There's an interesting article today by Sarah Lacy in Pando Daily. In it, she analyzes why there seem to have been a lot of high-profile failures among "celebrity" startups that had raised tons of money, and were being touted as doing very well by their boards and investors up to the point at which they, abruptly and with no notice, failed. In addition, she laments the fact that, in today's environment with the growing cult of the celebrity entrepreneur, boards seem willing to let "celebrity" startups spend all their money despite the obvious fact that the business is going to fail. Here's what she wrote:
"Witness Sean Parker’s disastrous Airtime. One of the old school investors in the round advocated that the capital be returned and it be closed down. Not a crazy request: It clearly wasn’t working. But other investors were happy to play “the good cop,” saying they still believed in Parker and were happy to let the bet ride. And those good cops are making a savvy move. They’d already written that money off, and don’t get any blood on their hands. If it goes under quickly? So much the better. They can focus more time on the winners."
In addition to Sarah's analysis of this phenomenon, and why it seems to be happening more frequently (with almost all of which I agree), there's another reason why VCs are willing to do this besides avoiding a confrontation with a celebrity entrepreneur (and possibly getting cut out of a great, future deal). This other reason has to do with a little-known corner of the asymmetric risk/reward structure of the venture business, and here's how it works.
Starting with the blindingly obvious: VCs get rewarded when they generate high returns on invested capital. If a VC doesn't make a lot of money on a deal, however, the way-way-off-in-the-distance second prize is getting one's money back (the euphemism is "getting one's bait back" -- no idea where that came from; it always struck me as odd: that one's investment was some kind of "bait"). That is, surprisingly, considered not a bad outcome. "At least I didn't lose my money!" is not something about which to brag, but it's also not an embarrassing admission for a VC. Sort of like kissing your sister on the cheek.
But, importantly, there is no third prize, not even way-way-way-way off in the distance.
This means that getting, say, a third of one's money back is considered a wipe out, and a professional embarrassment equivalent to losing everything.
So, if there is any money left short of an amount that would "get one's bait back", the psychological/professional incentives of the VC are (1) to go for broke and (2) hope that a miracle happens and a positive return is generated. If it does, the VC is a hero. If it doesn't, the VC is certainly no hero, but he's no worse off, having lost all his "bait", in the eyes of his partners and colleagues than if he'd (merely) lost most of the "bait". The fact that miracles like this almost never happen doesn't change the dynamic.
A very successful VC friend of mine expresses this as: "You can only lose your money once if you fail, but you can make many times your money if you succeed."
This dynamic, or asymmetric risk/reward structure, has been recognized in corporate law for a long time. It is why the law provides that, once a company is approaching the zone of insolvency, the fiduciary duties of the Board shift from favoring the shareholders to favoring the creditors. When a company is insolvent, the shareholders, who are unlikely to get anything in a liquidation, have an incentive to throw a "hail Mary" pass for two reasons: (1) if it works, they win, and (2) if it doesn't work, they are no worse off than they were before (i.e., they wouldn't have gotten anything in a liquidation, and that's what they're now getting). On the other hand, the creditors have no upside if the "hail Mary" works because they never get paid more than their principal and interest, no matter how high the upside. But, they do have significant downside if the "hail Mary" uses up valuable cash on which they, by law, had the first priority claim.