3. Discussion

Let us briefly interpret the results of the previous example and then discuss the advantages and disadvantages of staged capital contribution in more detail.

We have seen that, as time goes by, the investor learns about the company and its ability to meet the milestones from the business plan. As the business develops, uncertainty drops, the probability of a complete failure goes down, and the valuation of the firm increases. Because the valuation goes up if the firm succeeds, the entrepreneur gets a better deal with SCC than he would usually get with a lump-sum investment upfront.

 

SCC has two main benefits for the VC: A control mechanism and a signalling/screening mechanism.
 
Control mechanism of SCC:
  • With SCC, the entrepreneur has to come back to the investor periodically for funding
  • This allows the investor to monitor the firm and react to new information (e.g., enforce management changes if goals are not met, stop investing). 
  • SCC therefore allows investors to better control their investment. They receive an option to expand if things go well (keep investing) as well as an option to abandon if things do not go as well as planned (stop investing)!
  • Consequently, investors can limit their initial financial exposure to the firm. And they can manage the distribution of their profits:
    • By participating in an early round of financing, they have their foot in the door for future rounds.
    • They can subsequently terminate their exposure to the losers in their portfolio (option to abandon). Because the initial rounds of financing are comparatively small, early abandonment also means that the financial loss is limited for the VC.
    • At the same time, they obtain the right to keep investing (increasingly large amounts) in the winners in their portfolio (option to expand). In an industry where capital is available in abundance, such access to potentially promising ventures can be very valuable.

 

Signalling and screening of SCC:
  • Another nice effect of SCC is that it will tend to attract the better entrepreneurs.
  • Only entrepreneurs who are confident about their venture will be willing to defer raising capital, because it allows them to issue equity at more favorable terms in the future.
  • Less confident (or underperforming) entrepreneurs, in contrast, will prefer upfront financing. So if an entrepreneur enters into a SCC agreement, this signals the VC that the entrepreneur is willing to put the money where his mouth is.

 

 For the entrepreneur, in contrast, SCC is a "horse race between fear and greed.” 
 

"Fear" results from the VC's option to abandon:

  • With SCC, the company has a clear “fume date,” that is a date when it predictably runs out of money!
  • This provides a very high powered incentive to work hard and reach the defined milestones
  • This also implies, however, that the entrepreneurs have a constant fear of running out of capital. This might have adverse implications on the development of the business. For example, it could imply that entrepreneurs focus too much on the next immediate milestone and do not prepare sufficiently for the second or third milestone down the road.
  • With SCC, the entrepreneurs fate also depends on the VCs future behavior. What if the VC runs out of liquidity and cannot provide the capital for the next financing round? What if the VC loses interest in the company and abandons it despite good fundamentals? And what if the firm has temporary bad luck despite excellent fundamental prospects?

  

"Greed":

  • We have seen in the previous example that raising a lot of capital early on leads to maximum dilution of the entrepreneurs ownership stake.
  • To extract a higher valuation (and thereby secure a higher ownership stake in the venture), the entrepreneur therefore has the incentive to postpone selling capital until opportunity is “proven.”

  

It is important to note, however, that SCC is not free of charge.

  • Each round binds significant resources (management time, lawyers, new business plans, meetings, etc.)
  • As we have mentioned above, one possible problem for the entrepreneur could be that the VC has investment rights but no capital? Such a constellation can block the whole process and potentially eliminate the firm.
  • Also, it might be that the investors and the entrepreneur do not have the same incentives. For example:
    • They could have different time horizons. The VC wants to make sure that the firm is ready for exit within 5-7 years. The entrepreneur, in contrast, might dream of a multigenerational family firm.
    • Also, the fact that an investment is an option for the VC also has important implications. Remember the drivers of option value from the module Startup Financing. There, we have seen that the value of an option goes up if the project becomes riskier and if important investments are postponed. Consequently, the VC might have an incentive to push for excessive risk and to postpone investments as long as possible. This is not necessarily in the best interest of the entrepreneur, to whom the venture is more than an option.