# Compounding Interest

It's time for MBA Mondays again. For the third week in a row, the topic of the post has been suggested by a reader. Last week, Elia Freedman wrote:

"A suggestion for your next post. The logical follow-on is to explain the second half of the TVM (time value of money), which is compounding interest."

Before I address the issue of compounding interest, I'd like to recognize two things about the MBA Monday series. The first is that each post has a very rich comment thread attached to it. If you are seriously interested in learning this stuff, you would be well served to take the time to read the comments and the replies to them, including mine. The second is that the readers are building the curriculum for me. Each post has resulted in at least one suggestion for the next week's post. I dove into MBA Mondays without thinking through the logical progression of topics. At this point, I'm just going to run with whatever people suggest and try to assemble it on the fly. It's working well so far. So if you have a suggestion for next week's topic, or any topic, please leave a comment.

Last week, I described interest as the rate of change in the time value of money. And we broke interest rates down into the real rate, the inflation factor, and the risk factor. And we calculated that if you invested \$900 today at an 11.1% rate of interest, you'd end up with \$1000 a year from now.

But what happens if you wait a few years to get your money back and receive annual interest payments along the way? Let's say you invest the same \$900, receive \$100 each year for four years, and then in the last year, you receive \$1000 (your \$900 back plus the final year's \$100 interest payment).

There are two scenarios here and they depend on what you do with the annual interest payments.

In the first scenario, you pocket the cash and do something else with it. In that scenario, you will realize the 11.1% rate of interest that you would have realized had you taken the \$1000 one year later. It's basically the same deal, just with a longer time horizon. And your total proceeds on your \$900 investment are \$1400 (your \$900 return of "principal" plus five \$100 interest payments).

In the second scenario, you reinvest the interest payments at 11.1% each year and take a final payment in year five. If you reinvest each interest payment at 11.1% interest, at the end of year five, you will receive \$1524 as your final payment. Notice that the total proceeds in this scenario are \$124 higher than in the other scenario. That is because you reinvested the interest payments instead of pocketing them.

Both scenarios produce a "rate of return" of 11.1%. If you look at this google spreadsheet, you can see how these two scenarios map out. And you can see the calculation of total profit and "internal rate of return".

The fact that you make a larger profit on one versus the other at the same "rate of interest" shows the power of compounding interest. It really helps if you reinvest your interest payments instead of pocketing them. While \$124 over five years doesn't seem like much, let's look at the power of compounding interest over a longer horizon.

Let's say you inherit \$100,000 around the time you graduate from college. Instead of spending it on something, you decide to invest it for your retirement 45 years later. If you invest it at the 11.1% rate of interest that we've been using, the differences between pocketing the \$11,100 you'd get each year and reinvesting it are HUGE.

If you pocket the \$11,000 of interest each year, you will receive \$599,500 on your \$100,000 investment over 45 years.

But if you reinvest the \$11,000 of interest each year at 11.1% interest, you will receive \$11.4 million dollars when you retire. That's right. \$11.4 million dollars versus \$599,500. That is the power of compounding interest over a long period of time.

You can see how this models out in this google spreadsheet (sheets two and three).

Now let's tie this issue to startups and venture capital. Venture capital investments are often held for a fairly long time. I am currently serving on several boards of companies that my prior firm, Flatiron Partners, invested in during 1999 and 2000. Our hold periods for these investments are into their second decade. Of course not every venture capital investment lasts a decade or more. But the average hold period for a venture capital investment tends to be about seven or eight years.

And during those seven to eight years, there are no annual interest payments. So when you calculate the rate of return on the investment, the spreadsheet looks like this. It's a compound interest situation.

If you go back to the \$100,000 over 45 years example, you'll see that a return of 114x your money over 45 years produces the same "return" as 6x your money with annual interest payments.

The differences are not as great over seven or eight years but they are made greater by virtue of the fact that VCs seek to make 40-50% annual rates of return on their capital. If you read last week's post, you'll know that comes from the risk factor involved. The more risk an investment has, the higher rate of return an investor will require on their money in a successful outcome.

If you want to generate a 50% rate of return compounded over eight years on \$100,000, you will need to return \$2.562 million, or 25.6x your investment. See this google spreadsheet (sheet 4) for the details.

The good news is that most venture capital investments are made over time, not all at once in the first year. So the "hold periods" on the later rounds are not as long and make this math a bit easier on everyone involved (maybe a topic for next week or some other time?).

But as you can see, compounding interest over any length of time increases significantly the amount of money you need to return in order to pay the same rate of return as a security with annual interest payments. There are two big takeaways here. The first is if you are an investor, you should reinvest your interest payments instead of spending them. It makes a huge difference on the outcome of your investment. The second is if you are an entrepreneur, you should take as little money as you can at the start and always understand that your investors are seeking a return and that the time value of money compounds and makes your job as the producer of that return particularly hard.

1. Dave Pinsen

“The second is if you are an entrepreneur, you should take as little money as you can at the start and always understand that your investors are seeking a return and that the time value of money compounds and makes your job as the producer of that return particularly hard.”This reminds me of a related question I meant to ask in the comment thread of a previous post of yours (the one about the angel investments you and your wife make). In that post, you mentioned investing in the latest business of a particular serial entrepreneur. Since, as you say, an entrepreneur should take as little money as possible — and since, by definition, angel investments tend to be relatively small — why would a successful serial entrepreneur seek angel financing? Why not just self-fund if, presumably, the amount of money he needs is relatively small, and he has some money from his previous, successful ventures?

1. Mark Essel

I think it has to do with sharing the risk Dave, but you’ll get better answers out of the professional investors.

2. ShanaC

Sometimes this is better plotted on a chart. If you plot spreadsheet 3 onto a chart and then flip the axis, you will realize that even though it looks like there is a specific risk, in actuality in the initial the chart is asymptotic to the y axis (and as the company grows, ideally to the x axis), which means the risk is close to infinitely large. I would bet the asymptote approaches some number (aka, the initial return)- however that number, because of that asymptote, is not going to be a happy number. It explains why the initial investment should be small, and should be spread, because it means spreading that approach to that asymptote (aka the initial investment) widely- hopefully leading to a greater return.Charts are very useful here….However, would someone verify this, I had to make a chart and I am going on guts and some reviewing of calculus… (for some reason I’m thinking that your return is the area underneath the curve….)

3. fredwilson

He wouldn’t. Pincus, evan williams, dave morgan, mike yavonditte, paul forster and rony kahan, and a host of other serial entrepreneurs we backed funded the startup costs themselves. 500k is generally the number they are willing to fund on their own

1. Dave Pinsen

OK, thanks for the clarification.

2. baba12

a a rule it should be for every entrepreneur to avoid having to take money give up stock in their company.You never get rich by giving up equity and more importantly giving up equity is showing some disrespect/contempt for your own company.But unfortunately it is not always feasible to get a loan to be paid back with interest.I wonder if Union Square Ventures would be willing to just invest in a company and take no equity but take their investment plus a fair interest payment. Now that would be too philanthropic for their own comfort I guess.

1. fredwilson

not a chance. we take a lot of risk and need an equity return to compensate us for it.

2. Mark Essel

Thanks Fred, although it’s a pretty straight forward concept and calculations, I get a lot out of your connection to perspective in the last paragraph. Founders have to produce a ton to make the type of turn over VCs expect. We should only chase after venture funding when we know a particular investment will pay out \$\$ in the long term.

1. fredwilson

That’s the whole reason for mba mondays. Entrepreneurs should not go to b-school but they should understand finance

1. baba12

Not just Entrepreneurs but everyone should understand finance. If most folks know the cost of borrowing they would wait to save their money and then possibly buy what they want. Instead we have rich folks have educated society into spending frivolously and they have been smiling their way to the banks. Most folks who carry credit card debt are completely satisfied paying the minimum balances never realizing the compounding effects of their debt. I would hope Mr.Wilson would have such pieces laid out in simple terms and use his vast array of tentacles to spread the knowledge.

1. bernardlunn

That is great comment. It is amazing that basic money sense is not taught in schools. My wife and I are teaching our kids and it is never too early to start. The common sense stuff used to be taught in families but the finance industry made it all sound so complex – “trust us we will manage this for you, don’t worry your pretty head about it”. Warren Buffett is so cool because he makes even the complex understandable. MBA Mondays is great!

1. JLM

Warren Buffett/Charlie Munger and Berkshire Hathaway are excellent examples of the power of compound interest over a protracted period of time.Buffet, as an investor, has leveraged the power of compounding with good business decision-making focused almost entirely upon buying well positioned, sometimes pedestrian businesses (furniture for goodness sake) run by trustworthy people.Buffet may look like a stock picker but he is a business buyer — big difference. He is looking at the intrinsic value of the underlying business and leveraging that cash flow using his BH P/E ratio to create a value multiplying arbitrage.Mr. Buffet is not above a bit of financial alchemy.In spite of all of that, he has had a few real losers but he sticks to his principles and keeps moving on. The guy owns freakin’ Dairy Queen!Even Buffet, when the meltdown occurred, incurred losses which were fully collerated with the markets in general — he did not outperform on the downside.But Buffet has lots of cash, good cash flow and staying power. The key to harnessing compound interest concepts is staying power.

2. Dave Pinsen

“Even Buffet, when the meltdown occurred, incurred losses which were fully collerated with the markets in general — he did not outperform on the downside.”Why would he? Wasn’t he long-only, and un-hedged? Two investors I can think off the top of my head of who outperformed on the downside in ’08 were John Hussman, who limited the losses in his equity fund using hedges, and Marc Mayor (whose acquaintance I made recently, when he joined one of my sites), who was running a market-neutral portfolio.

2. Dave Pinsen

“If most folks know the cost of borrowing they would wait to save their money and then possibly buy what they want.”That’s not necessarily true. Everyone doesn’t have the same degree of future orientation or the same will to delay gratification. It’s a fallacy to assume that people do things that appear self-destructive, from your perspective, because they don’t know any better. I think most people who smoke, or gorge themselves on fast food, for example, are aware of the long term risks. They just don’t care. When life feels hard and the future looks bleak, depriving yourself of small pleasures today so you’ll die with a few extra dollars some day in the future may not hold the same appeal.”Most folks who carry credit card debt are completely satisfied paying the minimum balances…”I’m going to guess that most folks who pay only their minimum credit card balances aren’t “completely satisfied” with that arrangement. More likely, it fills them with dread. You might argue that they should have lived within their means in the first place, and you’d have a point, but for a lot of people their means have diminished in recent years. It can be hard to adjust consumption down to align with diminished means, particularly when spending is tied up closely with socioeconomic status.Falling into status traps is probably a greater cause of indebtedness than innumeracy about compound interest, and by contrast, avoiding them is probably a greater cause of financial health for those of average and above average incomes. That was one of the insights of The Millionaire Next Door.

1. JLM

Agree completely w/ all you say. The ability to buy “things” with care, discretion and an eye toward a smidgen of frugality is an art form. But it is an art which anybody can learn and exercise.One guy buys a “loaded” brand new Tahoe, the other buys a 2-year old “loaded” Tahoe. First guy pays for the “off the lot” depreciation retail, the second guy gets it wholesale. If at all.One gal buys @ Neiman Marcus, the other buys at Neiman’s Last Call. How many times are you going to wear a fashionable dress in the first 60 days of the season?These discrete buying decisions — which rarely have any real, measurable, meaningful utilitarian differences — can have a huge difference in the long term financial implications of your pocketbook.An oddity today is the coincidence of low costs of “things” and low costs of capital. If you have the stomach for it and you can handle the cost, now is the best time in years to borrow gobs and gobs of money. It is on sale @ 3.25%.In bad times, borrow the max, borrow at low costs, borrow long term. You will be repaying it with inflated cheap dollars when the worm turns. Just remember to buy durable investments like real estate.The greatest courage in the buy low — sell high world is the courage to buy low. And, then, to borrow even lower.We will all look back on this and say — damn I should have bought that lake house, that NY apartment, that big boat, that classic convertible, that airplane, that bimbo — just kidding about the bimbo (only rent, never buy bimbos).

No! In the short term – five years.

1. Mark Essel

5 years is an eternity to me, that’s long term. My fault for using such vague terminology to describe time.

3. ssaint

Fred, absolutely love MBA Mondays, while I’ve been familiar with the topics so far, it’s great to refresh the basics in such a clear and concise manner…

4. Healy Jones

3rd take away for an entrepreneur – this is why VCs often ask for cumulative dividends on their preferred stock…. and why you would really rather they bought non-cumulative preferred stock!

1. fredwilson

I don’t like dividends on preferred stock. Its like a growing anchor on the head of the entrepreneur. Some VCs have forced them on us in later rounds but they are not in our term sheets

1. Healy Jones

Alas, if VCs sometimes force YOU to take it, think of how hard it is for the typical entrepreneur negotiating with a VC all on their own…

5. Randall Lucas

An interesting adjunct to this would be the concept of reinvestment risk. Assume that one can get that 11.1% interest payment locked-in for 45 years; it’s not certain by any means that one can reinvest consistently on the same terms. It sounds like a nit, but it’s not at all: dealing with preferences for (or aversion to) that kind of risk led directly to some of the securitization practices associated with the most “toxic” of the toxic securities (MBS/ABS/CDOs).

1. fredwilson

Right. But you can buy a zero coupon bond for 30 years that implicitly offers the reinvestment at a fixed return

6. Eric Leebow

Great post, yet I’m wondering whether investing in a stock like Google for 45 years is a better return than compounding interest for 45 years. It’s also amazing how much stuff you learn in your MBA is a repeat of stuff they taught you or tried to teach you in grade school, yet it takes an MBA to finally understand it all and explain it to everyone.

1. fredwilson

The whole point of all these posts is to eventually evaluate equity investments. We’ll get to your google question

1. Eric Leebow

Right, google is just one example. The best VC investments are the ones that are not always seen (ie. a VC portfolio company goes public).

7. Heather Onstott

I was just thinking about the element of time on VC investments this weekend, and how often its effect is ignored or underestimated. The last paragraph of this blog is spot-on. Anecdotally, in commercial banking, depositors are disclosed the “APY” – annual percentage yield – which spells out the effect of compounded interest into a rate. Investors and entrepreneurs both would be wise to think in terms of this principle when evaluating capital investments.

Fred – clarification question. You say VCs like to earn 40-50% return on capital. This is the target for an individual investment as opposed to a portfolio, correct? Most VC investments don’t return close to this, but the ones that do probably suck up a disproportionate share of fund dollars as you double down on winners and sell or liquidate middling/losing investments.

1. fredwilson

Right. The good ones (generally a third of a fund) need to earn this return to cover all the others

I don’t like the way people conflate compound interest with huge gains. In your example you compare taking 11K/year to making millions over years and conclude it’s important to let the money compound. That too simplistic. If I am paying 26% on my credit cards then I should take the interest payments out of the investment. If I have spare money, I should take my interest payment + more and reinvest it in this wonderful risk free 11% investment. Investing exactly the amount I made in interest is unlikey to be the best amonut. It’s just an easy number because a lot of investments let you “let it ride”.For your next MBA Monday you should discuss why different people have different acceptable ROR. You can explain why it makes sense for some people to make an investment that would be unwise for someone else.Keep up the great posts…

1. fredwilson

Right. Different risk, liquidity, and net worth profiles. Good suggestion. Thanks

2. Mike

“…That [is] too simplistic.”Exactly! Which is why Fred noted that, “If you are seriously interested in learning this stuff, you would be well served to take the time to read the comments…” I view this blog as essentially a relay race, where Fred gets us off to a great start and then hands the baton to this community so that we can finish what he started. It’s that relationship, and comments like yours, that add real value.Great comment.

1. fredwilson

that’s right. i don’t pretend to know everything about a topic. but collectively we all do a pretty good job of nailing it.

2. paramendra

One thing I have wanted to do but have not come around to doing for lack of time is seek out the blogs out people who comment here and put them on some kind of a blogroll. I think that would make for a high quality blogroll. http://ptechnorati.blogspot

1. Mike

I think ShanaC did something like this with twitter. Might follow up with her to see how that’s progressing.

3. JLM

The most important characteristic of any investment is the ability to sleep at night while owning it. People have different levels of comfort. Don’t fight the feeling.The second most important characteristic is the ability to lose your money and to continue to live as you desire. Even if it hurts a bit.How did Bernie Madoff get all those sophisticated investors to part with their money?He gave them the false sense of security that allowed them to sleep at night. He understood his investors. And, of course, he was a pathological criminal.

1. ShanaC

I still worry about Madoff’s appearing. I know they will. He really understood the people he hit up. I should know, I live in the same area as them. And I’ve met Merkin’s kids. They have a good band…Similarity breeds trust.

2. Aaron Klein

Well put, JLM. I’ve seen a fascinating (and patented) new asset allocation model derived from that precise logic and implemented mathematically. It puts “modern portfolio theory” to shame. It uses historical market data and will even suggest a 0% allocation to asset classes that don’t match your appetite for risk, unlike MPT.I haven’t hit on the perfect strategy for helping the patentholder monetize this, but it certainly has the potential to revolutionize finance if it happens.

10. David Semeria

Fred I don’t want to be a PITA, but I’m not sure both the \$900 scenarios produce the same IRR. I had a quick look at the spreadsheets, but couldn’t work out how to view the formulae.One of the key assumptions of IRR is that cash flows are reinvested at the IRR. Since this is not the case in the first scenario, it’s hard to see how the IRR can be the same in both cases.I could be well be wrong; it’s ages since I did this stuff – and even then I never really liked IRR much.

1. Dave Pinsen

Whoops, meant to “like” David’s other comment. Quick trigger finger.

2. David Semeria

Fred,I did a bit more work on this and basically the problem is not with your example or with your spreadsheet, but – as I suspected above – with the assumptions behind IRRAs far as IRR is concerned, both examples are equivalent because IRR assumes the cash flows in the non-compounded scenario are also invested at the same rate as in the compounded one (ie the IRR).I don’t want to confuse people, this isn’t a big deal. Feel free to delete this comment and the one above.

1. fredwilson

As I said before, irr is a bitch

1. lucas

Hi, If i’m not mistaken, a solution to the reinvestment problem of IRR lies in the Modified IRR named MIRR which is taught to in business schools right now.Investopedia definition:While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that all cash flows are reinvested at the firm’s cost of capital. Therefore, MIRR more accurately reflects the profitability of a project.By the way the MIRR also resolves a second problem of IRR: multiple IRRs results when there are positive and negative cash flows over the years for the project. Check on Wikipedia about that !Lucas

1. Elia Freedman

MIRR is most effective in situations where you have multiple inflows and outflows not in order. IRR does not calculate these situations well at all. An example of this is where you make an investment of \$100,000 then receive back \$25,000 and then have to make an additional payment of \$50,000 followed by returns. IRR can’t handle this fluctuation correctly. MIRR was designed to handle this.

2. JLM

IRR is a measurement tool and one has to “read the instructions” to understand how to operate the tool. I view it as a discriminator between competing investment opportunities and as a framework to be consistently applied to develop a personal earthy sense over time as to the relative performance of investments.The obvious limitation is the implication that you can reinvest cash generated at the same rate of return.Applied consistently the comparison value is not lost as long as all IRR analysis contains the same flaw.Any financial analysis should include several different looks — a 360 degree look in my view — including MIRR, multiple scenarios, break even, “bait back”.I like to use a “bait back” analysis when looking at acquiring operating businesses. “How long before I get my bait back?” The term or time period of the return of your invested capital is also a great way to adjust for risk.If you get your bait back in 12-24 months, then thereafter you have no real skin in the game and the entire return is pure profit. This is very true in multi-unit operating businesses and the oil business.Always remember that at the end of the day, financial analysis is only a single data point in making an investment decision. A great rate of return would not likely compensate for mediocre management.Once you have invested you money, the most irrelevant piece of data is what you thought you were going to make.

1. David Semeria

Give me DCF any day of the week. Harder to get your head around, but once it’s in your bones, you really don’t need many other tools….

1. Dave Pinsen

The only other tool you’ll need is the crystal ball that tells you what the future cash flows will be. ðŸ˜‰

3. fredwilson

irr is a bitch

11. chris dixon

Compounding interest is the 8th wonder of the world. If you run the numbers at 5% risk free rate, turns out the Dutch overpaid for NYC when they paid \$65.

1. David Semeria

The 9th wonder of the world would be locking-in 5% risk-free for 400+ years.But you’re right, compound interest (especially at a few points above average) is indeed a wonderful thing.

1. Dave Pinsen

“The 9th wonder of the world would be locking-in 5% risk-free for 400+ years.”This is one reason why I never liked that example when I’d heard it used in the investment community in the past (though usually they’d use average annual S&P returns instead of a risk-free rate). Another reason, of course, is that most investors need to tap into their savings after a much shorter period of time, and average annual returns over a century or more aren’t necessarily representative of the average annual returns they are likely to experience during their investing years.

2. Pascal-Emmanuel Gobry

Well, what’s the median NYC bond yield? And as we saw in the 70s, New York *is* too big to fail…

1. fredwilson

We have a great ceo running this town. We are in good shape

1. Pascal-Emmanuel Gobry

Didn’t mean to imply otherwise, in fact I meant to say the opposite: you _can_ use NYC bonds as the risk free rate.PEG

2. ShanaC

unlike Nassau, one of the Next counties over *cough republican mismanagement for nearly 100 years cough*

2. fredwilson

We have a great ceo running this town. We are in good shape

1. kidmercury

my last comment with anti-bloomberg links is not appearing, you can see it on my disqus page, disqus.com/kidmercury

2. Mark Essel

Disqus takes a while to catch up sometimes.

If you think compounding is the 8th wonder of the world you’ve obviously never had my mums chicken soup. ðŸ™‚

1. ShanaC

That is so sweet of you….

2. fredwilson

Or my wife’s chocolate chip cookies

1. Tereza

Or my linzer cookies.We may need a bake-off to accompany Carl’s kegger road trip.

1. ShanaC

Or my whole wheat challah…Now that might be fun, a bakeoff

2. Tereza

Shana, thank you for bringing this sub-thread back to the core topic with your challah (which I am very eager to try).It reminded me that my very first compound growth calculations were on yeast bacteria, in 9th grade biology.So any yeast-based baking is totally a propos.Well done!!! ðŸ™‚

3. ShanaC

Now those I would actually want to see- I’m very much by eye. Whole wheatchallah is difficult to do and there are techniques I want to try, butwithout knowing compound growth of yeast versus more about breads ingeneral….(Yes people- there is a science to bread)I can send you the recipe and the gossip I have heard about this recipe andrelated recipes. My hillel was awesome that way…lot of women and men whowere into food and cooking…We should just start a message board of side conversations….

4. Tereza

Shana track down this book, and then let’s talk. The Lost Art of Baking with Yeast — Hungarian Baking by Baba Schwartz. http://bit.ly/aTcnZHIt may be more Gotham Gal than AVC but love to have the convo with you either way.

2. paramendra

AVC.com needs to run a contest of some sort. The winner gets those chocolate chip cookies.

3. awaldstein

Or my mom’s mandelbrot.Great comment Liad.

1. ShanaC

I would love the recipe for that, I grew up with mandelbrot…

1. awaldstein

Hey Shana I’ll talk to mom.@ almost 91, she still makes a great mandelbrot.

2. ShanaC

Yay- and you should preserve her recipes at her age, though she might makeit the way I make some food, by just making it. It will be a good gift foryour family.

3. awaldstein

Great idea.

4. paramendra

Murdoch also says good things about his mother. So does Bloomberg.

5. awaldstein

We all have them. We are just lucky when we have great ones.

4. fredwilson

Or my wife’s chocolate chip cookies

3. ShanaC

*snickers*

4. fredwilson

Lol

5. fredwilson

Lol

6. Mark Essel

O_o

12. Scott Barnett

It’s great to combine hard facts with emotion – the discussion of IRR made perfect sense, then I got to your last sentence. I had just read a blog entry last week from an entrepreneur who had raised multiple rounds of VC funding who suggested that you raise more than you need (http://bit.ly/dBwxDl). Clearly, from a non-emotional (and purely technical) point of view, your comment is correct – since VC’s will typically continue to reinvest, it gets harder and harder to give them their 50% returns the more money an entrepreneur takes. But then you’ve got the emotional aspects – how much of the company can/will I give up? Will I need multiple funding rounds to achieve success? The minute you add emotion to the equation, it’s nearly impossible to compute the outcome. One thing is almost universally true – you need to build a pretty darn successful venture for anybody to get their desired “return” once you bring a VC into the picture – and that is hard to do no matter what return you are looking for.

1. fredwilson

If an entrepreneur doesn’t care about his/her investor’s returns (and maybe they shouldn’t) then taking a ton of money if they can may be a smart move. May is the operative word

1. Wavelengths

“If an entrepreneur doesn’t care . . .,” then maybe we’re talking about a scam?In my observation, the true, heartfelt entrepreneur is taking on the effort and risk of putting together a company because he/she cares, with passion, about filling a market need, building a real business, creating jobs and a healthy workplace, and rewarding everyone who helps make that happen, including the financial investors, customers, employees, suppliers, landlord, community, and so on and so on.Thanks, Fred, for putting the investor view of compounding interest in place.

2. JLM

“My name is Jeff and I have been a user of OPM for decades.””Welcome, Jeff.”I have raised, borrowed and paid back over \$1B in my business career. And I am not even associated with the US Government.The world is divided into providers of money and users of money.If you are a user of money — get as much as you can and understand that you may not be able to get more in the future. Get all you need and then some. Only use what you actually need.You always make better long term business decisions when you are not being strangled by the balance sheet.When starting an enterprise investors are investing in you — you personally.When raising additional funding in the future, investors already have you. They are now investing in the performance of the company solely and exclusively and, in fact, may decide that you need to go.The difference between how users and providers of capital view finance is fundamental, defintive and irreconcilable. This dynamic tension is why some folks are entrepreneurs and some are funders of entrepreneurs.Be true to your own best interests and get as much as you can when you can but only actually use what you need. Never, ever, ever, ever confuse your own personal financial situation and net worth with the financial structure of a business. Your business is not going to pay your kid’s college tuition.

3. JLM

One more thing — if you exceed an investor’s return expectations, they will not refund to you the difference.I am very sure about this. LOL

13. Tereza

Fred, you echo what I learned in b-school about taking in only what you need. Of course include a cushion for unexpecteds, but generally keep it as low as possible. And that really jives with me.However, in the last two years, I heard so many people say “take in as much as you can because you don’t know when money will be available again.” It feels to me like hyped thinking one would want to avoid….but then again I hear that logic.Obviously that’s not core to the Compounding Interest topic as you’ve presented it for the MBA Monday. Was wondering you view on that — is it a perspective that spans different cycles when VC is less available?Thanks. Another great post.

1. fredwilson

Its the mindset of an entrepreneur who doesn’t give a shit about his/her investor’s returns. And I’m not sure they should care. But I sure do

1. baba12

well it should matter.When you borrow money from someone then you have to at least at the minimum be willing to state that you will return that back in due course, the hope and desire to be always to return it compounded.I guess if the thought process is always about seeing how “I can screw the other person over” then you will take all you can upfront. dilute your stake but since you are all bout screwing the VC you could careless. I wonder how many entrepreneurs you invest in know the responsibility that comes with the taking the capital.

2. Tereza

I guess if that understanding and alignement isn’t there at the beginning, it never will be. And undermine strategic value the VC could provide (if they have it to give). A lost opportunity. Sounds more like a bank loan.

2. JLM

We are all getting a bit too “goody two shoes” here. Remember we are talking about a class of investments and the type of free market capitalists that make Mako sharks nervous.The VC business is a rough and tumble business which requires some pretty steady nerves and while executed by some very nice and well educated folks can be a pretty damn hard edged business when it comes down to the short strokes.As an entrepreneur, get as much money as you can and only use what you need but don’t fall prey to the noble notion that you are going to talk some experienced venture capitalist out of a bit more when you REALLY need it without paying a very dear price for it, indeed.In times of trouble most investors default to doing nothing until they absolutely have to do something.Use competition to your very best advantage when seeking funding. Seek and obtain multiple term sheets and play one VC off against the other. Having said that, beware because all VCs are NOT the same. I would rather pay a bit more to be associated with some rather than others. There is a huge difference.Understand the motivations of ALL of the players.The Pension Fund boys are providing the funding to the VCs in huge chunks — \$25-50MM at a whack — based upon a glorified beauty contest, a pitch, a review of their track record, the chemistry and the “ties that bind” — sometimes called the network. The PF boys only have 2-5% of the entire PF assets in private equity including VC. Failure will not kill them. These guys draw good salaries w/ meaningful incentives, went to good b-schools, wear blue suits/blue French cuff shirts w/ white collars and cuffs on their pants. They are not personally as brave as a VC.The VCs are avaricious capitalists who have a damn good deal structure working for them. They get a management fee from which they have to run their business and a carried interest in the performance of the funds they manage. They invest the PFs funds knowing that only 33% will be long balls w/ men on base, 33% will be ‘hit batter, take your base’ and 33% will be flop sweat root canal failures. They know this before they even meet you. These guys wear business casual every day of the week. They are shameless “punters”, handicappers, pickers of talent and they will suck the life force out of their entrepreneurs without a minute’s hesitation. Make them rich and you will become rich in the process.Ahh, the entrepreneurs are diseased persons who cannot fail to follow their dreams and the VCs know this. They enable this dysfunctional behavior. They will fight for you to the last drop of your blood or until they figure which third you will end up in.So, get all the money you can and only use what you need and work like hell to make the VCs rich and a bit of it will stick to your fingers along the way. Save your emotional capital for the Easter Bunny.

1. Eric Vreeland

Hi JLM,I really enjoy your contributions to this community. I’m currently writing a paper on venture capital and was hoping I could chat with you sometime about the industry. Let me know if you think this might be possible. Thanks!

1. JLM

Feel free to call any time 512-476-5141 but Fred’s your boy when it comes to VC. He is the most knowledgeable and forthcoming pro you will stumble upon in this business.This blog is a delightful and almost perfect insight into an otherwise mildly arcane and clubby industry.This blog is an application of the most important skill in business — the ability to read upside down.

2. Tereza

JLM thanks for your outreach and forthcoming response.Naturally the mayor of Fredland is excepted from this. :-)No emotional capital here, really want to get the job done (and choose whether to raise VC….my objective from the start was no). There are always alternative paths.Have you seen the dynamic you describe lessened or exacerbated since the asset class was declared “broken”?

1. JLM

Oddly enough, I think the world continues to be awash with money but in some ways it is being guided by that cat who sat on the stove. I generally think that VCs raised quite a bit of money before the feathers hit the fan and are “struggling” to put it into quality deals knowing that this is a 1/3 1/3 1/3 business.The whole world has become more cautious hence the favorable impact on McDonald’s and WalMart.While VC \$\$\$ are a small, small fraction of fixed income and equity allocations of major pension funds, they have not had the traumatic public beheading “mark to market” experience that public securities have had as a result of the recession and previously ebullient markets. They therefore seemingly benefit by comparison.I also think they are paying a whole lot more attention to their existing portfolio given the dearth of encouragement coming from the IPO side of the house. You make different decisions if you think you are going to own something for a longer period of time.I don’t really think that the asset class is broken, I think frankly it has become so much more professional, transparent and accountable that the rule — 20% of the people make 80% of the money — has imposed itself. Why should VC be exempt?As to Fred, I think he is a particularly shrewd very well educated thoughtful guy who has a perfectly keen sense of where the sweet spot is as it pertains to the size of the funds he has under management, the overhead necessary to manage that enterprise and a specific focus at which a small firm can become a meaningful force.I also think that this blog is a particularly effective way for him to stamp his personality on a industry in which the personal touch is often overwhelmed by the simple commoditization of money. This is also a great audience of polite, thoughtful, accomplished folks and I personally enjoy reading it very much.

14. kidmercury

MBA mondays illustrates a few of my favorite things:1. inclination of blog stars to be educators2. crowdsourcing potential of blog stars3. need for a new CMS for blog stars (as we will learn as MBA Mondays progresses, a simple blog setup like typepad is grossly inadequate and cannot serve market demands)4. need for blog stars to incorporate game play into their community (a bit redundant, as every community will need game play, but especially crowdsourcing ones)5. brokenness of what is taught in “school” (aka govt training camps)as for compounding interest:1. everything depends on the risk-free rate, as we talked about last week. the risk-free rate is the basis of financial reality. that is a huge issue and IMHO it would behoove the professional investment community to understand arguments that any model which regards long-term treasury bonds as a safe investment is grossly misled.2. the reality is that there is no risk-free investment. what in life is risk-free? nothing, of course. everything is relative, and so, the value of compounding interest is dependent upon relative investment options.3. the principles of finance breakdown when there is a currency crisis. when precious metals rise for a sustained period, its a sign a currency crisis is brewing. imperialism often leads to currency crises as well, as the war agenda ends up being financed by printing money (i.e. theft by inflation) when other financing options are not available. the US empire is closing in on this point, and IMHO, should consider turning around. in hindsight professional investors will almost certainly wish it would have been so.as my contribution to MBA mondays, i’d like to put a kook spin on fred’s original post, which will involve interpreting fred’s original post through a conspiratorial, paranoid, distrustful lens (in other words, what i do everyday). “monday night kookonomics” (MNK). in the comments section only, of course. gotta keep your ear to the street!

1. Aviah Laor

It also proves that the investment aura is much more pleasant to deal with than the credit card debt, which (unfortunately) incurs the very same compound interest.

1. fredwilson

I should have talked about that. Very nasty stuff

2. fredwilson

I’m glad you like them so much kid ðŸ™‚

3. awaldstein

It also proves the concept of ‘Hacking Education” Kid.Fred’s comment above that ‘entrepreneurs don’t need to go to biz school but need to understand finance’ is a justification in itself for this blog and the eduhack concept.

1. Mark Essel

Excellent point Arnold, and am I’m very happy to be on the receiving end of biz information here.

1. awaldstein

You and I both Mark.We all need to reinvent ourselves daily in the face of constant change. We need info and education to do this. And we don’t need to stop time and go back to school…that is for certain.

15. Daniel Chow

Great article Fred. A concise sum-up on compounding interest would be: Interest paid not only on the initial deposit but also on any interest accumulated from one period to the next.On your last point about investor’s re-investing their interest payments instead of spending them, I think its important to point out the different ways that an investment yield / return can be computed in a financier’s world – namely that of the money weighted return and the time weighted return, as explained in this article:http://www1.finance30.com/i…The takeaway for an entrepreneur is that if you figure out the multiple ways that a rate of return can be viewed, you get closer to the perspective of how your potential investor makes a case for an investment in your business.

1. fredwilson

Good point

16. FarazQ

I love the ‘rule of 72’. It’s another way to think about compounding interest.Basically the rule of 72 helps you easily calculate how long it will take to double your money at a given interest rate. E.g. If you invested \$1000 at a Rate of Return of 7% per year. Assuming you re-invest the interest, the amount of time to double your money is 72/7 = approximately 10 years. If you get a 10% rate of return, you can double your money in 72/10 = approximately 7 years.You can also use the rule to figure out what rate of return you need to double your money in a certain period. E.g. Want to double your money in 4 years? 72/4 = approx 18% return required.To me this helps explain how compounding interest makes a huge difference. A 7% annual return may not seem much…but most ppl don’t understand that that means you are doubling your money in a decade.http://en.wikipedia.org/wik

1. fredwilson

It is also useful in analyzing subscription businesses

1. PhilipSugar

Can you expand on that?

1. zackmansfield

I think what Fred is referring to in subscription businesses is the compounding effect of adding (or losing) business. Take a monthly recurring revenue biz – if you add \$1000 in new MRR a month, the effect on your annual revenue rate is much more than \$12,000. Month 1 you have \$1000, Month 2 \$2000…by the end of the 12th month you have \$12,000 in MRR. The annualized sum of adding \$1000 per month is actually 78×1000 = \$78,000it’s especially important when analyzing churn in a recurring rev biz.see the spreadsheet here = http://spreadsheets.google….

1. Mark Essel

Thanks Zack, appreciate the explanation and sheet. So far all of this stuff is straight forward, which is groovy (busy learning web coding, can’t spin off to many cycles for learning finance).

2. markslater

excellent zack – its all about churn.

3. fredwilson

exactly

17. Aviah Laor

Simple and clear as usual. However, the magical effect on the 45 years deposit doesn’t work any more. To gain this rate you have to be much more risky (or work with the guys that don’t have debt collection problems)

1. fredwilson

18. Michael F. Martin

he second is if you are an entrepreneur, you should take as little money as you can at the start and always understand that your investors are seeking a return and that the time value of money compounds and makes your job as the producer of that return particularly hard.Fred just earned the ultimate integrity points. It’s one thing for the guys over at Venture Hacks to point this out. It’s another for a VC with LP money to do so. My hat’s off, Fred.

1. fredwilson

I’m a small fund guy. I don’t care about mgmt fees. I care about carry and most of all the success of the companies and people we back

1. PhilipSugar

“I’m a small fund guy. I don’t care about mgmt fees” that is the money quote of the month……says it all right there.

19. Scott

Great post, Fred! These MBA Monday posts have been great to share with my MBA classmates.

1. fredwilson

What school are you at?

1. Scott

I’m a first year MBA at Haas (UC Berkeley).Would love to have you on campus next time you’re in the Bay Area!

1. fredwilson

that would be fun.

20. purchase order financing blog

I liked the post. In your post you mention that most VC don’t get any interest payments during the years that they hold the asset, thus they demand a higher RoR.Now my question: Do you encounter many situations where the startup company has reached a point where they have free cash flows and can make shareholder distributions (aka “interest payments”)? I know common lore states that VC’s always want an exit strategy and want to sell or go IPO ASAP. However, in this market it may make more sense to hold the asset/business until conditions improve and just collect interest.I am sure many are laughing at the fact that I used the words startup and free cash flow in the same sentence. But I had to ask :-)–Marco

1. fredwilson

I’d rather see the company recap than pay dividends. We have finite fund lifetimes. Dividends can’t get us where we need to be. Cap gains are what we need

1. PhilipSugar

This and your comment about not accruing dividends are interesting.I enjoy this series and regardless of when and how you learned the concepts it is always good to see them tie back to the entrepreneurial world.What is your mechanism (polite term for hammer) to deal with the companies that don’t turn out to be runaway successes/flameouts?I’ve seen a lot value destroyed here because instead of saying: “well the market proved that it just did not turn out to be as big/fast growing as we thought lets maximize value” which has to be true in many instances, the company flails and takes a high risk gamble on a low probability outcome and fails.I.e. lets fire current management, bring in an expensive CEO, hire some additional expensive talent and watch it crash into the ground.Recaps aren’t always possible (you have to have somebody willing to recap)(I also totally agree that raising as much money as you can instead of as little as you need means long term you are screwing returns for everyone)

1. fredwilson

i think the best approach is to allocate very little of the fund’s capital to the non performing or under performing investments

21. ShanaC

Two things:I need to get a good book on spreadsheets and finances. I understand what is going on. Setting up spreadsheets for finance is still a messy process. Like why is there \$0 dollars, why is that not explicitly stated it is going back into the investment. How do you best write that up? But that’s a skill thing.Secondly- wow this makes me want to go back and learn more math.wow. because rate fluctuates in actuality because US bond yields fluctuate. wow. That is the most amazing thing I have learned ever. I could do this for the rest of my life. And that makes me feel incredibly dorky saying that aloud.Also, looking at this makes the Greece thing make sense now. Wow. That is so cool…I just looked up Black-Scholes. I can’t say I understand it all (way lots of math and physics). However, I can say that I think this is explicitly in this, especially if what happens if a currency goes sour. I really want to see how initial strike prices are done. That number can’t come from nowhere, and it is closely tied to Black-Scholes. Though I am perfectly ok with your topic choice. I’m learning a ton being passive in all of this.

1. fredwilson

Go take a finance course at stern if you can

1. ShanaC

What just happened? Did I say something totally that orbits the giant hairball?I first need to figure out the next few months…

2. Jeff DiStanlo

this is the only spreadsheet/finance book that i ever found useful. been building financial models in excel for 10 years. careful what you wish for about doing this for the rest of your life. it just might come true….. it did for me. lol.http://www.amazon.com/Finan

1. baba12

best place to get spreadsheets on finance is at http://is.gd/8vOwL.Mr.Wilson mentions taking a course at NYU Stern, Ashwin Damodaran I believe still teaches a course on Corporate Finance and his site has a ton of good information.

1. ShanaC

I’ll write to him ask him what to do.

22. frank

fred, you’re doing a nice job taking complicated concepts, making them digestible. Looking forward to cash flows…

1. fredwilson

I might do a month of mondays on that topic

23. baba

I would think that anyone who reads this column would have passed tenth grade for sure.Why I bring that up is cuz the concept of simple interests and compound interests are covered by tenth grade and one is supposed to remember the concept of Compound interests and how it works.If only the musings of Mr.Wilson were followed by those who were involved with the TARP program we would not have given those who took the risks and lost a second chance by bailing them out. I am sure Union Square Ventures does not get bailed out by their investors if some of their bets go bad.

1. fredwilson

No. We go out of business as it should be

24. martinowen

Forgive an old man (60) here. This was on the curriculum when I was in the equivalent of 8th grade in the US – don’t kids learn this any more? This is significant for your culture- mainly in the reverse direction. If you do not appreciate that debts grow if you do not pay off the interest + some of the principal it is conceivable that you end up with a financial crisis that could bring down a major bank or two. (but that could never happen)

1. fredwilson

I am sure that everyone is familiar with the basic concept. But a refresher course with a tie into the vc math is always useful

25. Pascal-Emmanuel Gobry

Amen. I should’ve added compounding interest to my earlier comment about time value of money. Indeed, it’s a wonderful thing. If only it was explained in high school perhaps people wouldn’t wait so much to save…

1. ShanaC

it was explained to me in high school, terribly, as an introduction to calculus. totally screwed up the calculus imho. My brother totally disagrees. But we learn math totally differently…

26. Elia Freedman

Great job, Fred! I think you got next week’s post: the rule of 72 and analyzing subscription models suggested by FarazQ and zackmansfield.I once heard Neil Degrass Tyson speak at a conference for math educators. He’s an amazing speaker if you ever get the chance (and his books are incredible). He told the story about how his daughter came home from school crying because she had gotten a low grade on a math assignment. When Mr. Tyson questioned the teacher, the teacher said she got the correct answer but screwed up the process. Mr. Tyson explained to the teacher that he taught his daughter a shortcut that allowed her to do the same problem in a fraction of the time and always derive the correct result. The teacher wasn’t moved and didn’t change the grade so he had to teach his daughter the longer, more complicated method. Keep in mind he told this to a room of 15,000 math educators! It was totally awesome as he got a standing ovation from half the room and the other half sat in their chairs scowling.Anyway… my point being that often times a good shortcut is better than a full analysis.

1. Jeff DiStanlo

i looked into the rule of 72 a while back. turns out it is actually more appropriately the rule of 69.3.plug the following formula into a spreadsheet and you will see that is what it solves to.(1+r)^n = 2ln((1+r)^n) = ln(2)n * ln(1+r) = .693n * r = .693n = .693 / ri felt so betrayed after using 72 for my whole life!

27. einherjer

I love MBA Mondays but I disagree with the name. Financial concepts are the basics of course but from my experience an MBA is all about skills, not just knowledge.Just a crazy thought: you should be posting some case studies while the “class” discusses it in the comments! Although, maybe this is not the right tool.

28. Phil Botana

All the talk of food reminds one of the fact that investing brings with it an opportunity cost. If you invest in something short term, there is probably little opportunity cost (unless the sum is large). If you invest large amounts of money for long periods of time, you may not be able to take your mama’s favorite cookie recipe and turn it into the business you know it can be.This is why adjustable rate mortgages were invented. Banks did not want to get locked into long loans at low interest rates. The opportunity cost is too great.

29. Suyog

30. paramendra

First time I am hearing of MBA Mondays. Has it been inspired by the Follow Friday phenomenon on Twitter? On there, they have Music Mondays, I think. ðŸ˜‰

31. Mark Essel