Reducing Risk and Improving Incentives in Funding Entrepreneurs

This article suggests backer financing mechanisms that encourage an entrepreneur to launch a start-up that has unacceptable risk although positive expected payout. It uses decision analysis and certainty equivalents to compare these mechanisms from both the entrepreneur’s and the backer’s points of view. Backers may be local and national governments interested in technology, job creation, and growing the tax base; foundations; charities; nongovernmental organizations; and even corporations or individuals interested in a new product or technology. Alternative mechanisms include (a) the equity participation model predominant in start-up financing, (b) outright incentive gifts, (c) insurance against downside loss, and two new ideas: (d) swap hedge and (e) revenue contract. We develop risk analysis models of the alternative mechanisms, from which we calculate the comparative risk-adjusted attractiveness of each mechanism to the entrepreneur for a similar level of expected cost to the backer. The best alternatives, two highly efficient new ideas, eliminate moral hazard and leave ownership and control in the hands of the entrepreneur. And in the revenue contract, the backer may be additionally rewarded with money back sooner. Teachers may use the modeling and analysis to demonstrate comparative analysis of hedging versus insurance and fixed versus floating contracts, as well as risk sharing.