BAT TEN BR IEFI N G IMPROVING THE WORLD THROUGH ENTREPRENEURSHIP AND INNOVATION
OCT 2016
Consider the Alternatives:
NEW WAYS OF FINANCING EARLY-STAGE ENTREPRENEURS
By Samuel E. Bodily John Tyler Professor of Business Administration University of Virginia Darden School of Business
O
ver the past decade more than $100 billion has been poured into promis-
ing early-stage cleantech companies (e.g., KiOR, Solyndra, Ener1, Fisker,
Beacon Power, to name a few). Famously, some of this money came from the
federal government in the form of loans, grants, and tax breaks. Hundreds of mil-
lions more was provided by private individuals, foundations, and non-governmental organizations, with the belief that these new technologies would ultimately reduce global energy consumption and generate great positive benefits for the planet.
* This Batten Briefing is derived from “Reducing Risk and Improving Incentives in Funding Entrepreneurs,” by Samuel E. Bodily, Decision Analysis, Vol. 13, No. 2, June 2016, pp. 101–116. The author is the John Tyler Professor of Business Administration at the Darden School of Business. He was a resident fellow at the Batten Institute for Entrepreneurship and Innovation at Darden during academic year 2012–2013.
We now know, of course, how these investments turned out—not well. Each company mentioned above went into bankruptcy, and some of them failed spectacularly.
But, if we assume that it is appropriate to encourage cleantech entrepreneurs to pursue potentially revolutionary new ideas, could we do so more effectively? Are there better ways for backers to encourage startups by reducing risk more efficiently than was done in the past? What are the best ways to motivate socially minded entrepreneurs to persevere in their quest to take on the world’s most pressing challenges? How would the various approaches compare? Using the tools of decision analysis, we set out to find some answers.
FINANCING INNOVATION SERIES
A Game-Changing Idea WE’LL START WITH A MINI-CASE STUDY about a hypothetical startup situation in which the idea for the venture and its financing are not in question. However, the
entrepreneur is unwilling to pursue it because the financial uncertainty is too high
and the personal risk is unacceptable. The case involves a novel cleantech opportunity, in which an entrepreneur has developed a smartphone app that would collect massive amounts of information regarding:
How might a supportive backer participate financially in the startup, push the entrepreneur over her risk barriers, and help launch the startup—all without taking away incentives for the entrepreneur to do everything possible to make the project succeed?
• photovoltaic and wind power production by time of day from wireless sensors; • real-time charge levels of batteries on electric cars from wireless sensors; • schedule data for the planned usage of electric cars from their owners.
The app and its associated algorithms can analyze the network data, forecast supply and demand for energy, and ultimately optimize car batteries to store energy from renewable generators across the power grid. This would enable the use of electricity generated by solar and wind to be available at times when it would otherwise
be priced higher, and the peak-capacity requirements for energy generation would thereby be reduced.
The entrepreneur’s technology clearly has practical potential, and she is even ready
to consider commercializing it as a startup business. Best of all, potential funders are
interested in supporting her because they favor cleantech and because this appears to be a viable business opportunity with good payout possibilities. The backers and the entrepreneur are aligned, since they both share a deep affinity for this exciting new cleantech idea, and the path forward seems straight and clear.
But there’s a catch: although preliminary projections suggest that the forecasted ex-
pected monetary value (i.e., average profit) of the project is positive, its financial risk makes the entrepreneur personally unwilling to launch the business, even though
she can secure the financing she needs to do it. For her, giving up income-producing work and putting family resources entirely on the line are simply too much (to say nothing about staking personal reputation on the startup). Moreover, she doesn’t
want to give away the lion’s share of ownership in the company by accepting capital from conventional venture capital (VC) sources.
Here’s the main question: How might a supportive backer participate financially in the startup, push the entrepreneur over her risk barriers, and help launch the
startup—all without taking away incentives for the entrepreneur to do everything possible to make the project succeed?
In this hypothetical situation, which is not at all uncommon, seed money has been raised and spent by the entrepreneur to refine the business concept. The business is ready for launch, and the entrepreneur has either personal money or investor
commitments sufficient to launch it. The forecasted mean payout of the business is
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BATTEN BRIEFING FINANCING INNOVATION SERIES
positive, but there is considerable risk—higher than the risk-averse entrepreneur is willing to take. Various stakeholders—call them backers—are interested in seeing the business get launched, understand the risks, and would subsidize the launch,
even allowing the entrepreneur to retain control and perhaps complete ownership
of the startup. These backers may be more benevolent than the typical VC firm that is focused almost exclusively on financial returns. The question is how to back the
startup in a way that will make the launch as attractive as possible to the entrepre-
neur (risk-adjusted) at a given expected cost to the backer. We are looking especially to align the incentives to foster best effort and good decisions by the entrepreneur.
The question is how to back the startup in a way that will make the launch as attractive as possible to the entrepreneur (risk-adjusted) at a given expected cost to the backer.
Considering the Alternatives IT’S HELPFUL TO BEAR IN MIND THAT THE KIND OF BACKER we have envisioned here (i.e., a foundation, government, or clean-energy benefactor) is chiefly interested in seeing the startup launched in a way that will best lead to the broad deployment of its technology. Of course, the backer would be happy to realize capital returns,
too, grown by a reasonable multiple, but this is not the primary motivation for supporting this entrepreneur. In fact, controlling the company may not even be that
significant to this backer; having some ownership may only be important as a way to receive something that can help the next cleantech entrepreneur. As a result, there
may be room for alternative financings that might help nudge our cleantech entrepreneur over the risk barrier and down the startup path.
EQUITY This is the standard model for financing a company, whether it happens by issuing
common shares, convertible preferred shares (i.e., postponing a valuation to a time
of less uncertainty), warrants, or some combination. It typically results in some loss of control of the venture for the entrepreneur.
INCENTIVE GIFTS Backers with social or governmental aims often give a gift to encourage a startup,
In fact, controlling the company may not even be that significant to this backer; having some ownership may only be important as a way to receive something that can help the next cleantech entreprenuer.
sometimes (as with the U.S. government encouraging cleantech) in the form of grants, awards or forgivable debt, which are similar to an outright gift.
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Considering the Alternatives [continued] INSURANCE Entrepreneurs may be especially fearful of losing all assets at the same time that
FIVE ALTERNATIVES FOR STARTUP FINANCING
they lose employment in their failing startups. Governments, foundations, and other backers can limit those potential losses by providing or subsidizing insurance that covers losses in profit that exceed some coverage amount.
REVENUE CONTRACTS Equity
Contribute an amount of capital and receive a percentage ownership of the company.
A backer may have great interest in providing capital with a payout taken not as
ownership but as a percentage of future revenue. The backer could have the opportunity to receive back more than was contributed. The advantage to the backer of such a scheme is that the payout comes much earlier than with equity, is more certain,
and might be completed even in situations where an IPO or other exit would never occur. The revenue contract may also be more enticing to an entrepreneur than
Incentive gifts
Provide an upfront lump-sum
alternatives that give up ownership, with less pressure to meet the hurdle of a buyout within a short time frame.
incentive gift award; this is like
DERIVATIVE CONTRACTS (E.G., SWAP HEDGE)
equity with no ownership share.
Many of the risks faced by potential entrepreneurs are totally uncontrollable. Yet
they can ruin the startup despite the best efforts of the entrepreneur, who may wisely choose to back away from a good idea. To the extent that these risks are tied to an objective measurable quantity, a solution may lie in a derivative contract.
Insurance
Subsidize an insurance contract that covers losses in profit beyond some coverage amount.
Here’s how this might work: the backer could write a derivative contract based
on some objective index that would compensate the entrepreneur for undesirable outcomes of a specific correlated—but uncontrollable—uncertainty. That is, such a contract would provide compensation to the entrepreneur in the event that the
business climate for the startup turns bad, as indicated by poor numbers of the index. The contract may offset the risk enough that the entrepreneur would be willing to
start the business. And yet, even when conditions are bad, the entrepreneur has every incentive to do the best he or she can with the business—as any success with it will
Revenue contracts
Provide an amount of capital in exchange for a fraction of revenue until some multiple of the capital contribution has been returned.
be remunerative in addition to the payoff on the contract.
The index should be positively correlated with the revenues expected by the
entrepreneur. Additionally, it’s important that it be objectively measured and publicly reported by an independent third party. Considering our cleantech entrepreneur, a
possible index could be a petroleum price index. The 50% drop in petroleum prices from 2014 levels exacerbated, if not caused, failures of cleantech companies.
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BATTEN BRIEFING FINANCING INNOVATION SERIES
For other startups the index might be: • Russell Business Cycle Index for a new online retail venture.
• The Case-Shiller Home Price Index for a real estate business startup. These indices would be objectively measured in a standard way by a third party not involved in the contract.
Derivative contracts (i.e., swap hedge)
Contribute a swap subsidy to the entrepreneur and write a derivative contract with the entrepreneur. This
There are a variety of ways to write derivatives (e.g., as swaps, options or collars)
contract specifies that an amount
might be written as a so-called “swap hedge” on the index, wherein at the end of the
the entrepreneur for each unit of
in the index. The pure swap is very efficient in reducing risk, as we will discuss later,
strike price, less a swap cost.
preneur must share when the index is high.
that an amount would be paid from
with a range of possible strike prices and payoff ratios. For example, the contract
would be paid from the backer to
contract the backer pays to the entrepreneur an amount for each unit of reduction
decrease in an index below the
helping us avoid options or collars that could be used to cap the amount an entre-
Alternatively, the contract specifies the entrepreneur to the backer for each unit of increase in the index above the strike price, plus a swap cost.
Comparing the Alternatives: OUR APPROACH WE EVALUATED THE PERFORMANCE OF THESE VARIOUS ALTERNATIVES from the two perspectives of the entrepreneur and the backer. For the entrepreneur, risk
plays a large role in the comparison. Therefore, we compared the alternatives using a certainty equivalent (CE), which is a risk-adjusted measure that represents the
precise “certain” amount that the entrepreneur would trade for an uncertain pay-
out. In other words, the entrepreneur is indifferent between receiving the CE and
receiving an uncertain payout amount. A negative CE suggests that the entrepreneur would not wish to launch the startup. The CE will be higher if the average outcome is higher with the same risk; it will also be higher if the risk is lower for the same
average outcome. In our analysis we compared the alternatives to each other and to
the status-quo outcome, in which none of the alternatives are used. We also tracked other measures that are important to the entrepreneur: 1) share of ownership and 2) control of the company retained by the entrepreneur.
With respect to the backers, we are considering them to be governments, founda-
tions, investment funds or individuals, and each backer may place many small bets
on a number of startup ventures. In each instance, therefore, given the combination
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Comparing the Alternatives: OUR APPROACH [continued]
of their stakes and diversification, the backers are much less risk-averse than the en-
trepreneur, who may have his or her entire asset portfolio and career tied to a startup. Therefore, we focused on the average cost of the alternatives for the backers, setting
insurance
the parameters for each of the alternatives in order to give the maximum amount of encouragement to the entrepreneur for that level of average cost. The business performance is measured by the risk-adjusted profit of the entrepreneur.
We performed our analysis using a very basic startup model in order to focus on the
equity
differences among alternatives, rather than the complexities of the startup business.
We also avoided dealing with streams of outlays and inflows by stating all cash outflows and inflows as present value numbers—hence no need to add time-value dis-
swap hedge
counting nor growth of revenues and costs over time. Think of the model as extend-
ing from the launch of the business to either exit from the company or conclusion of a contract between the backer and the entrepreneur. The profit of the business and the payout from any contract has been assumed to be settled at the same point in time as the exit or conclusion of the contract.
Since we are considering a variety of backers, some of whom would be completely hands-off, the profit is assumed to be independent of an equity contribution. If it
were deemed that a venture capital equity backer would add extra value beyond the equity contributed, that extra value could be added after the fact.
TABLE 1
COMPARISON OF RISK AND COST OF ALTERNATIVES
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Expected Cost to Backer ($000)
Percent Ownership and Control of Entrepreneur
Certainty Equivalent of Entrepreneur ($000)
Status quo
$0
100%
–$19.00
Incentive gifts
$10
100%
–$9.00
Equity
$10
92%
$11.52
Insurance
$10
100%
$67.05
Revenue contracts
$10
100%
$11.75
Swap hedge
$10
100%
$83.16
BATTEN BRIEFING FINANCING INNOVATION SERIES
Comparing the Alternatives: ANALYSIS
TO CONDUCT OUR ANALYSIS, we compared the five funding alternatives to each other and to the risk-adjusted evaluation of a base startup venture with no back-
ing. We set up the parameters of the model so that the expected (statistical average) cost to the backer was comparable at $10,000. We then calculated the CEs from a Monte Carlo simulation of payoffs, given the structure of the backer contract. The CEs for the entrepreneur for each of the alternatives is presented in Table 1. We
can compare the alternatives on a risk-adjusted basis, as viewed by the entrepreneur, given they have comparable cost to the backer.
We observe that the CEs for the status quo and for the incentive gift are both negative, making the startup opportunity unattractive to the entrepreneur, even if she
was granted a gift of $10,000. Equity, insurance, the revenue contract, and the swap hedge all have positive CEs, thereby encouraging the entrepreneur to set forth to
build the company. We see that the swap hedge produced the highest risk-adjusted value for the startup, making it a much more attractive alternative for encouraging an entrepreneur to take risk than the other alternatives.
The intuition for these results is as follows: The incentive gift, while a very welcome
gesture, does nothing to mitigate the uncertainty for the entrepreneur. The insurance does mitigate risk, but it covers the entire loss below a specified coverage amount,
Equity, insurance, the revenue contract, and the swap hedge all have positive CEs, thereby encouraging the entrepreneur to set forth to build the company.
which can be expensive to the backer for the degree of risk reduced. It is less bal-
anced than the swap hedge, which takes a share of the downside risk, not all of it,
and in return gives the backer a share of the upside potential. In contrast, insurance covers all of the downside risk beyond an arbitrary coverage amount.
Insurance does not have the advantage of rewarding the backer on the upside. The
swap covers the downside risk to the extent that the index is correlated with revenue. Yet it makes a greater risk reduction at a given cost, because when the outcome is good for the entrepreneur, some of that largess is returned to the backer. The en-
trepreneur may find it palatable to share some of the upside, given that the sharing occurs only when he or she has experienced good fortune, at least with regard to
the objective index. The swap hedge is a highly efficient way for the backer to share some of the risk.
The revenue contract, with a positive CE for the parameters used, provides enough
incentive for the entrepreneur to launch the startup. The contract, however, does not reduce risk to the extent that insurance and the swap hedge do. It is attractive for
other reasons that may be important to the backer: 1) it gives a return to the backer
sooner; 2) the backer needn’t wait for an exit event, such as an IPO or a buyout; and 3) the backer can receive a return that exceeds the amount of capital contributed.
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Risk Profiles from Simulation WE ALSO EXAMINED the actual profiles
of risk for the entrepreneur and the backer through Monte Carlo simulations of the
alternatives. Figures 1 and 2 show selected results of one simulation with four million trials. Figure 1 shows the profit results for financing alternatives including Equity, Insurance and the Swap Hedge. Figure
2 shows the histogram of outcomes and
statistics for the backer cost for those three alternatives.
Note how the insurance alternative ef-
fectively cuts off the downside of the profit risk profile, transferring it to the backer, who experiences a cost with a long tail
on the right. The maximum of $495.60
(thousands) for the backer is an order of
magnitude higher than the maximum cost for the other alternatives, except for the swap hedge cost.
Also note that the swap hedge greatly
shrinks the width of the entrepreneur’s risk relative to that of the other alternatives.
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BATTEN BRIEFING FINANCING INNOVATION SERIES
FIGURE 1: ENTREPRENEUR PROFIT
FIGURE 2: BACKER COST
To view a complete comparison of the risk profiles and statistics generated through Monte Carlo simulations, please visit: bit.ly/BattenBriefing-Bodily
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Incentive Compatibility, Moral Hazard and Control THERE IS ANOTHER STRONG REASON TO FAVOR THE SWAP HEDGE. Because
the swap contract is written on the outcome of an objective index, the entrepreneur has no incentive to be complacent or to give up, whether the index turns out to be
favorable or unfavorable. If entrepreneurs end up succeeding even when the index is
unfavorable, they get to keep the entire reward of their efforts, including the positive payout of the swap. They will always strive to do the very best they can. The risk
borne by the backer is related to the index, not anything that the entrepreneur does
In the revenue contract or swap hedge alternatives, backers have involvement directly in financial outcomes or in related payouts that may make them less inclined to demand a seat on the board.
or doesn’t do. Consequently, there is no moral hazard with the swap hedge.
With the gift award, the money is all in place prior to the launch of the startup. Although the gift may open the door to starting a company, it may lessen the pressure to try hard to succeed; some measure of success has already been won. The equity
alternative also takes some portion of the pressure off the entrepreneur, depending on the equity ownership percentage.
Insurance is even more strongly fraught with moral hazard. If entrepreneurs sense
that they are close to losing or have lost the coverage amount, they may make deci-
sions that are not in the best interest of the firm or stop working hard, with the risk falling onto the issuer of the insurance. Entrepreneurs will be more responsible if they have some skin in the game.
The revenue contract may reduce the incentives to produce by the percentage that
is paid out of revenue, but that is typically a small percentage. It is attractive to the backer, who will receive the payout sooner and without the necessity of a financial exiting event.
Compared to giving up equity ownership, all other alternatives have additional at-
tractions to the entrepreneur who wishes to retain both ownership and control of his company. In the revenue contract or swap hedge alternatives, backers have involvement directly in financial outcomes or in related payouts that may make them less inclined to demand a seat on the board.
10 BATTEN BRIEFING FINANCING INNOVATION SERIES
Swap Hedge: A New Way to Finance Startups? ACCORDING TO OUR ANALYSIS, the swap hedge is an efficient way for a backer to
reduce entrepreneur risk while encouraging effort and innovation for a given cost. In addition to the usual purchase of a share of a company so that the entrepreneur has startup capital, the backer may sweeten the deal with a swap hedge. This makes it
even less onerous for the entrepreneur to take on the startup, inasmuch as the downside of uncontrollable risk is covered. And it means, if the index is positive, that the backer is rewarded for supporting the startup. With the swap hedge, the backer is
taking a position based on an objective measure, not related to the amount of effort put out by the entrepreneur. It wouldn’t be unusual to find a backer who believes
that the index will go up, even when the entrepreneur has the opposite view. From a negotiation standpoint and a behavioral view, this makes for a win-win situation.
By enabling the entrepreneur to retain ownership and control of the company, the
revenue contract can provide sufficient encouragement to launch a business. Backers may be willing to agree to more generous terms, given that they get money back sooner, and in portions, rather than an all-or-nothing exit payout.
Equity, the revenue contract, or the swap hedge may play an increasingly impor-
tant role when backers connect with entrepreneurs online (e.g., via crowdfunding),
which makes it possible to have many smaller backers. In addition, the entrepreneur gains the advantage of publicity and public feedback. The revenue contract may be handled more like a pre-sale of a product.
Insurance can play a role, particularly when no objective index can be easily identi-
fied and/or when the entrepreneur is highly risk averse. However, a bigger portion of risk is taken on by the backer, and moral hazard comes into play.
So, thinking back to our hypothetical cleantech entrepreneur, prospective backers could use a swap hedge or a revenue contract to tip her toward taking a risk at a
much lower cost. More broadly, financing mechanisms like these, with lower cost, greater control, less moral hazard, and stronger incentives, may enable other prospective entrepreneurs to advance ideas that just might change the world.
By enabling the entrepreneur to retain ownership and control of the company, the revenue contract can provide sufficient encouragement to launch a business.
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Executive Summary THIS ARTICLE SUGGESTS BACKER FINANCING MECHANISMS that encourage an entrepreneur to launch a startup that has unacceptable risk although positive
expected payout. It uses decision analysis and certainty equivalents to compare these mechanisms from both the entrepreneur’s and the backer’s points of view. Backers may be local and national governments interested in technology, job creation, and
growing the tax base; foundations; charities; non-governmental organizations; and
even corporations or individuals interested in a new product or technology. Alterna-
To hear Sam Bodily discuss his research in a short podcast, see: dardenmba.podbean.com
tive mechanisms include three traditional models: the equity participation model predominant in startup financing, outright incentive gifts, and insurance against
downside loss; and two new ideas: swap hedges and revenue contracts. We develop risk analysis models of the alternative mechanisms, from which we calculate the
comparative risk-adjusted attractiveness of each mechanism to the entrepreneur
for a similar level of expected cost to the backer. The best alternatives, two highly
efficient new ideas, eliminate moral hazard and leave ownership and control in the
hands of the entrepreneur. And in the revenue contract, the backer may be additionally rewarded with money back sooner.
Samuel E. Bodily
John Tyler Professor of Business Administration Samuel E. Bodily researches decision and risk analysis, strategy modeling and analysis, forecasting and lifetime consumption, and investment planning. He has written several books, a wide variety of journal articles in publications ranging from Operations Research to the Harvard Business Review and more than 120 cases and technical notes on quantitative analytics.
c o p y r i g h t i n f o r m at i o n BATTEN BRIEFINGS, October, 2016. Published by the Batten Institute at the Darden School of Business, 100 Darden Boulevard, Charlottesville, VA 22903.
In addition to teaching strategy and decision analysis in Darden's MBA and Executive Education programs, he is a consultant to many corporations, utilities and government agencies. He was noted for both first and second place in the INFORMS case competition in 2011 and has received Wachovia awards for case writing in 2010, 2005, and 2001; and a Wachovia award for a research
email: batten@darden.virginia.edu www.batteninstitute.org
article in 1994-95. Previously, he taught at Boston University and the Sloan School of Management at the
©2016 The Darden School Foundation.
Massachusetts Institute of Technology, and has been a visiting professor at INSEAD Singapore,
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Stanford University, and the University of Washington.