Why Venture Capitalists Aren’t Funding The Businesses We Need
If you’re looking for money to start a new business, it helps to be white, male, attractive-looking, and living in a place like Boston or San Francisco. Better still, you want to have gone to a top-ranked university. People with these sorts of profiles win the lion’s share of funding from VC firms.
In 2014, Harvard Business School academic Alison Wood Brooks conducted a series of experiments designed to tease out the biases funders have toward certain groups. She found that male entrepreneurs are 60% more likely to get funding than females, even when women and men are pitching the same idea. Attractive males (as rated by participants) were 36% more likely to be successful than non-attractive males, she found.
In 2015, more than three-quarters of U.S. VC funding went to companies in three states: Massachusetts, New York, and California. Only 5% of capital went to female founders. Just 1% went to African-Americans and Latinos. Between 2007 and 2012, graduates of just six universities–Stanford, Harvard, Berkeley, MIT, NYU, and the University of Pennsylvania–received 10% of all the world’s startup financing.
We like to think that entrepreneurship is a game that anyone with a good idea can win, like anyone, if they’re good enough, can play in the NFL or the Major Leagues. But the reality, according to Ross Baird, an experienced VC himself, is very different. In the actual world, hundreds of millions of dollars go to $1,500 countertop ovens and $699 internet-connected juicers, while people building worthy and useful products get left by the wayside. VCs fund products that solve problems they understand, it’s often said. And, being largely white, male, and elite-educated themselves, they fund people of the same backgrounds.
Baird, who admits to being a white guy born of privilege himself, documents all this in The Innovation Blind Spot: Why We Back the Wrong Ideas–and What To Do About It–a clearly written critique of the VC industry’s pretensions, prejudices, and failings. Baird explains how it is that VCs keep funding businesses offering conveniences we don’t really need (like, for example, the disastrously named Bodega, which wants to replace bodega corner stores) while so many other needs, from hunger to financial inclusion, go largely unfulfilled.
Related Story: One Reason Black Founders Don’t Get Enough Funding? Black VCs Don’t, Either
“The idea that entrepreneurship is a meritocracy is a myth,” he writes in the introduction. “In the real world, money flows to the ideas that are the most convenient to find or the most familiar, not necessarily those that are the best. Simply put, the blind spots in the way we innovate–the way we nurture, support, and invest in new ideas–make all our other problems even harder to solve.”
LendStreet, a California startup offering debt consolidation to people in financial difficulty, features several times in the narrative. The business was started by Jerry Nemorin, the child of immigrants who came to live in the U.S. having fled war-torn Haiti. When Baird met Nemorin, he told him he liked his idea and wanted to help. He asked why he had struggled to find funding before. “Investors are all about pattern recognition,” Nemorin replied. “As a black guy, in central Virginia, solving poor people’s problems, I was 0 for 3.” VCs want to solve “my-world problems” not “real-world problems,” like the fact that millions of Americans are in debt and can’t see a way out.
VCs also want companies to be located near where they are, explaining why their funding is so concentrated (the average distance from funders to startups is 80 miles). Nemorin had to move to Cupertino, the home of Apple, to raise money. Y Combinator, perhaps the best-known early-stage funder in the country, won’t look at any business that doesn’t set up in San Francisco. It thinks they are 10 times more valuable than companies based elsewhere. “We would not be doing them a favor by not making them move,” Sam Altman, president of the accelerator, has said.
To get around the biases of other VC firms, Village Capital, Baird’s firm, takes a decidedly different approach. For one, it invests in areas often overlooked by Silicon Valley, including education, energy, and agriculture. For another, it uses a peer-to-peer approach to finding companies to invest in. Instead of choosing ideas itself, it outsources the job to groups of founders taking part in startup development programs it organizes through the year (though Baird and his colleague Victoria Fram do choose the short list).
Baird argues that founders are better at picking winners than VCs are, partly because they’re better at understanding what it takes to build a company, and partly because they’re better at identifying bullshitters. After a series of program workshops, founders score their contemporaries according to nine criteria, including their ability to solve a real-world problem and their ability to win sales beyond early adopters.
In the early days, this process sometimes led to problems, Baird says in an interview. In one case, a group decided to award funding to a founder as a “sympathy vote” because it thought there was no way he could actually be successful. In another, the group was so cutthroat that it deliberately gave poor marks to the best ideas. Village Capital now gets around this by making voting transparent, so participants are accountable for their choices. And, they set standards for what a good investment looks like, including the nine criteria, so the founders never go too far off the reservation.
Each program chooses two startups that get $100,000 in seed funding. In about 50 programs since 2009, 80 startups have been selected, receiving a total of $6 million. These include companies like Upsie, which offers warranties for consumer products at prices a good deal lower than many retailers (analysts speculate that Best Buy makes half its profits from warranties, such as its markups). Another of its companies is Emrgy, a small-scale hydropower company that generates energy from shallow or slow-moving waterways.
Village Capital currently has a fund worth about $18 million, with much of the money coming from family offices (funds run on behalf of high net-worth families) and foundations. It’s also received a $2.6 million grant from the U.S. Agency for International Development’s Global Development Lab.
Baird and Fram argue that VCs bet on what they’ve seen work before (the pattern) rather than what might work in the future. And they say the peer method allows quieter, though capable, people to get noticed. It’s not simply a question of who can make the best elevator pitch–it’s who can prove to a group they have what it takes to be successful. It’s not about charisma; it’s about demonstrating they can make progress as the group meets for weekly sessions, they say in an interview.
The method certainly seems to help female entrepreneurs. Women make up only 25% of the founders who’ve entered Village Capital’s programs so far. But they’ve won investment 40% of the time. “Our women founders point to the open and collaborative nature of the process of peer selection, which rewards those who work well with one another,” Baird says.
One female entrepreneur funded by Village Capital is Sarah Bellos, CEO of Stone Creek Colors, a startup in Tennessee that makes natural clothing dyes. The company grows indica in fields that once grew tobacco; the nontoxic dyes are used in high-end jeans from brands like J. Crew and Nudie. “We’re applying the principles of plant breeding and chemical engineering to replace the insane use of textile dyes across the [clothing] industry,” Bellos told Fast Company this year.
Small-scale funding for small business
Though the VC industry has many successes to its name, from Facebook to Amazon, its track record as a whole isn’t that great. In 2012, the Kauffman Foundation, which focuses on entrepreneurship, analyzed nearly 100 VC funds it had invested in over a 20-year period. After accounting for fees and “carry” (the share of profits taken by investment managers), it found that only 20 produced returns higher than 3% annually. VCs are typically incentivized to raise bigger funds (because they make more money) and to invest in companies that they can quickly flip. That leads to short-termism of a kind that favors investment patterns (like the current craze for very expensive kitchen equipment) rather than longer-term projects that actually solve problems.
Baird says government can help spread new business creation beyond hotspots like Boston, San Francisco, and New York. For example, he proposes the novel idea of a “job bond”: a financial instrument that’s like a bond to build a new sports stadium but is designed to encourage companies to hire more workers. Groups of private investors, including individuals and foundations, would put up a pool of capital with a specific purpose–say, investing in agricultural businesses in rural Indiana. Then the government would repay the capital from increased payroll and sales tax revenue as the company expands (the mechanism is like a social impact bond). Another idea would be to offer tax breaks for “opportunity funds” in distressed communities (as proposed under the yet-to-be-passed Investing in Opportunity Act).
Baird’s motivation for writing the book comes from an insider’s knowledge that the system isn’t allocating resources to the best and the brightest, just to the best connected and most visible. He is worried that the VC industry’s blind spots “are causing the death of what we know as the American Dream and preventing many other great ideas around the world from having a chance to begin with,” he writes. “I’m baffled that the American Dream seems to have been confused with the Silicon Valley Dream, which means that more people don’t see these opportunities outside the mainstream.”
At the end of his book, Baird argues for a more differentiated financial system. He says the VCs have a “one size fits all” approach, whereby some businesses fit the profile and are funded to the maximum, while many smaller companies, with less immediately sexy business models, struggle to find capital. He argues VCs need to move beyond the obvious sources of ideas and go out to the rest of the country, where plenty of other innovation is also taking place. And, he says we need to get beyond the old binaries of profit and nonprofit and instead fund businesses that make money and solve problems at the same time.
Baird writes: “The new social contract should be: If you’ve got a great idea, no matter who you are or where you live, you’ll have the chance at least to try.”
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