Considering the Alternatives: New Ways of Financing Early-Stage Entrepreneurs

Contributor: Samuel E. Bodily, Professor of Business, University of Virginia

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Over the past decade more than $100 billion has been poured into promising 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 millions 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.

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.

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:

  • 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 expected 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 positive, but there is considerable risk — higher than the risk-averse entrepreneur is willing to take.

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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 entrepreneur (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 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, 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.

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.

Insurance

Entrepreneurs may be especially fearful of losing all assets at the same time that 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

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 alternatives that give up ownership, with less pressure to meet the hurdle of a buyout within a short time frame.

Derivative Contracts (E.g., Swap Hedge)

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.

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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 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.

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.

There are a variety of ways to write derivatives (e.g., as swaps, options or collars) with a range of possible strike prices and payoff ratios. For example, the contract might be written as a so-called “swap hedge” on the index, wherein at the end of the contract the backer pays to the entrepreneur an amount for each unit of reduction in the index. The pure swap is very efficient in reducing risk, as we will discuss later, helping us avoid options or collars that could be used to cap the amount an entre- preneur must share when the index is high.

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 payout. 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, foundations, 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 of their stakes and diversification, the backers are much less risk-averse than the entrepreneur, 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 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 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 discounting nor growth of revenues and costs over time. Think of the model as extending 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.

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 backing. 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.

searched for: umbrella

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, which can be expensive to the backer for the degree of risk reduced. It is less balanced 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 entrepreneur 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.

Equity, insurance, the revenue contract, and the swap hedge all have positive CEs, thereby encouraging the entrepreneur to set forth to build the company.

Figure 1: Entrepreneur Profit

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 effectively 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.

Figure 2: Backer Cost

To view a complete comparison of the risk profiles and statistics generated through Monte Carlo simulations, please visit: bit.ly/BattenBrie ng-Bodily

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 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 decisions 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 attractions 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.

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.

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 important 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 identified 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.