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Nudging The Entrepreneur Down The Start-Up Path An entrepreneur may see the start-up as his or her child with all the desire to control over its destiny that parenthood might entail.

By Samuel E. Bodily

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So, How Best to Encourage and Inspire An Entrepreneur?

Consider some innovation in funding to match the innovation inherent in entrepreneurship. There are some novel methods on how to nudge an entrepreneur over the risk barrier and down the start-up path. There is a classic example of a risk going bad illustrating the dilemma faced by stakeholders, who want to invest in a worthy entrepreneurial cause.

Over the past decade, backers — including the federal governments, foundations, individuals and others — invested more than $100 billion in promising early-stage clean-tech companies, such as KiOR, Solyndra and Ener1. They hoped that the innovative companies would find original ways to reduce global energy consumption and improve the world. Instead, the companies went bankrupt as the cost of petroleum plummeted, making innovative alternative energy too costly by comparison. If that is the assumption, then it is appropriate to encourage cleantech entrepreneurs to pursue potentially revolutionary new ideas, could we do so more effectively? Are there better ways for backers to encourage start-ups by reducing risk more efficiently than was done in the past?

Also, backers should keep in mind the psychological needs of these risk averse entrepreneurs. An entrepreneur may see the start-up as his or her child with all the desire to control over its destiny that parenthood might entail. And, entrepreneurs may have all their financial resources insync. They need risk sharing.

Tried and True Financial Mechanisms:
Equity Financing: The standard method for financing a company is through equity financing, issuing, for instance, common shares or convertible preferred shares. The problem is that the entrepreneur may be very reluctant to give up any degree of ownership in the company.

Incentive Gifts: Incentive gifts provide an upfront substantial amount of money. They might come out of social or governmental motivations and in form of grants or forgivable debt. But, the gift doesn't mitigate the uncertainty for the entrepreneur.

Insurance Against Loss: Entrepreneurs may worry about losing all assets and at the same time might lose employment if their start-up fails. Backers can limit those potential losses by providing insurance that covering the losses into profits that exceed some coverage amount.

Potentially More Successful Financial Mechanisms:
Revenue Contracts: Revenue contracts are seldom used in start-ups. A backer may have great interest in providing capital with a payout taken not as ownership [as with equity funding] but as a percentage of future revenue through a revenue contract. The payout to the backer comes much earlier than with equity and is more certain. It may be delivered as a regular payment of a percentage of revenue that continues until a specified multiple of the principal investment that has been met, or perhaps as a return of the principal plus an annual return. In the case of crowdfunding, it may come as a product if they've been given funds for developing a video game or a software, as an example.

Meanwhile, the revenue contract may be more enticing to an entrepreneur than giving up ownership. Swap Hedges: Research suggests that the most efficient financial tool may be a derivative contract, such as a swap hedge, in which the entrepreneur may be compensated for uncontrollable and undesirable conditions, that leads to worsening business climate and, in turn, compensating the backer for increasingly desirable conditions.

To the extent that these risks are tied to an objective measurable quantity, a solution may lie in a derivative contract where the conditions are measured by an index that is objective and reported by an independent third party. There is another strong reason to favor the swap hedge. Because the swap contract is written on the outcome of an objective index, the entrepreneur has no incentive to be complacent or to give up, whether the index turns out to be favorable or unfavorable .

(This article was first published in the January issue of Entrepreneur Magazine. To subscribe, click here)

Samuel E. Bodily

Professor of Business Administration, Darden School of Business, University pf Virginia

Samuel E. Bodily is the John Tyler Professor of Business Administration at Darden School of Business, University of Virginia. He has Ph.D. and S.M. degrees from the MIT Sloan School of Management and a B.S. in Physics from Brigham Young University. 
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