Research by Darden Professor Samuel E. Bodily suggests several new ways to encourage entrepreneurs teetering on the edge of launching a high potential startup but fearful of the financial risks involved.
“You want to support entrepreneurs with good ideas who are aware of the risks and want to mitigate them,” says Bodily. “You want to motivate socially minded entrepreneurs to persevere in their quest to take on the world’s most pressing challenges.”
So how best to do it?
“Let us consider some innovation in funding to match the innovation inherent in entrepreneurship,” Bodily writes in his article titled “Reducing Risk and Improving Incentives in Funding Entrepreneurs,” published in the June 2016 issue of the journal Decision Analysis. His research proposes novel methods on how “to nudge an entrepreneur over the risk barrier and down the startup path.”
Bodily uses a classic example of a risk gone bad to illustrate the dilemma faced by stakeholders who want to invest in a worthy entrepreneurial cause. Over the past decade, backers — including the federal government, foundations, individuals and others — invested more than $100 billion in promising early-stage clean-tech companies such as KiOR, Solyndra and Ener1. They hoped the innovative companies would find original ways to reduce global energy consumption and improve the world.
Instead, the companies went bankrupt as the cost of petroleum plummeted, making innovative alternative energy too costly by comparison.
“But, if we assume that it is appropriate to encourage clean-tech entrepreneurs to pursue potentially revolutionary new ideas, could we do so more effectively?” asks Bodily. “Are there better ways for backers to encourage startups by reducing risk more efficiently than was done in the past?”
Also, backers should keep in mind the psychological needs of these risk-averse entrepreneurs, Bodily says. An entrepreneur may see the startup as his or her child “with all the desire for control over its destiny that parenthood might entail.” And entrepreneurs may have all their financial resources on the line. They need risk sharing, he asserts.
Using decision analysis, Bodily formulated a model with changeable parameters “related to the business itself, the risk tolerance of the entrepreneur and the cost of subsidy of the mechanisms” to look at tried and true financial mechanisms including equity participation, outright incentive gifts and insurance against loss. He also looked at two new ideas: revenue contracts and swap hedges.
Tried and True Financial Mechanisms:
- Equity Financing: The standard method for financing a company is through equity financing, issuing, for instance, common shares or convertible preferred shares. The problem is that the entrepreneur may be very reluctant to give up any degree of ownership in the company.
- Incentive Gifts: Incentive gifts provide an upfront lump sum of money. They might come out of social or governmental motivations and in the form of grants or forgivable debt. But the gift doesn’t mitigate the uncertainty for the entrepreneur. Although the gift helps a startup, it may lessen the pressure to try hard to succeed because some measure of success has already been won.
- Insurance Against Loss: Entrepreneurs may worry about losing all assets at the same time that they lose employment if their startup fails. Backers can limit those potential losses by providing insurance that covers losses in profit that exceed some coverage amount. But insurance is strongly fraught with moral hazard. If entrepreneurs sense that they are close to losing, they may make decisions that are not in the best interest of the ﬁrm.
Bodily’s model — using a certainty equivalent (a risk-adjusted measure that represents the precise certain amount that the entrepreneur would trade for an uncertain payout) — found that two other financial tools might prove the most helpful to the risk-averse entrepreneur.
Potentially More Successful Financial Mechanisms:
- Revenue Contracts: Revenue contracts “are seldom used in entrepreneurial startups,” says Bodily. “A backer may have great interest in providing capital with a payout taken not as ownership [as with equity funding] but as a percentage of future revenue through a revenue contract.” The payout to the backer comes much earlier than with equity and is more certain, he says. It may be delivered as a regular payment of a percentage of revenue that continues until a specified multiple of the principal investment has been met, or perhaps as a return of the principal plus an annual return. In the case of crowdfunding, it may come as a product if they’ve given funds to develop a video game or software, for example. Meanwhile, the revenue contract may be more enticing to an entrepreneur than giving up ownership.
- Swap Hedges: Bodily’s research suggests that the most efficient financial tool may be a derivative contract, such as a swap hedge, in which the entrepreneur may be compensated for uncontrollable and undesirable conditions that lead to a worsening business climate and, in turn, compensate the backer for increasingly desirable conditions. “To the extent that these risks are tied to an objective measurable quantity, a solution may lie in a derivative contract,” he says, emphasizing that the conditions are measured by an index that is objective and reported by an independent third party.
For example, the objective index for a clean-tech startup could be a petroleum price index; for a new online retailer venture, it might be the Russell Business Cycle Index, which forecasts the strength and direction of the business cycle; or for a real estate business startup, it might be the Case-Shiller Home Price Indices, which track changes in the value of residential real estate.
“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,” Bodily says.
“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,” says Bodily. “They will always strive to do the very best they can.” And the risk to the backer is related to the index, not to the entrepreneur’s effort. Consequently, there is no moral hazard.
“In short, the swap hedge is a lot more efficient way of reducing risk while offering less moral hazard and encouraging innovation,” says Bodily.
The preceding features research detailed in “Reducing Risk and Improving Incentives in Funding Entrepreneurs,” by Samuel E. Bodily, Decision Analysis, Vol. 13, No. 2, June 2016, pp. 101-116.
Professor Bodily further discusses his findings in the Batten Briefing Consider the Alternatives: New Ways of Financing Early-Stage Entrepreneurs, as well as Research & Relevance: New Ways of Financing Early Stage Entrepreneurs, a podcast produced by Darden’s Batten Institute for Entrepreneurship and Innovation. Professor Bodily, a Batten Fellow, is interviewed by Erika Herz (MBA ’01), Batten’s director of research and intellectual capital.