Unicorpse and The Moral Hazard of Making Unicorns

UnicorpseI’m sure that many more thoughtful than me has written about the moral hazard of venture capital. In economics, moral hazard occurs when one person takes an unreasonable risk because someone else will bear the burden of the negative consequences. In the age of unicorns, the moral hazard in venture capital has never been greater. Moral hazard and exuberance to make unicorns leads to unicorpses. I was reminded of this today during a conversation with an emerging growth business run by capable, but  young entrepreneurs.

The Situation

The 20 something entrepreneurs with whom I was talking have built a solid, already profitable business generating $4.3 million ARR. The company has taken a total of $200k of outside financing. With a modest amount of incremental capital, the business has the potential to be a $30 to $50 million revenue business in 5 years and to be meaningfully profitable. Such a business could easily fetch $100 to $150 million in exit value, producing a significant amount of wealth for the entrepreneurs. In addition to producing personal wealth, after such an exit the entrepreneurs will have built a successful company, made money for their investors, established a reputation for themselves and find themselves with the personal wealth necessary to finance the start of their next business. They would be imminently “back-able” and set up nicely for a long and productive career.

Objectively, a $100 to $150 million exit in three to five years is possible for this company. Objectively, a unicorn type multi-billion exit isn’t possible. But sticking to the straight and narrow of building a solid profitable business is hard. Bad influences abound. Entrepreneurs, like the ones running this company, are flooded with tech-centric news about the birthing of a unicorns and are shielded from the harsh reality of entrepreneurial failure. The infrequent unicorn gets lots of press where the 40% failure rates that plague venture capital fade to black. It is no wonder then that many entrepreneurs (particularly young entrepreneurs) fall victim to the instinct to try to make their company into a unicorn. Lets go raise $[fill in the blank] and pursue [fill in big hair audacious goal] becomes the mantra, whether or not the opportunity has unicorn characteristics or the use of proceeds is well aligned with what the business is. Raising all of that capital leads to spending, and higher burn. After all “we’re not giving you the money to have you save it” and “you can’t save your way to success” are common refrains. In most situations, higher burn rate equals higher risk of failure. High risk, but not necessarily higher reward.

Who mourns the unicorpse?

With high-loss rates and returns concentrated in a small number of investments that go full unicorn, venture capital is more fraught with moral hazard than ever. Venture capitalists have portfolios and their performance is generally evaluated at a portfolio level. This portfolio level evaluation applies whether the evaluation is of a firm or an individual investing partner. Venture capitalist cares less about the success or failure of any single investment than the success of his/her overall portfolio. Knowing that loss-rates are high and returns are concentrated in a few large deals, venture capitalists have an inherent incentive to swing for the fences on every investment, increasing the risk and potential reward of each investment.

Who bears the cost? The entrepreneur.

Pragmatically speaking, an entrepreneur can manage only one entrepreneurial endeavor at a time. In fact, we investors often tacitly, if not explicitly, require this. We want the entrepreneur single-threaded, we need the entrepreneur single-threaded. I’ve got a portfolio, but you put all of your eggs in one basket…

To make ourselves feel better, we have lots of platitudes for entrepreneurs who experience failure.

It is better to have tried and failed that never to have tried at all.

You learn more from failure than you learn from success

There is no shame in failure.

All true; but when push comes to shove, venture capitalists are master pattern matchers and a tried and true heuristic is that past entrepreneurial success is a predictor of future entrepreneurial success.  Many investors would prefer to back an entrepreneur with a successful track record and a mediocre idea over an entrepreneur coming off a failure with with a good idea. A 20/30 something entrepreneur coming off of a failure is going to have a very difficulty time getting his/her next business financed. Conversely, a 20/30 something entrepreneur coming off of a successful exit is with a successful exit under their belt is much more likely to get financed.

No Villains Here

To be clear, I’m not vilifying venture capital or venture capitalists. There is nothing untoward about the economic motivations of investors.

I’m also not suggesting that intentionally increasing the risk of an investment is risk-free for the investor. Higher operating  risk implies a greater chance of capital loss. There isn’t a moral hazard in every venture capital investment situation. For example, some businesses operate in winner takes all markets. In such situations the motivations of the investor and the entrepreneur are nicely aligned because the go big or go home philosophy of company building is the right approach due to market structure.

I am, however, suggesting that the entrepreneur bares a greater proportion of the risk associated with venture capital investments; or at least that the consequences of failure are greater for the entrepreneur than the investor.

An Alternative Approach

When you swing for the fences, you strike out a lot. No manner of platitudes for the entrepreneur who tried and failed can remove the moral hazard.

Entrepreneurs in growth stage businesses face different calculus. In a situation like the one I described, the entrepreneurs have already created value for themselves. Taking a bigger than necessary financing round and swinging for the fences puts that built in value at risk and buries it under a larger preference stack than is necessary.

Making unicorns is risky business. There is another way.

Consider taking less capital. Consider staying laser focused on your core market and building a defensible position that is resilient to attack. Win narrowly and then exit. This may mean taking a more risk averse path to unlocking the value of the business. Raise less capital. Moderate burn. Get profitable as soon as possible and exit sooner. If that means not raising capital or raising less capital (and taking less dilution) all the better.

Young entrepreneurs operating an already successful business would be wise to remember that some unicorns end up unicorpses. It is better to be modestly valuable and alive than to have had the potential to be wildly valuable and dead.

Call me old fashioned. Call me risk averse. I’m guilty as charged.

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Vulnerability and Entrepreneurship

I was browsing through the new Tattered Cover store in the recently renovated Union Station in Denver a few weeks back and found myself standing in the Business Psychology section of the store. For some reason, I have a habit of finding that section without trying – gravity seems to pull me there. In any event, I started thumbing through a book by Brene Brown, named Daring Greatly. The subtitle of Daring Greatly reads: “How the courage to be vulnerable transforms the way we live, love, parent and lead.” There aren’t many books that stand-out to me as having altered my world view; Daring Greatly definitely did.

I had not heard of Brene Brown’s work before I picked up the book. Brown is a researcher professor at the University of Houston Graduate College of Social work and has spent the past the past ten years studying vulnerability, courage, authenticity and shame. This is pretty delicate subject matter; the kind of stuff our culture causes us to fear talking about an open, authentic and empathetic way. But her work strikes me as incredibly important as we struggle to counter-balance cultural cues which cause us to suppress self-doubt and hide insecurity in favor of bravado (false bravery). The book also includes important insights for entrepreneurs and leaders.

There are so many great takeaways from the book and one has to read it to get the full picture. For me, several concepts stood out.

  • Vulnerability and weakness are not one in the same, despite the fact that our culture confuses the two. Expressing vulnerability is a constructive process, not a character flaw.
  • Shame is the greatest barrier that impedes our willingness/ability to make ourselves vulnerable. Fear of shame causes us to hide our vulnerability from others.
  • Shame and guilt are not one in same. Shame says: I am [bad, lazy, fill in the blank] and there nothing I can do about it. Guilt says: I did something bad and, I don’t want to do it again and it is within my power to change the behavior that led to the bad act. Shame hides in a corner trying to stay out of sight, guilt is self-correcting.
  • We admire vulnerability when we see it in others, but we abhor seeing it in ourselves. We are blind to the fact that coming to grip with our vulnerabilities makes us stronger.
  • We all have shame… yes you too. Shame is the enemy. The way to defeat shame is through dialogue. Shame hates being outed, so in order to defeat shame, we have to talk about it.
  • One cannot be courageous until they are willing to make themselves vulnerable. Vulnerability is the root of courage. You have to be willing to make yourself vulnerable before you can dare greatly.

It helps to look at this through the lens of an entrepreneur. Entrepreneurs take on incredible risk when they start a business, because the risk of failure is so high. Our society abhors failure and as a result fear of a failure is a huge shame trigger for most people. Entrepreneurs must to overcome this fear of failure (and the social stigma associated with failure) before they even start. They must be able to say to themselves:

I am passionate about what I am doing. Although I will strive to succeed, I might fail. But if I fail, I will do so knowing that I have the pursued my passion, given my best and that is enough for me, regardless of what others think.

IMHO, there is no shame in failure for an entrepreneur. Quite the contrary, entrepreneurs should take great pride in their accomplishments regardless of the eventual outcome of their work. This philosophy which permeates healthy entrepreneurial cultures is well summed up by a quote from President Theodore Roosevelt’s Man in the Arena speech.

It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.

– Theodore Roosevelt

If you don’t have the time or inclination to read Daring Greatly, I’d encourage you to listen to Brene’s TED talk on vulnerability. I’m betting hearing her speak will cause you to want to read the book.

Kudos to Brene Brown for going to the uncomfortable places in human psychology. It is no surprise that a thoughtful look at what makes us most uncomfortable can lead to so much insight.

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