Venture Capitalists

Venture Capitalists^[3]

Imagine that you’re a venture capitalist considering lending me money to start an Internet company. My business plan entails enacting implementations that utilize the synergies of leveraged . . . and then going public. Obviously, you would love to fund me. Your main worry, however, is my reputation for laziness. Fortunately, I’m also known to be greedy, so you intend to structure a deal under which my greed will overcome my laziness, causing me to put in maximum effort.

You agree to put $10 million into the business, but only if I put in $70,000 myself. The $10,070,000 will go to setup costs, and I won’t get any of it if my business fails. True, my $70,000 is trivial compared to what the business needs, but it represents a large sum to a college professor. You want failure to cause me a massive amount of pain so that I will be motivated to succeed. In return for the $10 million, you ask for 40 percent ownership of the company.

I suggest an alternate arrangement. You see, besides being lazy and greedy, I’m also fearful. I offer you 80 percent of the company in return for you giving my company $10 million and giving me $1 million. I want to guarantee myself a profit if the company fails, so I’m willing to trade 40 percent of this company for $1,070,000 . Should you go along? Under my arrangement, I own a smaller part of the company and do much better if the company fails. Consequently, I have a far lower incentive to work hard under my arrangement than yours. Under my proposal, however, you double your share of the company. Which proposal better serves your interests?

It depends on how lazy I am and how much my laziness could hurt the company. If my level of commitment will determine the success of the company, then your arrangement is preferable to mine. In contrast, if the company’s prospects for profits are largely independent of my efforts, then you should accept my proposal. Note that it’s not just the risk of the venture that’s relevant to your decision but rather how my actions might affect this risk. If, say, the venture is extremely risky, but my efforts matter little to the company’s success, then you should go with my fearful proposal.

^[3]Ibid.