 1989). The talent criteria [human capital], perhaps the most important quality a venture capitalist looks for in a portfolio company, is also one of the most difficult areas to assess (Kozmetsky, Gill, & Smilor, 1985, p. 5). David Gladstone (1988), when president of the largest public venture capital firm in the United States concluded, The problem with the venture capital business is that when we analyze people, our perceptions of others are usually wrong (p.30). According to the results of this study, venture capitalists fail to achieve an accurate human capital valuation in 57% of the deals. In other words, venture capitalists experience significant surprises in their assessment of the human capital over half the time.
Turning to the body of literature on management assessment in industrial psychology, we find several insights from previous researchbut none directly addressing the context of venture capital due diligence. Research on assessment began with the need to match people with jobs during the military buildup during World War II. The first 30 years of research in this area were focused almost exclusively on selecting people for entry-level or middle-management jobs in large organizations (Campbell, Dunnette, Lawler, & Weick, 1970). Very few studies exist that examine the methods used to assess senior managers (DeVries, 1993). Of these studies that included senior managers, nearly all were limited to large, traditional corporations like AT&T (Howard & Bray, 1988). In the context of venture capital due diligence, not one empirical study in the industrial/organizational psychology body of literature has examined the specific methods that are used to assess senior managers. Due diligence is the research process that venture capitalists typically conduct before making an investment decision.
The psychology literature tells us what methods are available to assess people. There are seven major categories of assessment methods: job analysis, documentation analysis, past-oriented interviews, reference interviews, assessment centers, work samples, and psychological tests.
Job analyses are typically conducted prior to an interaction with the candidate. The purpose of the job analysis in the context of new venture creation is to answer the question, What human capital is specifically needed for this venture to survive and grow? Subsequent methods are used to collect data to evaluate the degree to which the target managers possess the human capital attributes that were articulated in the job analysis.
Documentation analysis refers to the collection and review of written documentation about the target managers. Such documentation can include resumes, legal records, tax information, and publications written by or about the managers.
Past-oriented interviewing is a relatively recent development. For many years, social scientists were skeptical of any kind of pre-employment interviewing (Roth & Campion, 1992). All interview formats were thought to be invalid predictors of future performance. However, by 1988, researchers began distinguishing among various types of interviewing formats, as opposed to grouping all interviewing into one category, and some interesting findings resulted. A major distinction emerged between the unstructured interview format and the structured interview format. Researchers in the late 1980s and 1990s consistently suggest that structured interviews are considered to be the most valid of all assessment methods, and unstructured interviews are considered the least valid of all methods. A past-oriented interview is a type of structured interview in which the interviewer discusses specific accomplishments and failures in the candidates career history. It is a fact-based interview format that usually follows a chronological pattern through the persons career. Examples of past-oriented questions are Lets talk about your first job. What were some high points and specific accomplishments? How about some specific low points and failures. What might your supervisor tell me were your strengths and weaker areas during that job if I called her? Tell me about a time in that job in which you organized and planned a project from start to finish. Now lets talk about your next job. The underlying notion is that the best predictor of future performance is past performance.
A meta-analysis by Weisner and Cronshaw (1988) found that structured interviews produced mean validity coefficients over three times as high as unstructured interviews. Validity coefficients in this context measure the degree to which a persons ratings after an interview match their actual on-the-job performance. These two researchers reviewed a total of 150 validities with a sample size of 51,459. Unstructured individual interviews had a mean corrected validity of .20. In contrast, structured individual interviews had a mean corrected validity of .63. Subsequent research by Wright, Lichtenfels and Pursell (1989), McDaniel and colleagues (1994), and Dipboye (1994) also support the claim that the structured interviews are valid predictors of future performance.
Reference interviews are discussions with people who have observed the behavior of the target managers. There are several possible sources of reference interviews: personal references, supervisors, coworkers, industry players, current employees, suppliers, customers, lawyers, accountants, bankers, or other investors.
Assessment centers are formal, multi-day sessions in which candidates are tested on their skills relative to the job for which they are applying. It is not clear if an assessment center has ever been conducted during venture capital due diligence. None was conducted in this study.
In contrast to past-oriented interviews, the work sample method does not rely on measuring past behaviors. Work samples provide insights into present or hypothetical behavior. Work samples in the context of venture capital due diligence are sessions in which the venture capitalist quizzes the target managers on various aspects of the business. This looks like an audition: What would you do if . . . How would you . . . ? What do you know about this industry? How will you . . . ? What are your plans for . . . ? The problem with this type of format is that it measures how target managers behave on their best behavior, which may not be how they typically act.
Psychological tests are occasionally administered to candidates for lower-level or middle-level positions in large organizations. These tests measure psychological traits that are considered relevant to the performance of job tasks. These tests rarely surpass the r = .53 level of validity in predicting job performance for lower- to middle-level positions (Van Clieaf, 1991). For senior-level positions that are arguably more complex than narrowly-defined jobs, the use of psychological testing is more problematic. Guion (1991) concluded that it is difficult to advocate the use of personality measures in most situations in which assessment decisions are made.
To summarize, many scholars agree that human capital influences a new ventures performance. Assessing human capital accurately during due diligence can be quite challenging. The half-century of research in industrial psychology on personnel assessment gives us a platform from which to launch our examination of human capital valuation in the context of venture capital due diligence.
The participants in this study were venture capitalists at United States-based venture capital firms. The unit of analysis is the deal. A deal is a transaction in which a venture capital firm invests in a new venture. N = 115 venture capitalists were contacted using a snowball sampling technique (Babbie, 1990). Early respondents were asked to provide referrals to several other venture capitalists, who were contacted by telephone, and so on. Fifty-one venture capitalists participated, yielding a response rate of 44%. The respondents represented forty-eight different venture capital organizations across the United States. Since several respondents agreed to discuss more than one deal, the total number of cases in the study is N = 86 cases. Approximately half of the deals were so-called early-stage and half were later-stage deals. In addition, 28 separate interviews took place with colleagues of the respondents to provide corroborating data on specific cases. These second interviews were conducted in order to test the inter-rater reliability of several measures in the questionnaire.
A pilot study was conducted with N = 13 cases to validate the questionnaire instrument. In the main study, a 12-page questionnaire was administered verbally to all of the respondents. Twenty-five case interviews were conducted in person, and 61 were conducted by telephone. Each interview lasted approximately 90 minutes.
The 12-page questionnaire contained primarily closed-ended questions. The questions were designed to record factual data about the amount of time that venture capitalists allocated to various methods of human capital valuation during specific deals. In addition, several qualitative questions recorded venture capitalist assumptions and beliefs about the process of human capital valuation. The scale comprising the dependent variable, the accuracy of the human capital valuation, had a Cronbachs " = .82. Inter-rater reliability for this variable was r = .64. See Table 1 for variable definitions.
Threats of respondent bias were reduced in several ways. First the design of the survey does not allow respondents much wiggle room. These questions asked for very few attributions, opinions, attitudes, or other subjective data. Instead, the questionnaire is primarily fact-based. Second, respondents were additionally motivated to be truthful because they knew that a second member of their team could be interviewed to confirm and/or elaborate on their responses. Third, a second member of the team was interviewed in 33% of the cases in order to test for inter-rater reliability.
Human Capital Valuation Methods
We now have an glimpse of which methods venture capitalists use to conduct human capital valuations and an idea of how much time they allocate to each method per deal. Venture capitalists think that the human capital is an important enough factor that they allocate a substantial amount of time to its assessment. The mean amount of time that venture capitalists allocated to all methods of human capital valuation was 120 hours. The method that venture capitalists favored the most was the work sample, to which they allocated 64 hours on average. In second and third place were reference interviews and past-oriented interviews, respectively. Venture capitalists conducted a written job analysis in 21.4% of the deals. Finally, 3% used psychological testing, and none used an assessment center. These results suggest that venture capitalists prefer to spend time in face-to-face discussions about business-related topics (work samples), rather than talk with other people (reference interviews), conduct intense discussions about career experiences (past-oriented interviews), read about the management team members (documentation analyses), think about what human capital is needed (job analysis), measure psychological traits, or conduct formal assessment centers. See Table 2.
We might have found that venture capitalists all tend to use a similar approach to human capital valuation. However, the data suggest that the opposite is truethere are vast differences in the way in which venture capitalists conduct human capital valuations. This is detected in the high standard deviation and wide range in the hours spent on each method. For example, the highest number of hours a venture capitalist spent on work sample discussions was 290 hours, compared to the low of 4 hours. Past-oriented interviewing ranged from 0.0 hours to 100 hours. This wide range suggests that different venture capitalists have different approaches to the process of human capital valuation. Another indicator that venture capitalists used dramatically different methods was the high correlation among the use of methods. It seems that venture capitalists do not use one method to substitute for another method. Rather, it appears that VCs make more of an all-or-nothing choice in selecting methods to assess management. For example, those who allocated time to past-oriented interviewing also tended to allocate time to reference interviewing. The correlation between these two methods was r = .68, p < .01. Perhaps these findings are due to the differences in assumptions made by venture capitalists about the process of human capital valuation. Their different approaches are examined later in this paper. See Table 3.
Human Capital Valuation Methods and Accuracy
The relationships between methods and accuracy were different for early-stage deals v. later-stage deals. Let us discuss what is considered traditional venture capital, or early-stage deals first. Early-stage deals were defined as seed or startup phase investments. Allocating time to past-oriented interviews and work samples was significantly positively related to the accuracy of a venture capitalists human capital valuation. In other words, the more time that was spent using these two methods, the more accurate their predictions about the behaviors of the target managers.
Job analysis, documentation analysis, and reference interviews were negatively related to accuracy, but the relationships were not statistically-significant. The overall model predicting the accuracy of human capital valuation accounted for much of the variance, R2 = .83, p <.01. Figure 1 is a chart of the beta coefficients in a hierarchical regression analysis (Cohen & Cohen, 1983).
An unexpected finding occurred when we compare later-stage cases to early-stage cases. The direction of the relationship between work samples and accuracy flipped from positive to negative. Work samples were expected to be weaker predictors of accuracy than past-oriented interviewing. However, what is surprising is that work samplesthough positively related to accuracy in early-stage caseswere so negatively associated with accuracy in later-stage cases. In early-stage cases, work samples beta coefficient was $ = .63, p < .01 whereas it was $ = -1.06, p < .05 in later-stage cases. This finding is counter-intuitive. It suggests that spending more time in work samples is associated with less accurate human capital valuations. One possible explanation for this finding is that work samples are conducted differently in early-stage cases than later-stage cases. Direct interactions in the form of a work sample in early-stage cases tended to be more collaborative, personal, and exuded the tone of Lets put our heads together and see if we can build this business plan together. In contrast, work samples in later-stage cases were more formal, more business-focused and less personal, and more combative in nature. These exuded a tone of We want to quiz you aggressively on many aspects of your business. It is possible that this differential application of the work sample method accounted for the difference in relationship to the accuracy of human capital valuation.
The positive relationship between past-oriented interviewing and accuracy held up in later-stage deals as well as early-stage deals. This suggests that past-oriented interviewing is a robust method in both early-stage and later-stage cases.
Why Venture Capitalists Use Certain Methods
This section provides a brief overview of the results related to the third research question: Why do venture capitalists use certain methods to conduct human capital valuations? It takes the discussion one step beyond the numbers to examine fundamental assumptions and beliefs that guide the actions of venture capitalists during due diligence. Venture capitalists approach the task of human capital valuation very differently. After many iterations of content analysis, four key factors emerged as the points of distinction among different approaches. The factors are: 1) the assumption of whether it is possible or impossible to achieve an accurate human capital valuation, 2) quantity of data collected, 3) balanced use of multiple methods, and 4) degree of systematic data analysis. The qualitative data were analyzed in the following manner. Respondent quotations were analyzed for evidence of a belief that accuracy was possible or was not possible. The quantity of data collected was measured by the total number of hours spent on human capital valuation. The balanced use of multiple methods was indicated by the extent to which respondents used multiple methods of human capital valuation, rather than concentrating on just one or two methods. Finally, the degree of systematic data analysis was measured by the presence of point-by-point ratings of the human capital (following a job analysis), as well as the use of written documentation (usually in the form of 3-ring binders).
Venture capitalists follow different approaches to evaluating management. Several different approaches to human capital valuation were identified and were given names. These typologies reflect differences in the assumptions and beliefs of venture. The seven typologies that emerged from the data were: airline captain, art critic, sponge, infiltrator, prosecutor, suitor, and terminator. Remember, these typologies refer to venture capitalists approaches to evaluating entrepreneurs. The typologies do not refer to entrepreneurs themselves. Venture capitalists who used the airline captain approach to human capital valuation achieved a very high average IRR of .80. However, only 13% of venture capitalists used this approach. The more popular approaches earned lower IRRs on average. See Table 4.
Airline captains are systematic and thorough in their collection and analysis of data, the way an airline captain conducts a pre-flight checklist. They base their analyses on data rather than just intuition. In contrast, art critics make snap judgments based on intuition. They think that they can assess a person quickly, the way an art critic judges a painting. Sponges soak up data in a nonsystematic way and then analyze it unsystematically. One sponge called his approach to human capital valuation due diligence by mucking around. Infiltrators try to become a quasi member of the management team. They spend many weeks or months participating in strategic planning meetings and even visiting potential customers together with the target managers prior to making an investment decision. Prosecutors aggressively question the target managers in a formal setting, the way a prosecuting attorney questions a witness. Suitors are more concerned with wooing management than assessing them, so they spend time trying to make a good impression rather than critically evaluate the management team. Finally, terminators are convinced that it is impossible to achieve accurate human capital valuations. Therefore, rather than allocate time to human capital valuation, terminators buy companies and simply terminate and replace managers that do not perform. Early evidence suggests that some of these approaches are more effective than others, as indicated by the range in IRRs. However, more research is needed to evaluate the effectiveness of specific approaches to assessing human capital.
Towards a Theory of Human Capital Valuation
This study certainly does not provide a definitive theory of human capital valuation. It has identified a large hole in the literature and has taken some modest steps to fill it with theory and empirical research. Scholars and venture capitalists lack conceptual tools in this area. They have theory from marketing and strategy to guide their assessments of the product and market factors during due diligence, and theory from economics to guide their assessment of the financial aspects of the deal. But there is not a theory of human capital valuation to guide assessments of the human capital.
A theory of human capital valuation must answer two questions: 1) what is human capital and 2) how can it be assessed most accurately? For theory to advance in this area, we need to learn more about the component constructs in the nomological net around human capital valuation. This study has perhaps helped to identify what some of those component constructs are: the range of human capital valuation methods including job analysis, documentation analysis, past-oriented interviews, psychological testing, assessment centers, reference interviews, work samples, as well as control variables such as VC years of experience, interviewing skill, the broader context of venture capital, early- v. later-stage cases, etc.
What this study also suggests is that human capital is far from the intangible factor that it is portrayed to be by accountants and economists. It is capital. Like all capital, it has properties that can be assessed and appraised. But the degree to which any capital can be valued is determined by the effectiveness of the methods that are used. In this study, several venture capitalists used very thorough and rigorous methods in their human capital valuations. Their human capital valuations were considered very accurate across many deals, and boasted high IRRs. Venture capitalists who were less thorough and rigorous made many mistakes in their human capital valuations. Perhaps human capital is an intangible only when ineffective methods are used to assess it.
Directions for Future Research
This study has uncovered many questions that require further examination. This study is like an unfinished mural on the side of a building. One can see the sketch marks of the overall design, but only some of the parts have been painted. Multiple opportunities exist for future research. Future studies could make a contribution by focusing a microscope on an individual method. For example, the topic of a study could be, The use of past-oriented interviews in venture capital due diligence. This would provide greater insights into what each method looks like in practice, as well as the assumptions of the venture capitalists who use them. Or, another topic could focus on packages of methods and approaches. Perhaps a study could use the typologies that emerged from this study to test for differences in accuracy rates across the typologies. Or, to take it one step further, it would be interesting to learn which typologies are most effective for measuring which dimensions or attributes of human capital. This would increase the precision of our understanding of this phenomenon.
Another area for future research is time efficiency. Conceivably, a venture capitalist could achieve an accurate human capital valuation if she studied a person in-depth for 6,000 hours. However, in this population, time is very important. It would be interesting to research which methods deliver the highest accuracy units per hour of use. For example, it is possible that the infiltrator typology is very accurate. Infiltrators follow around a person or group for many months and become one of them. However, this typology may be prohibitively time consuming. Infiltrators may be wasting a lot of time. In contrast, other typologies may deliver more accuracy per hour than infiltrators.
Venture capitalists may learn several things from this study. First, the past-oriented interview appears to be a more robust method for achieving accurate human capital valuations than other methods. If a venture capitalist found himself or herself failing to use this method, they may want to consider using it. In addition, the study offers a preliminary theoretical framework to describe the factors that affect the accuracy of a human capital valuation. This framework may be used as a diagnostic model or checklist to help venture capitalists plan their human capital valuation processes. The ultimate application of human capital valuation theory is to develop methods for human capital valuation that achieve the most accurate valuation possible, while consuming the fewest resources possible. The goal is to minimize the probability of undervaluing the human capital, which can lead to a false rejection. In addition, it is important to reduce the probability of overvaluing the human capital, which can lead to a false acceptance of a deal that should be rejected.
What are the implications of this research for society? All too often, venture capitalists make mistakes about the human capital and allocate scarce funding dollars to new ventures that fail. Forty-two percent of the deals in this study were considered by the respondents either neutral, losers, or mega-losers from an investment return standpoint. This poor success rate results in an inflated cost of capital for entrepreneurs. One possible reason for the failed investment decisions is that venture capitalists have had neither theory nor empirical research to suggest what methods are most effective in assessing people during due diligence. So they make mistakes. The paper began with the quotation by Arthur Rock, the venture capitalist, who said, Nearly every mistake Ive made has been in picking the wrong people, not the wrong idea (Bygrave & Timmons 1992, p. 6). When new ventures fail, not only are investors negatively affected, but jobs are lost, and new technologies are not innovated. In contrast, an advancement of our understanding of methods for human capital valuation is expected to lead to fewer mistakes. Fewer mistakes mean that scarce funding dollars may be allocated towards new ventures that survive, grow, and generate new technologies and jobs for society.
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