I’m sure that many more thoughtful than me have written about the moral hazard of venture capital. In economics, moral hazard occurs when one person takes an unreasonable risk because someone else will bear the burden of the negative consequences. In the age of unicorns, the moral hazard in venture capital has never been greater. Moral hazard and exuberance to make unicorns leads to unicorpses. I was reminded of this today during a conversation with an emerging growth business run by capable, yet young entrepreneurs.
The 20 something entrepreneurs with whom I was talking have built a solid, already profitable business generating $4.3 million ARR. The company has taken a total of $200k of outside financing. With a modest amount of incremental capital, the business has the potential to be a $30 to $50 million revenue business in 5 years and to be meaningfully profitable. Such a business could easily fetch $100 to $150 million in exit value, producing a significant amount of wealth for the entrepreneurs. In addition to producing personal wealth, after such an exit the entrepreneurs will have built a successful company, made money for their investors, established a reputation for themselves and find themselves with the personal wealth necessary to finance the start of their next business. They would be imminently “back-able” and set up nicely for a long and productive career.
Objectively, a $100 to $150 million exit in three to five years is possible for this company. Objectively, a unicorn type multi-billion exit isn’t likely. But sticking to the straight and narrow of building a solid profitable business is hard. Bad influences abound. Entrepreneurs, like the ones running this company, are flooded with tech-centric news about the birthing of a unicorns and are shielded from the harsh reality of entrepreneurial failure. The infrequent unicorn gets lots of press where the 40% failure rates that plague venture capital fade to black. It is no wonder then that many entrepreneurs (particularly young entrepreneurs) fall victim to the instinct to try to make their company into a unicorn. Lets go raise $[fill in the blank] and pursue [fill in big hair audacious goal] becomes the mantra, whether or not the opportunity has unicorn characteristics or the use of proceeds is well aligned with what the business is. Raising all of that capital leads to spending, and higher burn. After all “we’re not giving you the money to have you save it” and “you can’t save your way to success” are common refrains. In most situations, higher burn rate equals higher risk of failure. High risk, but not necessarily higher reward.
Who mourns the unicorpse?
With high-loss rates and returns concentrated in a small number of investments that go full unicorn, venture capital is more fraught with moral hazard than ever. Venture capitalists have portfolios and their performance is generally evaluated at a portfolio level. This portfolio level evaluation applies whether the evaluation is of a firm or an individual investing partner. Venture capitalist cares less about the success or failure of any single investment than the success of his/her overall portfolio. Knowing that loss-rates are high and returns are concentrated in a few large deals, venture capitalists have an inherent incentive to swing for the fences on every investment, increasing the risk and potential reward of each investment.
Who bears the cost? The entrepreneur.
Pragmatically speaking, an entrepreneur can manage only one entrepreneurial endeavor at a time. In fact, we investors often tacitly, if not explicitly, require this. We want the entrepreneur single-threaded, we need the entrepreneur single-threaded. I’ve got a portfolio, but you put all of your eggs in one basket…
To make ourselves feel better, we have lots of platitudes for entrepreneurs who experience failure.
It is better to have tried and failed that never to have tried at all.
You learn more from failure than you learn from success
There is no shame in failure.
All true; but when push comes to shove, venture capitalists are master pattern matchers and a tried and true heuristic is that past entrepreneurial success is a predictor of future entrepreneurial success. Many investors would prefer to back an entrepreneur with a successful track record and a mediocre idea over an entrepreneur coming off a failure with with a good idea.
A 20/30 something entrepreneur coming off of a failure is going to have a very difficulty time getting his/her next business financed. Conversely, a 20/30 something entrepreneur coming off of a successful exit is much more likely to get financed. The risk of failure falls more on the entrepreneur than on the investor, particularly when the dollar amounts invested are high as is the case with most unicorn wannabes.
No Villains Here
To be clear, I’m not vilifying venture capital or venture capitalists. There is nothing untoward about the economic motivations of investors.
I’m also not suggesting that intentionally increasing the risk of an investment is risk-free for the investor. Higher operating risk implies a greater chance of capital loss. There isn’t a moral hazard in every venture capital investment situation. For example, some businesses operate in winner takes all markets. In such situations the motivations of the investor and the entrepreneur are nicely aligned because the go big or go home philosophy of company building is the right approach due to market structure.
I am, however, suggesting that the entrepreneur bares a greater proportion of the risk associated with venture capital investments; or at least that the consequences of failure are greater for the entrepreneur than the investor. I’m also suggesting that we investor should be sensitive to this fact by making sure we don’t overcapitalize the businesses in which we invest and by not inappropriately ratcheting up the risk profile of the companies in which we invest in the name of portfolio management. We should manage risk/reward on the basis of what is appropriate for each investment, not on a portfolio theory basis.
An Alternative Approach
When you swing for the fences, you strike out a lot. No manner of platitudes for the entrepreneur who tried and failed can remove the moral hazard.
Entrepreneurs in growth stage businesses face different calculus. In a situation like the one I described, the entrepreneurs have already created value for themselves. Taking a bigger than necessary financing round and swinging for the fences puts that built in value at risk and buries it under a larger preference stack than is necessary.
Making unicorns is risky business. But you don’t have to make a unicorn to create value. There is another way.
Consider taking less capital. Consider staying laser focused on your core market and building a defensible position that is resilient to attack. Win narrowly and then exit. This may mean taking a more risk averse path to unlocking the value of the business. Raise less capital. Moderate burn. Get profitable as soon as possible and exit sooner. If that means not raising capital or raising less capital (and taking less dilution) all the better.
Young entrepreneurs operating an already successful business would be wise to remember that some unicorns end up unicorpses. It is better to be modestly valuable and alive than to have had the potential to be wildly valuable and dead.
Call me old fashioned. Call me risk averse. I’m guilty as charged.