Recently a friend and I was working on some business ideas. We were thinking through scenarios where smart people come up with great business ideas or business models that can generate impressive returns but require capital to do. If the capital markets work perfectly for the specific risk profile of the business (assume that it can be assessed correctly), then all capital should only be able to demand the market rate of return on capital.
We ran some simulations on this. To simplify the whole business and risk, we assume it is a very low-risk infrastructure project that returns constant cashflow across 10 years, one year after the initial cash injection. A project that can bring in >27%, when raising all of its funds from a capital owner, should be split 60-40 if the market hurdle rate is at ~12% for that risk and tenure. This means that though the capital holder is financing 100% of the project, he needs to give up 40% share of the returns to the ones who structured and pulled the project together.
Now, when the project returns rises to 33% over 10 years; and the market hurdle rate remains at 12%, then the capital holder needs to give up 49% share. This means that if the project that the smart guys are able to put together can return more than 33%, then the capital owner needs to give up more than 50% of the returns even though he is contributing 100% of the upfront capital. This is a hard bargain for the ‘entrepreneurs’ organising the resources to strike with capital holders.
This is perhaps how the Thomas Piketty argument about the relative bargaining power of capital gets played out. At the same time, capital can afford to be more patient because the cost of upkeeping capital isn’t as high as trying to upkeep a living person with the wits and capabilities to develop all the ideas and organise the resources. And because capital is more ‘tangible’ and ‘calculative’, it can keep forcing all kinds of cost upon labour side of the equation. In this blog post, labour basically includes the ‘entrepreneurial’ elements as well that is typically somewhat associated with capital.
This is where debt comes in. Instead of getting a co-investor, the project entrepreneur should be able to borrow to finance the project. And the debt tenure can be shorter. A simple solution could be to take out a 4-year debt at 7% interest; this would require the entrepreneur to sacrifice 85% of the project cashflow for the first 4 years, in exchange for the rest of the project’s cashflow. Technically, when structured as a debt, the market interest rate should be lower than the market hurdle rate. Yet because the ‘project’ is new and may not have a sufficient track record, financiers may demand collateral and other risk-management tools to enhance the credit standing. Technically, when structured as a debt, the market interest rate should be lower than the market hurdle rate. Yet because the ‘project’ is new and may not have a sufficient track record, financiers may demand collateral and other risk-management tools to enhance the credit standing. This means that the entrepreneur would have to give out more than he needs to reduce the risks of the capital holder further despite the risk profile of the project.
So, the entrepreneur who does not have any capital to contribute will be seen as having a mouth-watering return since there isn’t any ‘capital at risk’ for the entrepreneur, but the reality is that there is some opportunity cost. Yet if the entrepreneur’s salary is built into the project returns, then he doesn’t have the ‘opportunity cost’. The extra upside would be his ‘supernormal return’.