Inclusive Capital Part I: How VC Limits Innovation
Many of the solutions we have today, from electricity to running hot water and indoor plumbing to public transportation, have their start as entrepreneurial ideas - developed by private markets that only after years (or decades) turned into the ubiquitous public utilities and services we have today.
These innovations have changed the world. But we have the power to do so much more. Modern-day entrepreneurship has increasingly begun to focus on the needs of the most affluent and, as wealth inequality continues to rise, we see entrepreneurship increasingly focusing on problems that are affecting a smaller and smaller number of us, in less and less meaningful ways.
So how do we unlock the power of entrepreneurship, that great engine of innovation, to address these most meaningful challenges? In part two of this post(? rant?), I’ll dive into some of the structural issues with the way investors support entrepreneurs (and some solutions), but first, it’s helpful to outline the basic premise of how venture capital works at its earliest stages today.
This is a complex topic, and there have been many (many) books written about this but, hopefully, this will provide a simple framework for understanding this complex problem.
Entrepreneurs need investors (and investors need entrepreneurs).
The Kauffman Foundation estimates it takes ~$30,000 to start a business. If the founder isn’t independently wealthy, that means they’ll need a loan… but over 83% of businesses don’t raise capital from formal financial institutions (ie: banks, credit unions, etc). Instead, entrepreneurs often rely on investors. In the earliest rounds, this can look like a patchwork of friends and family to fill their first rounds, but 78% of Americans are living paycheck to paycheck, and if an entrepreneur falls into this group (along with their friends and family), and “bootstrapping” isn’t an option, entrepreneurs have to look to outside investors: venture capitalists (VCs).
VCs rely on pattern recognition to guide their decisions.
Investors at the early stage are overwhelmed with opportunity. There are so many different startups to invest in and such a limited amount of capital that they rely on “fast and frugal” heuristics to determine who will receive their investment. They find opportunities that answer a few questions, like “do I understand this problem?” and “have I seen people and companies like this be successful?” and “who do I know that is backing this opportunity?” For those entrepreneurs that don’t pass these few questions, investors send them away with a quick “good luck.”
Entrepreneurship is problem-solving.
At its core, business is a tool to solve problems for other people in a way that they will pay for. The problem can be anything. Literally anything. Think of the most ridiculous product or service you’ve ever seen be successful. Whatever it is, if it’s a successful business, it solves someone’s problem, somewhere, for money. (Or the founder has, at least, convinced an investor that it solves a big enough problem for enough people so it has private investors keeping the business afloat, but that’s a different blog post for a different day).
To solve a problem, the entrepreneur needs to know it deeply.
We could spend a lot of time getting into why this is important, but someone else already did that hard work: Dr. Angela Jackson’s latest research shows the value of what she calls “proximate leadership” (lived experience of the company’s leadership). It boils down to a simple concept: effective, meaningful solutions to problems come from those that have the deepest personal experience with them. If you don’t know the problem intimately, you’re extremely unlikely to know the solution to that problem.
Entrepreneurs solving systems-level issues don’t fit traditional investors’ patterns.
Let’s go back to the top on this. A few of the key questions that most early-stage investors ask themselves when they’re looking at a potential investment include the following, are stacked against entrepreneurs solving some of the biggest challenges in the world. I’ll try to explain how briefly:
“Do I understand this problem?” This is a totally understandable and normal question to ask. The flip side, though, is that if an investor lacks empathy for, education about, or experience with the problem being presented, they’ll pass. Let's paint with a broad brush here. The structure of traditional VC means that empathy is mostly out (VCs see thousands of deals a year and only invest in around five on average. Being in that position could kill anyone’s empathy) and education is rare (few investors spend their time thinking and learning about the systemic challenges that don't affect them, like housing, hunger, healthcare, etc.). Lived experience is almost non-existent. Investors are in the upper tier of societal wealth distribution. Often, they’re in the top 10%, if not the top 5%, of wealth holders. They do not experience issues with access to or quality of financial services, or healthcare, or education, or food, or housing, simply because they have the capital for these to not be issues for them. The problems that affect most people, in most places, don’t affect most private investors.
“Have I seen people/companies like this be successful?” Companies led by Black, Latinx, and Indigenous founders combined raise less than 3% of all VC funding. Less than 10% goes to female founders, and less than 20% goes to mixed-gender teams. Less than 25% of capital in the US is distributed outside of three states: Massachusetts, New York, and California. A deep dive of 500 “unicorn”-level companies shows that fewer than 15% are solving issues that matter to most people. These challenges are intersectional: women of color raise a fraction of a percentage point of venture capital and, when they do raise, secure rounds that are 5-10% the size of the median seed stage round. It’s a self-perpetuating problem: few startups led by women or people of color, based outside of major venture hubs, solving big problems, have successfully scaled up and exited massively, so few investors see these types of companies as having potential to succeed, so few investors considering such deals invest. This problem is exacerbated in early-stage investing by the over-reliance on team evaluations, given the lack of company track record or other standardized metrics to forecast future success.
“Who do I know that is backing this opportunity?” A PRRI study showed that more than 70% of White respondents had a 100%-White social network. More than 80% of investment decision-making teams are White men, and a classic requirement of some of the most prestigious VCs is that a deal must come to them from a recommendation within their network. This insular and exclusive network makes it next to impossible for entrepreneurs from different demographics to break in. This is also a self-reinforcing challenge, as people (investors or not) strive to fit in with their peers. A well-known study highlights that the most effective way to influence the adoption of a specific behavior is to share that a person’s peers are exhibiting that behavior. Interestingly, this approach exerts a subconscious influence - the person affected will often list other reasons before (or entirely instead of) noting the behavior of their peers as a driving force for the behavior change. Breaking out of this pattern of investing in who you know, or who your friends know, presents a challenge to investors who often invest as much for the social prestige as for the returns.
This reliance on pattern-matching is limiting both societal innovation and investor success
Despite the amazing successes of certain stand-out firms, funds, and vintage years, most venture funds don’t return the money that gets put into them. When you take a look at the distribution of investment, the reason for that becomes clear: investors are only actually looking at a small portion of the overall number of opportunities. Diverse entrepreneurial teams have been shown to generate higher returns, and the myth that the pipeline just isn’t out there is just that - a myth. This data isn’t an anomaly. Even studies from major financial institutions like Morgan Stanley show that diverse teams drive higher returns. These major institutions have even gone the extra steps to identify specifically why these teams outperform.
This isn’t just limited to the demographics of the entrepreneur. The specific intersection of inclusion and impact (a focus on the big problems that affect most people in most places) has led firms like Kapor Capital to generate top-quartile returns. This intersectional approach doesn’t generate returns in spite of its focus - but because of it.
So why do investors continue to rely on this model? And what can we do about it?
Check out my next blog post to learn more.
In the meantime, if you have thoughts or questions on the above - let me know in the comments below!
