Tuesday, July 24, 2001

Venture capital rationally hurts companies Many people are blamed for the recent Internet boom and its subsequent crash. This includes clueless journalists who hyped companies, sleazy analysts who sold bogus recommendations, and greedy entrepreneurs who launched stupid ventures. But perhaps most hated are the venture capitalists, who epitomized the ignorant avarice that's the hallmark of all speculative bubbles.

Entrepreneurs in particular often criticize their venture capitalists for making the company take stupid risks. Unfortunately, it is perfectly rational for venture capitalists to always force a company to take on more risk that its employees want.

Imagine a venture capitalist and an entrepreneur who are both equally greedy. It's still 1997, so the venture capitalist gives gobs of money to the entrepreneur (and several of her MBA classmates) who all go off and start various businesses. Everybody is interested in maximizing the return on their investment, but for each entrepreneur this means growing their company, and for the venture capitalist this means growing his portfolio of companies.

Just as a stock market investor can improve his returns by buying several different stocks, our venture capitalist diversifies away some of the risk unique to each individual company by owning a portfolio of investments (see figure 1). Note that our entrepreneur is not so lucky. Her success depends entirely on the success of her company, and her company alone.

Figure 1.

One way to think about the utility of an investment (U) is to balance its expected return (E) with its riskiness (volatility, s, the standard deviation), magnified by some risk aversion constant (A).

So, U = E - A.s^2

All this means is that the value of an investment (U) is it's expected return (how greedy you are) minus how afraid you are of losing your money (see figure 2)

Figure 2.

The thing is that even if the venture capitalist and entrepreneur are equally greedy (both have the same E) and equally afraid (both have the same A), the venture capitalist will still push the company to take greater risks than the entrepreneur. Because the VC has diversified away company specific risk through a portfolio, he expects a higher return for any given risk level. The entrepreneur on the other hand is completely invested in her company, and has to bear the full brunt of its riskiness (see figure 3).

Figure 3.

The moral of this story is that venture capitalists aren't necessarily more greedy than the employees of the companies they fund, but are primarily interested in their portfolios as a whole, and (rationally) try to hit a home run with every company. This is bad news for the companies who might be quite content with just getting to second or third base. But of course, as VCs are acting perfectly rationally, the companies knew what they were getting into when they sought out and accepted the money.
Link to this column.


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