They contribute with management expertise, governance practices and knowledge about capital markets, thus helping to take the invested company to the next level.
Moreover, they make most of the profits when realizing returns from the successful investments and, as such, do pursue maximum return for their funds.
Perfect match among interests of VC firms, investors and entrepreneurs? Well, not quite. See for instance the quotes below:
"Our business can reach a good size, with steady growth and manageable risk, thus indicating a good return on investment. Why couldn't we attract VC firms? Am I missing something?"
"Shouldn't the VC firm, as our partner, have the same interests that we do? So why pushing for faster growth, if it increases our risk so much?
The answer to the
questions above lies in two components that can create conflicts
between VC firm and the entrepreneur (and often also with the investor in the
VC fund): (i) impact of risk in the VC performance fees and (ii) differences in
risk aversion.
They can be better explained with one example. Let's suppose that we should select one of the following US$ 1 million investment alternatives.
In the first, chances are that in 2 out of 10 you would lose the whole $1 million. In 4/10 you could recover the invested amount with no profit or loss; and in another 4/10 you could get $2 million back, making $1 million in profit!
In the second alternative, in 8/10 times you would lose the whole $1 million. And in 2/10 you would get back $6 million.
Where would an entrepreneur - who could be investing most of his/her savings in the business - place the bet? And what would be the choice of an individual making an investment in a VC fund?
From a pure expected return perspective, both alternatives would average total cash back of $1.2 million, or 20% return. From the investor point of view, the difference would be mostly dependent of his/her aversion to risk.
Clearly, alternative one has a much lower risk (statistical "standard deviation" and "variance"). The above mentioned entrepreneur would probably select that option. I believe that even the average investor in a VC fund, as long as not in a "casino betting" type of strategy, would probably finance the first business.
And how about VC
firms? Do they have similar incentives? Let's consider a firm and its partners who
make most of their profits and bonuses from success fees, for instance, 20% of
realized returns, if any is made.
In alternative one, their expected fees would be $40 thousand. Compare that to the $200 thousand in the second alternative. Five times larger! This explains why VCs seem to like so much internet traffic (and other high risk/high potential size) based businesses.
It is true that total fund diversification somewhat reduces portfolio risk. But with such compensation structure, it is to the firm's benefit to undertake riskier investments, even with the odds of losing the whole
investment. Mostly if there is no VC partners'
personal money being coinvested in the fund.
This is not a criticism to VC funds in particular. The conflict occurs with most asset managers that have a performance based compensation, who make investment decisions with third party (financial) assets.
Qualified investors (the market) should be able to negotiate their investment terms. They could demand adjustments to performance fee structure, establish practices to limit risk levels or require coinvestment practices, if they feel appropriate.
My objective is to alert Entrepreneurs, who should realize such different incentives, when negotiating with VCs and understand that the lack of VC interest could mean lower investment potential but also risk, not necessarily lower expected return.
Also, if possible, look for other financing alternatives to their business such as investors that would consider a longer term, dividend based return on their investments.
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