When does fair reward become sheer greed? I was recently approached by a veteran property developer who had agreed to buy a shopping centre at a price he claimed was a bargain. He suggested I put up all the capital at risk and that we share the equity upside 50/50. I told him not to bother sending me details of the scheme: his terms were so one-sided that I had no interest in participating.
The worst aspect of this venture was the idea that a successful entrepreneur would have no skin in the game at all — zero money at stake if it all went wrong.
I am astonished at the audacity of such wheeler-dealers, specialists in undertakings where if it’s heads they win and if it’s tails you lose. Why would anyone accept such arrangements? Yet it seems there are takers.
Our era of low interest rates and plentiful liquidity has not only seen earnings multiples expand to extreme levels, but also massive inflation in the promotions demanded by entrepreneurs. A world awash with cash, desperate for returns, means backers tolerating egregious mark-ups by founders and packagers of investment propositions. Whether it is stock market IPOs, tech start-ups or management buyouts, advisers are encouraging promoters to expect ever bigger slices of the pie.
I would say envy ratios have risen substantially over the years. (The envy ratio is the equity price paid by management versus the equity price paid by capital backers.) While a ratio of 3 to 5 might have been seen as acceptable in the past, 5 to 10 has been much more common in recent times. This reflects the weight of money sloshing around the financial system and the number of investors keen to do deals at almost any price.
Since the culture permits such enrichment, many private equity and venture capital firms try to extract for themselves the absolute maximum from every deal. The poor old limited partners who stump up the cash pay all the bills. Because these asset classes have done relatively well, huge sums are still flowing into the coffers of the bigger names in the sector, from institutional sources such as pension funds and insurance companies.
Some might say the envy ratio is irrelevant — what matters is the overall price of the deal — but I hate to be seen as “dumb money”.
If management holds capital providers in contempt then the partnership is unlikely to work well. Moreover, incentives should be aligned as far as possible. When management seizes too much equity, investors often retaliate by making their instruments more expensive.
For example, they might charge high, compounding coupons on their loan stock. So the percentage of the equity that managers own accrues much less of the value. This paves the way for an adversarial relationship.
I probably receive a couple of business plans a week describing pre-revenue tech ventures. Most are software applications. Each one claims to have a novel concept with huge potential and their valuations typically appear to me to be bonkers. I might be prepared to risk a little cash in some if the founders were being more realistic.
I was recently told that 1.5m tech start-ups a year are launched worldwide. Only an incredibly small fraction will make it. Most entrepreneurs would be better off avoiding the overcrowded digital space, fashionable though it is.
I accept that if an entrepreneur possesses an important patent, a juicy mining claim, a prized copyright, a lucrative planning permission or some other definite property that has underlying worth, then a big promote can be justified.
But so many businesses expecting silly valuations are simply me-too copies, riding on the coat-tails of an earlier hit. The hype surrounding the often notional fortunes made from the Silicon Valley unicorns is infectious. Highly educated and ferociously ambitious entrepreneurs think capital is cheap and believe their concept business should be valued on curious metrics such as multiples of revenue or worse.
Of course, the philosophy outlined above may just mark me down as a dinosaur. There have been tectonic shifts in the economy that could mean old-school principles about investment no longer apply. Yet I am too set in my beliefs to jump on the bandwagon now.