Should VCs Pick People Over Business Ideas?

Many an entrepreneur contemplating the search for venture capital has been told that investors place more importance on the human capital behind a business idea than the idea itself. As one tip sheet on what VCs look for says, "Of all of the above, the need for a strong management team is by far the most critical." But are venture financiers mistaken in placing halos on humans and horns on ideas? One research study says so.

In a 2004 study published in the Journal of Business Venturing a pair of University of Toronto researchers examined whether venture investors primarily try to pick winners or to build them. The results indicated that financiers tend to back companies that have good technology, but are in need of management expertise. "VCs also appear to make a common attribution error overemphasizing startups' human capital when making their investment decisions," the report concluded.

There are a couple of reasons why VCs make the mistake of prizing people above all else. One is the typical human tendency to overvalue people and undervalue situational factors. Another is the VCs' own unrealistically lofty impression of their own managerial prowess.

The result is that sometimes VCs back losers because they like the team members, and neglect potential winners because they aren't impressed with the founders. It's also possible that they sometimes force out founders when they should have left well enough alone.

In a 2000 paper by a pair of University of Chicago economists, the researchers confirmed that VCs tend to insist on influencing the selection of senior management of companies they back. About half the time, they said, the investors explicitly expected to play a role in shaping management teams after investing. "Because the investment memoranda vary in the amount of detail they provide, this almost certainly understates the VCs' activities in this area," the researchers say.

What can capital-hungry entrepreneurs take from this view of venture capitalists?

First, be sure you have a great-looking team before you seek VC financing. Image matters as much as substance, and some researchers have found that executives that worked previously at well-known companies tend to receive more credence with venture investors -- although companies led those with lower-profile backgrounds do as well or better.

Second, be ready for investors to try to shape your management team, including possibly even replacing you.

Third, don't take any of it too much to heart. Fancy executives won't necessarily improve your chances of success, even if you do have to have them to get the money you need.

Mark Henricks is an Austin, Texas, freelance journalist whose reporting on business, technology and other topics has appeared in The New York Times, The Wall Street Journal, Entrepreneur, and other leading publications. Learn more about him at The Article Authority. Follow him on Twitter @bizmyths.

Image courtesy of Flickr user Alan R. Light, CC2.0