The Dow Jones may be at an all-time high, but entrepreneurial activity in the United States is close to a 40-year low. According to the Kauffman Foundation’s 2017 State of Entrepreneurship report, many startups face serious barriers because they are run by women or people of color. Geography also plays a part. According to the Economic Innovation Group, 50 percent of firms created since the great recession were built in just 5 (large, wealthy) counties.
Why? One big reason: the mathematics of venture capital.
Over the past six months, we’ve interviewed over 200 asset managers — from big university endowments to pension funds — who each manage more than $100 million. This trillion-dollar asset manager group largely ignores the typical entrepreneur, as they need to see a fund size of $100 million or more to even consider investing with a VC.
Most don’t hit that mark. We tracked over 300 investment funds that invest in non-coastal parts of the country, from Seven Peaks Ventures in Bend, Oregon, to NRV in Richmond, Virginia, and found fewer than 5 that were investing $100 million or more. These funds want to pump money into local economies but find it difficult to raise enough themselves.
There have been some important recent steps to help narrow this gap — for instance, Steve Case and our partners at Revolution just raised a $150 million venture capital fund — but this is just the tip of the iceberg. In a world where banks are too big to fail, most sources of capital for entrepreneurs are too small to succeed.
That’s the bad news. The good news is that changes can be made if we’re willing to explore uncommon solutions to the problem.
Create a consortium of regional funds
What if regional funds joined forces to share capital and profits? Unlike when coastal investors fly in and out, these fund managers would remain tied to their local communities and create a network of individuals and companies working to solve problems in their own backyards.
Collaborations like this could also produce a different crop of fund managers. Organizations like the Kauffman Fellows have been helpful in creating a new generation of investors, but today’s VC decision-makers are largely an exclusive group: fewer than 5 percent are women, and less than 1 percent are people of color.
When we’ve floated this idea, we’ve gotten questions about cost, because an investor in a fund that invests in other funds pays fees twice. One solution could be to make this next-generation fund of funds a “super general partner,” investing in both the next-generation fund managers, supporting their infrastructure, and their underlying companies.
Bring back community banks
Only 1 percent of businesses ever raise venture capital. Community banks have long been a source of capital for businesses in the other 99 percent. Yet, according to the Richmond Federal Reserve, the number of community banks has declined 41 percent in the past decade — cutting off critical life support for new ideas. Only five new banks have formed in the U.S. since the Great Recession. For a frame of reference, this was 100 to 200 a year during pre-recession years.
Regulations such as Dodd-Frank have created high compliance costs that have contributed to some of the decline. But big investors have also largely viewed community banks as too small to invest in. Here’s where we can innovate. The Kauffman Foundation has recently funded an exciting pilot of microenterprise lending institutions that are able to originate loans and sell their best-performing loans to larger banks, getting fresh capital to fund new enterprises. Ideas like this can bridge Wall Street and Main Street, backing founders who will no longer be too small to succeed.
Try a ‘middle option’
Nearly all startup investments fall into one of two classes. First, equity — I own a percentage of your company and can make a high return, but it’s high risk, and my money is locked up for 10 to 15 years. The other option is a loan — the risk and return are both lower, and the payback is sooner. But many startups are too risky for equity and too small for debt.
We see an opportunity for a “middle option” — revenue-based financing. This tool is used to finance movies and restaurants, and it works like this: Investors get 5 percent of a company’s top-line revenue each quarter until they make three times return on investment. Innovative funds like Fledge and Lighter Capital, both in Seattle, are already doing this, and groups such as Zebras Unite are helping identify a group of quality, long-term profitable companies that may be a fit for structures like these.
We often think of innovation as WHAT idea we’re going to invest in, WHAT the next great trend is. In order to solve the problems that exclude most entrepreneurs, we need to think more about the HOW as well.