Recently, I had a conversation with a local Midwest entrepreneur who made the comment that he could not understand why the venture capital, angel investors, and bank lenders wanted to keep putting money into his enterprise when he felt the company should close up shop? It was an interesting comment that I had to think about for a bit but there may be a reason for it.
One reason, especially for venture capital funds and bank loan officers, has to do with incentives. If faced with closing down a business or keep it alive, mainly providing just enough funding to keep the lights on. Let’s look at a simple example. Assume a loan officer (and this could be a venture capitalist as well managing a portfolio) at a bank has a portfolio of 3 loans – Company A for $100,000 at 10% interest; Company B for $200,000 at 5%; and, Company C for $500,000 at 8%. Assuming all is well and the companies are making their payments on time, annual interest income would be $60,000 (A=10,000 + B = 10,000+ C =40,000) on total portfolio of $800,000 or an average annual rate of return (assuming that the loan principal stays the same) of 60/800 or 7.5%.
Many loan officers managing a portfolio of loans are measured, at least in part, by their loan portfolio performance (annual interest income/average loan principal). Assume that during the year, Company A runs into trouble and looks like it may have to default on its loan. If Company were to default at the beginning of the year and the loan was deemed non-performing or uncollectible, the loan portfolio loses both the interest and the principal of the loan. In other words, the loan officer sees her loan lose $10K in interest income and a loss (reduction of income from the portfolio) of $100,000. In total, the portfolio performance will have interest income of $50,000 less the $100K in principal loss generating $50,000 net loss divided by $700,000 in principal left from B and C.
If the compensation package for the loan officer is based on loan performance, she will typically have an incentive to either keep the loan alive and try to restructure so the firm can sustain or at least push off killing the loan until the next year or later. The loan officer will try to restructure interest rates, lessen the annual principal repayments and/or other steps to put off formally announcing the loan as non-performing taking a hit to current year loan performance (and missing a potential bonus).
With a venture capital portfolio, a similar situation may exist. A VC fund is generally judged by either Cash-on-Cash Return to Limited Partners (LPs), the Internal Rate of Return (IRR) or the Net Present Value at a certain rate. While they won’t want a company to a fail and lose the entire investment in a firm, they have the general understanding that a certain percentage of firms won’t make it. Instead, a VC portfolio has an incentive to defer the loss as long as possible to lessen the time value impact of the lost investment on portfolio performance. Similar to banks, if they sense that a company in their portfolio is not going to make it, the will provide just enough capital to keep it alive on fumes hoping things may change, another company will buy it at ‘fire-sale’ prices, or at the least, keep deferring the inevitable of shutting it down and taking the loss at a later year before the fund needs to close.
So much behavior in business, management, investing and other functions can be explained, at least in part, by incentives. Using incentive systems as a guide may explain some of the behavior of investors in young companies.