Why Not?
VCs and entrepreneurs have a classic conflict of interests. The VC has a portfolio of companies and wants each of them to behave in a value maximizing way, even when doing so requires taking tremendous risks and forgoing good but not great avenues for growth and exit. The entrepreneur has one company and often has their financial well-being tied up in the result. A scenario that puts $1mm in the pocket of the entrepreneur will almost always be attractive to the entrepreneur — in many situations the same situation might not be attractive to the investor. This phenomenon is known by all venture capitalists and by most entrepreneurs, yet it persists.
At the risk of coming across as horribly naive, I have been wondering lately why it is we never see funds that try to solve this issue by giving each entrepreneur in the portfolio a taste of the carry on the fund. I suspect the knee-jerk answer would be that it would damage the incentive of the entrepreneur to perform, but I’m not sure I buy that. I’m not suggesting that you make it easy to get rich just sitting back and waiting for the portfolio, but if the idea is align the interests of all parties around making decisions that maximize potential outcomes, it would be more like an insurance policy for the entrepreneur — a way to have some level of safety net (assuming, of course, that the fund actually has a decent return — a big assumption in this business).
What would be in it for the VC?
Comment by Gary — August 31, 2006 @ 9:04 am
Gary, there are two primary things “in it” for the VCs. First, it would solve the conflicting interests issue — the entrepreneur would feel more free to take bigger bets on hitting the home run. Second, it would (at least if it weren’t common practice) be a differentiating reason to take money from a particular fund — the VC would be able to better leverage her/his reputation for having a quality portfolio by attracting the best people who would want their taste.
Comment by Nathan Dintenfass — August 31, 2006 @ 9:35 am
A safety net might also provide a disincentive if you know your taken care of regardless of the success of your venture. If I were a VC, I’d want the company I invest in to view their success as a matter of personal survival.
As for choosing one VC over another, I really have no idea how competitively most entrepreneurs are wooed by VC’s. I’d think VC’s could always just offer better terms, more cash, or take less control.
I think the big issue would be the people putting money into the fund. Given that most ventures fail, I’d hate my stake in the fund to get diluted by the very people who lost the money that was invented in them.
Comment by Gary — August 31, 2006 @ 1:16 pm
Well, like I said, I’m not sure I buy the disincentive part — though, of course, you’d need to structure it to not let freeloading be an option, nor could the safety net be so attractive that you wouldn’t still have a big incentive to go for it. I think it would be more about knowing that you won’t be totally broke if things don’t go well, freeing you up to make big bets. Such a scheme would only work if the benefit of aligning incentives outweighed any chances of creating disincentives, and you’d need to find a way to kick someone out of the circle if they just aren’t cutting it.
Comment by Nathan Dintenfass — August 31, 2006 @ 1:24 pm