The last bastion of arbitrage

There is an old investment adage that there are no $20 bills laying about. This is referring to the elusive existence of “arbitrage opportunities.” Sometimes referred to as riskless profit. The thought being that there is no free money laying about because astute investors will swoop down and collect all the $20 bills laying about until they are all gone.

The last time I studied finance we were told that these risk-less money making opportunities in trading could be measured in milliseconds. Today– I don’t know other than it must be even harder to capture trading arbitrage opportunities.

In short there are not arbitrage opportunities in the public markets because there are too many players with the same information and really fast networks and computers. But perhaps arbitrage exists in slower, less liquid markets – such as the market for human capital?

Let’s consider the technology start-up market for human capital. Start-ups typically are seeded by entrepreneurs with enough moxie to generate intellectual capital (venture speak for a “good idea”.) Hopefully the entrepreneur will also create a proof of concept and maybe a working prototype of some sort.

Then they market this idea to a bunch of ivy-league educated people that mostly do not have any entrepreneurial experience and they sagaciously affirm or decry the start-up concept. The few entrepreneurs that are fortunate enough (or unfortunate depending on the deal terms) to gain expansion funding, then go about the really hard work of building a business. This mostly means capital investment, product development and marketing and sales. Most of this involves hiring other really smart people to do the work and expend their talents and contribute their IP.

So then the question arises in my mind, how does arbitrage work here? Let’s look at the “gives” and “gets” in this equation. The entrepreneur usually gets an ownership position (also called equity), a salary (sometimes deferred) a fancy title and the joy of a 24×7 job with little to no diversification other than what they possessed going into the deal. Sometimes the entrepreneurs have to vest on some agreed upon schedule. This is usually a 4 year term with a 1 year period prior to any stock vesting. So if they are replaced (fired) during that 1st year of this schedule they may have nothing. Note, statistics show that most founders are eventually replaced as executives by their venture boards.

The entrepreneur gives all this away in order to get the validation of the venture capital community and expansion capital. There are also number of intangibles such as the psychic return of being in a venture backed company and the esteem that being in a start up brings, but how do we measure this?

The venture capitalists get a direct ownership position with no vesting schedule and depending on the percentage of the company owned, they may have control of the board. Note that venture investors have the ability (nay the responsibility to their investors) to diversify as much as possible. In exchange for these privileges VCs give their investor’s money and some of their own if they happen to be partners in the fund. For those that do not know most venture fund capital comes from large pension funds, endowments, wealthy individual investors and such. The partners of theses funds contribute a modest amount of their own capital as well.

Now we get to the really interesting part of the equation- the workers in venture backed start-ups. These folks (yours truly included), take a non-diversified role for usually a bit less than industry standard with he thought being that a stock options package will compensate when the company is wildly successful. These workers may or may not have a substantial percentage of ownership and their options agreement is the last one negotiated and you can be sure that it is the least advantaged of the three.

So who comes out ahead here? Clearly the VCs. If you ever drive down around the homes of those VCs that were present during the Internet and telecoms bubble, this is pretty clear. As responsible investors, they are seeking to exercise their fiduciary duty by getting the best deal for their investors. The entrepreneur usually does ok even if the firm fails and last in line are the rank and file. Which leads me to our initial discussion on arbitrage.

Is it possible that much of the economic profit being garnered by the venture community and entrepreneurs is really arbitrage on human capital? After all, when you consider the gives and gets, there is no other role that is less diversified or protected from the outrageous risk of a start-up than the rank and file. Perhaps, the extraordinary profits that VCs reap (sometimes) is really a form of the last bastion of arbitrage- human capital?


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