Inclusive Capital Part II: Why VC Limits Innovation (and how to fix it)
The problems we are facing as a society require nothing less than the harnessing of the full potential of our minds. Hunger, education, healthcare, housing, and economic mobility are the defining challenges of our society. They require governmental, philanthropic, and entrepreneurial solutions.
When government lacks the will (good luck getting anything through Congress), and philanthropy lacks the capacity (a recent UBS report noted that globally, philanthropy amounts to ~$1.5 trillion), we must rely on entrepreneurship and the power of business to create scalable solutions to make life better for all.
To unlock the power of entrepreneurship, we need to change how we support these critical engines of innovation. In my last blog post, I outlined how the approach investors take to supporting entrepreneurs limits the potential of entrepreneurial innovation to drive impact on the biggest issues of our time (and how that approach also limits investor returns).
But how did we get here? What are the challenges behind the problems we see in investing? And how do we fix them?
This is a short list of only some of the many problems and opportunities - I’m eager to hear what thoughts, questions, and ideas they spark with you.
Problem: Lack of accepted standards: Investors rely on pattern matching because early-stage companies lack the track record and collateral that later-stage ventures have access to. Entrepreneurs can’t give five years of historical financials if their company is one year old. Without these objective evaluation mechanisms, investors are often forced to rely on unstructured, subjective information - the evaluation of which is deeply susceptible to implicit biases like in-group bias, selection bias, confirmation bias, etc. This particular issue exacerbates the challenges of venture capital in two ways: first, by making it more difficult for investors to set a clear standard for investment, and second, by giving investors the leeway to adjust their criteria as they see fit to match to certain deals.
Potential Solution(s):
Milestone-based evaluation tools: Village Capital’s Abaca platform uses a unique methodology that evaluates company development on eight different criteria - from team to product to scalability - using a milestone-based framework, instead of relying on business track record.
Founder evaluation tools: The challenge of venture capital can be in forecasting the potential of specific founders to lead their companies to success - but the process of codifying traits for success is tricky (though several have tried and some success has been made).
Problem: Network barriers. Fund managers and investment decision-makers lack access to a representative group of entrepreneurs due to largely self-imposed barriers, developed to help them sift through the mind-boggling number of opportunities they have in front of them at any given time. If fund managers are to effectively identify impactful, innovative, and investable opportunities, they have to remove these barriers - or at least change how they work. Right now, these network barriers create a disproportionate bottleneck for innovations built by Black, Latinx, and Indigenous founders.
Potential Solution(s):
Open application processes: This isn’t as radical as it may seem. Kapor Capital has taken this approach (to great effect), by codifying their investment criteria and opening the opportunity for any founder to pitch them directly. This approach can wildly shift the way fund managers consider potential investments.
Change the demographics of investment decision-makers: To the point of White men having exclusive social networks, one approach to expanding network access is simply to change who is making the investment decision.
Supporting those that are already here: Black, Latinx, Indigenous and women fund managers exist. In fact, they’ve been shown to generate higher returns. But first and second funds can be difficult to raise for many of the same reasons raising early-stage venture capital is difficult to raise. Creating LP meeting opportunities for fund managers from these backgrounds, providing first-loss guarantees, and/or developing other incentives to support these managers can make a critical difference building a more representative field of investment decision-makers.
Creating broader pathways to the field: Venture capital is one of the most opaque and exclusive industries in the world. One approach to change the demographics of leadership of these funds would be to simply open up pathways to get into the field - through internship programs, degree and credentialing programs, fellowships, and more. The diversity of junior staff at funds, those doing the majority of sourcing and initial evaluation, can have outsize effects on the demographics of the fund’s pipeline and, ultimately, its portfolio.
Intermediary partnerships: The rise of accelerators, incubators, and other intermediaries has been hard to miss over the last ten years. Their networks are deep, and often focused on specific sectors or demographics. Partnering with these organizations can help investors access vetted and diversified deals.
Problem: The early-stage problem. Funds are incentivized by their business models to invest in larger deals for any number of reasons. These deals are often safer for the investor because they have a longer track record and a higher level of financial resiliency. The investor often feels they can also rely on others’ due diligence processes, allocating fewer resources to the research process, making it cheaper to make these later-stage deals than to go through the hard work of sourcing, evaluating, and investing in earlier-stage companies. Finally, the amount of time and energy it takes to make a $50,000 investment is often only slightly less than making a $500,000 investment, further incenting fund managers to move more capital at a time. This creates a critical capital gap at the earliest stages of venture development.
Potential Solution(s):
Risk-adjusted fund fee structures: The traditional 2:20 fee structure wasn’t built to evaluate startups on their merits and determine whether we should support them or not. It was built for whaling. A redesign of fee structures for allocating capital at the earliest stages is necessary. We need a purpose-built solution for the unique challenges of evaluating and investing in early-stage ventures. Higher fee structures for funds could mean more resources to evaluate potential investments, which could mean higher potential for stronger returns.
Investor subsidies for earlier-stage investments: This happens for certain fields already, but subsidies and first-loss guarantees from philanthropy and government can help mitigate the risk of early-stage investors and open up capital markets for earlier-stage ventures, giving them a longer runway and improving their ability to survive - ultimately generating higher returns upon exit.
Problem: Short-termism: Funds of all stages are driven by a relentless focus on short-term vs long-term performance. VC, in particular, is built on the idea of an exponential growth model to meet returns expectations within the life of the fund. VC funds are typically structured around a ten year life cycle, and seek to exit individual investments in a 3-5 year time period while generating massive returns. This focus on timelines puts companies in a pressure cooker - forcing founders to operate and expand at unsustainable speeds, at unbelievable pressure, and results in fully half of these companies failing outright, while fewer than 10% of investments end up returning the full fund (and most of the profits). This approach limits the potential returns of the fund by essentially writing off half the portfolio from the outset.
Potential Solution(s):
Diversifying operating models: It’s time to re-evaluate the ten year lifecycle of the fund and to recognize that it takes longer for most companies to scale. Those that can keep their holdings iliquid for a longer period of time can drive higher returns over the long term. Government and philanthropy can contribute to the development of these other operating models by supporting deeper analytical research in this space.
Diversifying investment structures: The traditional equity-only approach to investment cuts out a wide range of companies that have the opportunity to drive strong returns. Revenue share agreements, for example, have been shown to generate venture-comparable returns (3x-5x over a 2-5 year period) while funds that employ them regularly see much higher rates of portfolio survival than their equity-only counterparts. To further incentivize use of these structures, investors, government, and philanthropy can contribute to the development of standardized agreements (similar to SAFE and KISS agreements), the creation of a taxonomy of risk and return to clarify these structures for non-professional investors, and additional field research.
These are just some of the many challenges and opportunities that exist in the inclusive capital space. What are some of the ones you’ve seen? Share more in the comments below!
