VCs and other investors need a contract with their seeker that blunts conflicts of interest
Professional investors know there are plenty of companies out there that would make them lots of money, if only they could find them … and persuade their current owners to take some funding and advice.
Venture capitalists, SPAC sponsors and activist hedge fund managers have become the go-to experts for investors hoping to track down these elusive investment targets. Everyone involved — whether it’s the VC, a company hoping to acquire a compatible technology or independent investors — would love to get a piece of some wildly promising company that’s so far been undervalued or uninterested in outside assistance.
Economists have produced a lot of research on how to write contracts that incentivize hired seekers to quickly find the best possible acquisition for their investors, UCLA Anderson’s Beatrice Michaeli explains in an interview. But, she continues, this research typically assumes the seeker’s job ends with landing the acquisition. In real life, that person often stays around to run the business. The dual roles of finding and then managing lead to conflicts — between what’s best for the seeker/manager and what’s best for the investors — and these conflicts aren’t resolved by traditional contracts.
Managing Conflicts of Interests
A working paper by University of Washington’s Felix Zhiyu Feng and Yifan Luo and Michaeli offers a contract formula that incentivizes the seeker to bring potential targets to the table quickly — and to do the hard work of milking that investment for strong returns once it’s acquired.
Their findings suggest that the investors’ requirements for a suitable acquisition start out high. Both the threshold for investing and the compensation for the seeker fall progressively as time goes on without an acceptable target. In the production stage, the investors set output expectations and the seeker/manager’s resulting compensation based on the information provided during the search stage about the capabilities and weaknesses of the target business.
The setup addresses two common issues in this type of contracting. First, the seeker may not be sufficiently motivated to exert enough effort to find targets in a timely manner, a problem that falls under the broad umbrella of moral hazard. The declining thresholds for both acquisition requirements and the seeker’s returns are incentives for the seeker to bring good possibilities to the table as early as possible.
Secondly, the hired seeker may not pass on all the information about the target to the investors, during the search process or while managing the business. This problem arises if it’s more lucrative for the hired seeker to hide a target’s flaws — perhaps to get a deal done quickly — than to reveal everything about its quality. Basing the seeker’s future pay on reaching output levels derived from the information shared during the search incentivizes revealing any issues that might make the goals difficult to reach. A higher payout with higher output encourages the seeker to continually push for the highest goals attainable.
More Investment Targets Are Better Than One
Michaeli and co-authors find that the best deal for investors is not the first acceptable one that the seeker brings to the table. This differs from conventional wisdom, which suggests the highest returns come when the search process ends and production starts as quickly as possible.
The researchers, on the other hand, model a situation in which the seeker brings one acceptable target after another. They find that their contract setup leads to investors taking on more targets, and gaining higher returns, than a process where the search ends with the first acceptable target.