Hurdle rates – If the bar is too low it might be a trap

Recently, I was considering investing in a business whose brand I really like. The capital structure was unique because although young, the company had been funded through a very low-interest loan from an angel investor. Maturity for the loan was approaching in six months and the investor refused to extend the term. The company desperately needed cash to pay down the loan and to support growth. Our investment committee wasn’t thrilled that a large portion of the investment would “leave” the company.

Young businesses are highly risky due to size, market uncertainty and other operational challenges. Understanding this risk is the most valuable skill set for both investors and entrepreneurs. Investors work with hurdle rates – minimum required rate of return – and will only invest in companies whose expected return clears the hurdle rate. Similarly, entrepreneurs apply hurdle rates to capital budgeting – allocation of capital to projects whose return is higher than the cost of capital. Entrepreneurs who don’t fully understand the risk of their businesses could make investment mistakes that destroy value. In this particular case, management assumed that the cost of capital of the debt security equaled that of the overall business. This underestimation of risk resulted in fast growth, but through reckless investment decisions. Underestimating risk creates several business challenges. Below are a few examples.

  • Paradox of Choice: When cost of capital is superficially low, a large number of projects clear the hurdle rate and management will spend too much time deliberating on opportunities that would normally be unworthy. Faced with too many options, management could lose the stamina, rigor and discipline required to make good investment decisions. The more the errors made, the more each incremental investment destroys value.
  • Smoke Screens: Revenue growth is usually a leading indicator for return on investment. And, since young companies are often valued on a revenue basis, entrepreneurs could get caught up in premature value celebrations before discovering lagging investment mistakes e.g., revenue with low gross margin, revenue with high fixed cost, or revenue that is inconsistent with overall strategy. Investments accompanied with high fixed costs are particularly hard to unwind.
  • Capitalization: Today’s high valuation must be paid for by high revenue growth or through a future down round, both of which induce tremendous stress to the entrepreneur. Additionally, debt often results in complications around secondary transactions when paying back the principal and around interest obligations that affect profitability.
  • Adverse Selection: Investors with an ability to augment value often have a strong grasp of business risk for target companies. Investors offering valuations that are “too good to be true” may not fully understand the underlying business and therefore cannot add much value. Some might have ulterior motives that create distraction. Before accepting capital, entrepreneurs should perform due diligence on potential investors as if the company were using its stock to buy into the investor’s value ecosystem (network, technical expertise etc.).

In summary, whilst cheap capital might appear attractive on the surface, it presents challenges that can potentially result in future value destruction.

Scalability – Just because it’s small doesn’t mean it will grow

Starting in 2004, I spent a few years tracking the promising story of Freddy Adu. Freddy, then a “14” year old phenomenon, and widely tipped to be the next big thing in soccer, became the youngest athlete ever to sign a professional soccer contract. He was drafted by D.C. United. United made a bet that he would grow into a superstar and would either help the club win many trophies or would be traded for a handsome return. Freddy was a flop. There was a rumor that although he appeared small, he was actually “20 something” and was only better than his youth teammates because he was significantly older. Whatever the true story is, United made a massive error in evaluating Freddy’s potential.

I spent the last two weeks in the Bay Area with senior executives of the several businesses owned by our Limited Partner. Our objective was to explore the entrepreneurial ecosystem in the Valley (hence my inability to write in the last two weeks). We met with many young companies with aspirations of growth and domination. However, I observed a clear distinction between companies with demonstrable potential for growth and those without. When analyzing growth potential, I focus on three primary levers: Customer satisfaction; Unit economics and Distribution.

  • Customer Satisfaction: Customer satisfaction is arguably the best way to prove scalability, due to the power of the virtuous cycle of referrals. Satisfied customers drive greater retention rates and spread positive news about the brand, which results in further customer acquisition and more revenue. Companies use several tools such as Net Promoter Score (NPS) to measure customer satisfaction. High-growth companies have high scores relative to their peers, possess a deep understanding for why and have clear strategy and resources to exploit their advantage.
  • Gross Margin: Strong unit economics provide solid validation for sustainable profitability of a product beyond temporary factors such as hype or promotion. Additionally, there is a self-reinforcing loop between customer satisfaction and profitability. The more customers refer a product to peers, the lower a company’s customer acquisition costs and the higher its profit margins.
  • Capacity / Distribution: This is a catchall for all the processes that culminate in an economic transaction. Distribution starts with the capability to source and produce enough inventory followed by the ability to place it in the hands of customers as quickly as possible and in a way that is most convenient to them. Certain constraints in this value chain could limit the ability of a business to scale. A great example I read recently used inventory constraints to explain why Uber is valued more than Airbnb. Whereas there are relatively fewer people willing to open their homes regularly to strangers, there are many car owners with excess capacity to transport others during their down time.

When assessing startups, investors and entrepreneurs must carefully assess scalability of key growth levers. For example, is observed revenue growth driven by discounts? Is the product scalable at full price? Are there potential bottlenecks to growth e.g., scarce raw materials, regulations around distribution etc.?

Freddy’s case reminds me a bit of myself. While in college and at 5’6 and 135lbs, I lost a meaningful sum of money investing in height enhancing supplements. I only stopped when I realized that instead of growing taller, I was developing love handles.

Feels good to get back to writing!