Entrepreneurship Part V: The Entrepreneur's Response

Unfortunately, uncertainty about the hurdle rate only inflates the effective rates of return that entrepreneurs strive for. In order to attract venture capital, an entrepreneur must inevitably promise exceptionally high returns. If they do not credibly promise to exceed an investor’s hurdle rate, then they will not get funded—the investor will keep his or her money. It is only logical for entrepreneurs to assume that the more rapidly they can promise to generate large returns, the more widely they are “casting their net” for venture funding. As this presentation suggests, entrepreneurs must “demonstrate the opportunity for a 20X - 30X return on investment”.

Once a venture is funded, it is bad faith for an entrepreneur to say, “I changed my mind! I’m going to put this in a savings account and pay you 2.5%!” So, when you see or hear about entrepreneurs spending enormous sums of money and burning through cash at a phenomenal rate, don’t be quick to conclude they are idiots. They are most likely simply following through on a commitment to investors: to exceed their hurdle rate by generating large returns rapidly.

Of course, expectations that turn out to be wrong produce economic bubbles that pop. If the entrepreneur fails to generate the expected returns, the effects are wide-ranging. If venture money was used to hire people, they will lose benefits, take pay cuts, or get laid off. The entrepreneur may default on loans or leases. Certain assets may get sold for deep discounts.

Tags: Business, Finance

Created at: 18 February 2009 12:02 PM