Evolving the VC model to deliver the impact
The VC model
The (near) Future of Impact VC
The impact investment space is witnessing an unprecedented influx of interest and capital. Asset managers, PE, VC, corporate funds now operate in a space which was the sole domain of the public and third sectors. The false disconnect between profits and purpose is abating as entrepreneurs apply new technologies, and create investment propositions, capable of delivering both.
The idea that impact and money are mutually exclusive is fading. A new narrative surfaced around the 2008 crash when activists and the impact community at large — realised a de growth agenda would absolutely be rejected by governments, shareholders and the market. We started to talk about the business model of impact and climate change as an opportunity.
A new logic has emerged; technologists invent products and services to solve previously intractable challenges. Global marketplaces and internet enabled business models offer scale sufficient to attract private capital. SDGs orientate investment toward common goals, and ESG and other impact frameworks create accountability. The enabling environment includes policy shifts (carbon budgets), market forces (natural resource depletion), and shifts in public perception (ethical consumption).
This has given rise to a new optimism unifying us to address the challenges of our age. The headlines are positive, not least because the numbers look big, $502 billion AUM (Assets Under Management) in impact funds and growing. Sadly this is still negligible against the $5-$7 trillion required to meet the SDGs annually, but it does mark the very beginnings of a much needed redirection of capital. It signals a consensus that the current system is incapable of delivering the innovation and transformation we need to meet growing societal needs, combat the climate crisis and deliver equitable growth.
Like all new models impact investment it is not without challenges. Fragmentation and lack of standardisation along with legitimacy and intent of investors are hotly debated topics.
Where there is less debate is on the necessary adjustments to the deeper investment thesis, structure and instruments of impact investment — beyond the look and feel of the portfolio.
This is particularly the case in VC startup funding which is problematic given it is our main source of high-risk innovation capital. Given the scale of the climate crisis you may feel startups are irrelevant in comparison to transforming larger carbon emitting sectors such as energy and infrastructure. It would be a mistake to view it like this.
Rather we need to maximise the utility of the limited high-risk capital available to de risk not only the portfolio, but the culture of investment itself, to facilitate the transition to a zero carbon economy.
Most capital is massively over-leveraged — trapped in fund structures with increasingly out of date thesis’, or seeking safe harbour in lower risk financial assets — real estate, pensions, bonds. To make it viable to redirect more capital to innovation, we need a concerted approach to de-risk new instruments. In this context the role of startups, and critically how we fund them as a driver of innovation — is legitimate. Currently only 1% of impact funding goes to seed stage entrepreneurs who are equally mission and profit driven.
VC’s as the main provider of impact investment
Traditional venture capital provides an interesting and viable model for risk-taking and high-growth ideas, so it should be a natural fit for social and environmental innovation — however in practice, it is not.
1) VC’s invest in companies who aim to dominate markets choosing business with monopolistic tendencies because those are easy heuristics to discover, with clear patterns for scale. That’s not the right answer for impact businesses where the market is fragmented with a mix of private, public and non-profit provision, and where scale is about outcomes (and not always market share).
2) VCs have 5–8 year time horizons so startups need 3 to 5 in which to scale and capitalise on investment. Impact businesses by definition address market failures and their customers are often the public sector, innovation isn’t easy to predict as a 3 to 5 year game. As a consequence they take longer to grow; 5 year time horizons are too arbitrary.
3) Most of VC money is trying to find new unicorns when in reality impact businesses make returns by creating value-added networks, collaboration solutions, and by simplifying highly complex and regulated systems. The financial projections of impact startups are being compared to traditional ones. How can business models which account for externalities be as profitable as those which don’t? It’s not a fair comparison.
4) Cheap capital is drying up, seed rounds are now series A size, and barriers for impact businesses to access VC funds are growing.
The Gartner Hype Cycle (if you aren’t familiar with it) is the 5 stages that technology adoption tends to take. The Hype Cycle and isn’t driven by some mystic underlying forces — it’s driven by behaviour and financial structures.
- Fund invest-to-harvest cycles (particularly for VC) is 8 to 10 years. That’s the same amount of time we have to stop irreversible climate change. We simply don’t have time for the market to follow its usual logic of waiting to see what will pay off.
- Competitive behaviour means if investors haven’t got in on the action they will likely wait for the space to be further de-risked. This means they will wait for the heuristics to become better known. This not only slows down investment, it concentrates it into similar business models. This threatens actual innovation in favour of business models that are probabilistic.
- The market becomes saturated with lots of similar propositions, investors watch each other and pile in together at the cost of other solutions. Driven by herd mentality this fuels speculative and disproportionate valuations that firms often fail to live up to.
We know there are no shortage of good ideas to address climate change and social inequality. Yet we see capital bottleneck because the investment instrument is misaligned with the needs and behaviour of many impact businesses.
Some Starting Points
Given there has been little to no experimentation in reframing VC investment for impact startups — we need to find some start points for further enquiry. I’ve been able to do some basic modelling on these interventions but need access to more data.
1) 40% of startup money is spent on social media spend.Granted that’s largely limited to direct-to-consumer startups but it’s a business model VCs favour. This is creating a ponzi scheme where 40% of the money in the startup ecosystem is returned to technology giants facebook, amazon and google. I’ll be discussing this in more detail in a future blog on data ethics, but needless to say (at a minimum) it drives carbon intensive consumption, and for startups it’s inefficient and wasteful.
What if startups didn’t compete for market share, but instead organised themselves across a value chain with a range of products and services being swapped in and out behind one brand. Each startup (or business unit) would have more energy to dedicate to product innovation rather than competing for market share. This can be applied to other efficiencies of scale; collaborative procurement, shared infrastructure and open source development. It would also significantly decrease the amount of capital each invention needs.
2) Social Impact Bonds as systems intervention. SIBs show what is possible when you coordinate multiple service providers to deliver interventions to complex challenges. They are a solution to public procurement processes that make it hard for local agencies (often better placed) to secure government contracts. They also shift risk from service providers to investors. SIBs have taken a fair bit of heat because early iterations failed to distribute returns across the network, the fund mechanism outperformed expectations, and investors disproportionately profited. Service providers being protected from risk were also cut out of returns. I hear that Bridges and others are working on remedies to this that remain attractive to investors. However early iterations of the SIB model provides some useful lessons.
What if we thought about portfolios in a similar way. Each startup (or agent in the network) is the one best placed to deliver against an overall aim or challenge. Investment can be distributed accordingly rather than arbitrarily. This would allow us to invest into a network of solutions rather than an entity which is incentivised to compete. These collaborative networks give rise to multiple governance questions and challenge how we conceptualize risk and return. However in an increasingly disintermediated world these challenges are already abundant.
3) The reality of VC fund returns. Only 5% of VC investments achieve 3x return, 10% return at 2–3x, 35% at 1–2x, with 50% of all VC investment only returning at 1x. Yet if you are looking for VC investment you have to look like a unicorn and talk like a unicorn promising 10x returns. The logic is that one of them will hit, and the distribution curve is modelled to absorb the losses. For high-risk it’s incredibly formulaic.
What if we moved from the 10x promise (or rather gross exaggeration) and instead had a more realistic conversation about the price of capital in different parts of the fund. 50% of most VC funds could operate under quite a different thesis without actually being put at that much risk. Coupled with some IP incentives portfolios can reduce the burden for impact ventures to conform to the anticipated returns of traditional startups. VCs do it anyway — why not more deliberately in the name of impact?
4) How we hold IP hinders innovation We view IP as something to hold and exploit and not as something that when open is generative. How we hold IP speaks to extraction capitalism. It’s byproducts are many, from monopolistic tendencies to wealth inequality. The IP system, like all systems, is under stress. Big data doesn’t fit easily in the traditional categories which raises massive questions about who owns data, and therefore who can exploit the IP. This lack of clarity is resulting in growth of trade secrets as innovators confronted with a hyper competitive market privatise gains early. This isn’t a good thing when we have 10 years to solve the biggest challenge humanity has ever faced.
What if rather than IP protection, impact funds deliberately used IP licensing and data commons, and rather than investor terms that seek to capture second and third order value before it’s even be born — IP was defacto available under licence for whosoever can exploit it with investors benefiting from the long tail of invention. Faced with the urgency of our collective challenges what behaviours and steps do we need to incentivise an IP system to support renewal economics?
5) Beyond the portfolio. Positive impact isn’t a corporate strategy or an investment thesis — in a complex system where feedback is real-time and continuous, so to must ethics management be. In complex systems there is no such thing as wholly good or wholly bad. Impact isn’t a set thing and narrow definitions don’t really help with the nuance. Externalities happen continuously. They’re relational, beyond our intentions and outside the scope of our influence.
What if instead of being preoccupied with the appearance of impact, VC funds became powerful data trusts capable of tracking the weak signals of unintended consequences across their portfolio, and using collective intelligence to help startups adjust.
These are just a few thoughts on how we can move from a VC culture designed for extraction economics to renewal economics. There are many more. I am interested in speaking with investors who would grant access to their data, and their portfolios to test the viability of some of these assumptions and develop data models to support a new investment thesis. If anyone has any thoughts on the future of impact VC be great to hear from you.