Entrepreneurship Part IV: The Invisible Hurdle

Now, if every investor walked around with their hurdle rate tattooed on their forehead, the lives of entrepreneurs might be pretty simple. They simply wouldn’t bother approaching an investor unless their ventures could exceed the hurdle rate.

Of course things are more complicated…

  • The hurdle rate is different for different investors
  • It depends on the particular mix of return-generating assets they currently hold as well as the assets they have access to. Some assets are liquid (quickly and easily bought and sold, like common stocks) while some are not (like Manhattan skyscrapers).
  • It can change frequently as environmental factors result in higher or lower returns on held assets.
  • Investors make mistakes about rates of return: putting money in what turn out to be bad investments and withholding money from what turn out to be good ones.
  • The hurdle rate along with tolerance of risk can also change after investors sell assets. This may create a "hole" in the portfolio, so the investor may seek low risk even if it means low returns.
  • Some investors don't try to be purely rational in their investments. They may spend money out of a sense of charity, as a gift, or to return a favor. This is more likely to be the case with individual "angel" investors, and less likely to be the case with venture funds that pool money from multiple investors.
  • They may go through personal experiences that raise or lower their tolerance of risk.

As a result, many investors (including venture capitalists) do not know their own hurdle rate at any given time. Instead, they employ rules of thumb. For example, when considering a portfolio of venture capital investments, as this presentation suggests, investors assume around half of their investments will be totally lost, another four out of ten will fail to yield attractive returns, and only one or two will actually succeed.

Over time, investors will consciously or unconsciously move money out of under-performing assets and into the best-performing ones. The hurdle rate is like Adam Smith’s invisible hand. You may not see it, but for many practical purposes, it should be assumed to be there.

Tags: Business, Economics, Finance

Updated at: 16 February 2009 6:02 PM