What Can Venture Capitalists Learn From Impact Investors?
The zeitgeist for how startups are currently financed focuses predominantly on venture capital. Venture capital might be the right choice for a business in certain circumstances, but there are also countless stories of entrepreneurs being pushed in different directions against their will, having to sacrifice their values, or simply losing control of their business. Venture capital also does not generally support organizations outside of high-growth technology companies, and many great entrepreneurs are unable to raise capital unless their business fits this particular mold. Finally, venture capital contributes to the growing income inequality in the United States because only high-net-worth individuals are able to play their hand at the VC game. The point is not to bad mouth venture capital but to demonstrate that there is ample space for new approaches.
Impact investors work with companies all over the world, oftentimes in emerging markets where it is difficult for local entrepreneurs to raise capital from traditional sources. They also work across many different sectors, such as health care, agriculture, environment, and education. They must navigate a varied and nuanced investment terrain where traditional equity and debt investments are often not the right fit for their portfolio companies. As a result, they utilize new and creative investment approaches to focus on making a return and also making a positive difference in the world.
Daniel Epstein, co-founder of The Unreasonable Institute and The Unreasonable Group, wrote a great article for the Huffington Post about quasi-equity in emerging markets. The idea of the article is that traditional equity and debt investments often do not transfer very well to businesses in the developing world. Equity investments need liquidity events to make a return, and it is extremely rare that a company is purchased or goes public in a place such as Kenya, Nigeria, or Pakistan. In addition, the entrepreneurs are often much more interested in making a difference in the world and creating lasting organizations than they are about selling their companies to Google or Facebook. Daniel presents quasi-equity, typically a revenue sharing investment approach, as an attractive alternative to both investors and entrepreneurs working in emerging markets.
There are many more examples of impact investors using novel approaches to allocate capital in parts of the world that are under served by traditional financial markets. Ross Baird with Village Capital uses peer-based due diligence to enable the entrepreneurs to decide amongst themselves who is best suited for investment. John Kohler has pioneered a demand dividend instrument, essentially an entrepreneur friendly revenue share, which follows a similar approach to the quasi-equity investments Epstein mentions. Other organizations, such as The Omidyar Network, utilize hybrid investment approaches where they make grants and investments simultaneously.
These creative approaches to investment are also relevant in places, such as Silicon Valley, where there are already vibrant startup ecosystems. Innovation in the way we approach investment could provide many benefits; it could support entrepreneurs to raise capital that is less extractive to their organization, enable founders to maintain control of their company over the long term, and finance companies in ways that remain focused on long-term growth rather than quick exits.
A recent TechCrunch article referenced Kent Goldman, a former partner at Bay Area VC fund First Round Capital, who is starting his own seed-stage investment fund that shares a percentage of the funds carry (carry is basically the funds ROI) with the portfolio companies. Entrepreneurs he invests in not only get money for their company, they also receive a portion of the profits if the fund itself does well. Kent's idea is that the entrepreneurs will be invested, literally and figuratively, in the success of the other portfolio companies. This small change in the way Kent is approaching ownership could create mutual benefit and bolster an ethic of contribution for everyone involved. It's a small step, but it is also a great example for how these little changes might just make a big difference.