This post builds on the Dhando Investor post which with 20 comments was getting a bit cumbersome. Deepak Nadiger made an interesting comment and I wanted to respond and decided to do it with a fresh post. The hurdle rate discussion is an opportunity to be innovative and delight customers. In the businesses I have built in the past these have been central themes and I believe that there is an opportunity to build interesting plays that scale fast using the approach of innovation and delighting customers. In 1985 in India we used this approach and in four years built a business which had revenues of $12 million.
Time is the enemy of IRR which is why startups need to work extra hard to create value quickly. In the case of PayPal start to IPO was two years ( four is a hard par for the course). The PayPal IPO was post dot com bubble. In fact it was in late 2001 which was really dot com winter and a very tough time to IPO.
As usual please chime in with your views.
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bb,
I think the method you are following is great and I wish you luck. In my case when I was in the US and raised angel money I had my entire technical architechture done and a team which was ready to join once funding closed. We had a company which weput in $50,000 of our own money and ended spending around $10000 of which $5000 was paid to a company that helped us put the technical architechture in place. We managed to get a lawyer to work on a contingency basis. Zero fee if round did not close. If it did they would get around $10000 and 0.5% of founders stock.
I knew my domain really well and what the roadmap for the company was. All this took me about six months to do and I started looking for money at end of month 2 and finished mid way through month 6.
I had lot of domain knowledge and a good track record with Citibank but as an entrepreneur I was a rookie. In fact from Raja Bhoj I became Gangoo Taili.
A condition of closing was that we relocate from the East Coast to the West Coast which my cofounder was not prepared to do and the deal fell apart. I ended up abandoning my startup called ZipPay and joined PayPal as VP and probably ended up doing much better financially then I would have with ZipPay ( most payment startups other than PayPal failed ). I did play a very key role in getting PayPal to win but I was a rookie at many other things which would have made it quite probable that ZipPay would fail had it started.
A silver lining was that I sold the domain name ZipPay to Bank of America which failed when it launched a competing product against PayPal. IF BoFA was Raja Bhoj, PayPal was Gangoo Taili. For those who believe that Raja Bhoj always win this and many other such instances may convince them otherwise.
In fact the odds are stacked heavily in favor of GT in GT v/s RB especially if the innovation is disruptive. ( Read Clayton Christensen ” Disruptive Innovation”
Interesting discussion on raja bhoj and gangu taili. deviating away from the hurdle rate discussion.
Well, I have a significant experience in M&A but i’m starting a venture relating to media. I might be a Raja Bhoj in M&A but I’m definitely a Gangu Taili as far as media is concerned.
It has been difficult to attract the right team for the venture. I’m not even looking at angel investment as of now. becoz after 3-4 months of effort, the investor will ask about “TRACTION”. My point is why should I waste 3-4 months to hear about TRACTION, when i know for a fact that I dont have an investible team. I’m instead focussing on getting the product out ( a scaled-down version) and networking with as many customers as possible. I’m putting all my personal savings at stake.
If customers like my product and value proposition for the scaled-down pilot, then the team, capital, infrastructure all will fall in place.
I thought it would be a waste of time estimating the market-size, having a proper business plan and trying to get VCs to listen to my idea at this stage of the venture. After having a ball-park guestimate of the market size, and mentally having a limit on the maximum time and money I want to put at stake, the credo is JUST DO IT.
Just open the shop and display your product. Customers will start walking in. Then its upto you how you convert these customers and….the amount of learning these customers will give you, no ‘expert’ will be able to give you.
Going this way has the risk of delaying the project, but to get a few angels to listen to your idea before starting to execute itself will take atleast 2-3 months. i think its worth the effort.
regards
Hmm. The aim then is to seek “alpha” – a rate higher than the interest free return. While hurdle rates and high watermarks used to be commonplace during bad times, it’s less common now with very few top quality managers and too much capital going towards them. High watermarks offer fees only if the fund manager crosses highs of the last x years, meaning if a fund manager takes 100 to 120 and drops to 110, and then rides up to 132, he gets fees on (132-120) where 120 was the last high. Avoids performance whipsaws affecting returns.
One of the reasons consumers may not be attracted to them – assuming consumers are skilled to choose efficiently – is that this structure may prompt very low risk taking especially with risky asset classes like equity. Lower risk than one can take is actually a bigger problem than we usually acknowledge.
Let’s go numbers: If a manager who’s innovative decides to not take fees or profit sharing under a tax free hurdle rate. To compensate his time let us say he would need to earn 25 lakhs a year. That means on a 10 cr capital he would need to get 22% returns (minus 10% short term capital gains) per year, which has not been tough the last few years, but things have changed.
The only way to earn money (or lose less) on downsides is to allow for futures/options, and that effectively curbs returns on the upside (effectively you buy insurance). So the market needs to go up 30% for a 22% hedged return.
30% is by no means common so some risks need to be taken, and if there is risk there is downside potential, meaning no income to this guy. Even if he’s an ultra smart manager, he will end up walking away because we have the 2 and 20 schemes in demand where he can pass over the downside.
You can’t usually attract more people by charging less based on a hurdle rate. The only thing you can do is to actually outperform, and then people will come to you if your post-fee return is higher than the rest of the gang. The 3 and 30 on John Arnold’s 300% return is nothing when you consider the real return you get.
Perhaps what I’m saying is: unless there is a market downturn, the demand for good/risky managers will be high, more money will flow to them under 2&20s, and they will not want to think about a hurdle rate bridge. But if there is a turn of events…yes, that will be the time to get attention using such schemes.
Almost nothing is easy in a high aspiration startup but I have one maxim that has helped me ” When a fish stinks it stinks from the head”. There is little to be gained from blaming investors, subordinates, the environment, customers or subordinates.
Attracting, retaining and motivating talent is a key task and it can be done.
Is there a good ESOP plan which has protection for employees and does not allow them to get shafted by promoters. At one of the Indian startups I invested in I worked for four months as a full time VP and I got a good understanding of how important communication,listening and setting an example is. We talked long into the night about why quite a few people did not trust ESOP’s and got them to participate in the design of the plan.
A lot depends on the culture you want to foster. How much information can you and should you share ? These are not easy questions and I think there is no one best way. If people can trust you as a leader they will do a lot for you and the challenges of retention, motivation and recruiting will become much easier.
On the hurdle rate phenomenon, it has a flip side too. It’s only when an investment avenue / Fund Manager is too sure of delivering IRR way beyond the hurdle rate, it might offer the features you seek….(No fees…yes, no STT/Service Tax I am not sure since these are indirect taxes).
But you might as well factor in that great demand for such proven avenues/ rock star Fund Managers will render them beyond the reach of every investor – and in that sense they can’t have mass appeal…scalable in value terms if you keep the ticket size big.
Many of the industry’s biggest names — Steven Cohen of SAC Capital, Paul Tudor Jones of Tudor Investment, Louis Bacon of Moore Capital, Steve Mandel of Lone Pine Capital and others — do not need to expand existing funds further and often believe that more cash would hurt their returns. Even when they find they have the capacity to take more money, they typically turn to their existing investors first.
Check this out : http://gpsurvivalkit.blogspot.com/2007/05/2-and-20-has-now-become-3-and-50.html
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