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.

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