Is it the Horse, or the Jockey?

Posted by on October 1st, 2015

Many of KCSA’s clients are small, frequently falling within the emerging growth category (as defined by the JOBS Act). Investors evaluating these early-stage companies use a different set of metrics than those used to evaluate large- or mega-cap companies. For example, Instead of Enterprise Value or P/E, PMs and analysts often look at more qualitative factors, such as a company’s go-to-market strategy or business model. They also consider the economics and opportunity of the industry overall.

However, when we boil down the factors that contribute to the long-term success of an early-stage company, two distinct components emerge: the business model and the management team. As an investor evaluating emerging players in a growth industry, what’s the most important consideration?

In other words, is it the horse, or the jockey?

A study appearing in the Journal of Finance1 takes an interesting approach to this question. After following 50 public companies from their inception to their IPO, researchers concluded that successful companies rarely deviate from their initial business idea, suggesting it is extremely important that investors pick a good business. At the same time, companies commonly replace their initial managers with new ones, yet still are able to go debut an IPO and achieve success. This, in turn, suggests that early-stage investors are regularly able to find management replacements or make improvements that are good for the business.

So management isn’t important, right? 

Not quite. Obviously, a specific person has to have the initial idea and start a company. It’s just that poor or under-qualified management is much more likely to be remedied by new management, than a poor or misguided business idea is to be remedied by a new idea.

From the investor relations perspective, it’s important to position clients around a sound business model and strategy, rather than having the next Mark Zuckerberg at the helm.

1 http://faculty.chicagobooth.edu/steven.kaplan/research/kss.pdf