Redesigning venture capital (part II): A blueprint

This article is part of the “Redesigning venture capital” series. Read part I (“The challenge”) here.

In a recent article, I argued that the traditional venture capital model is severely limited in its ability to leverage the power of entrepreneurship to address complex societal challenges. In this follow-up essay, I present the contours of an alternative approach that will serve as the basis for bringing systemic thinking to entrepreneurial finance.

 

The challenge

Let’s start with a short recap.

As I contend in part I of this series, traditional venture capital firms operate under paradigms, structures and mechanisms that create optionality of an incremental—not transformative—nature. In other words, VCs favour systems optimisation, not systems change.

My main argument is that the Discounted Cash Flow method—which is widely used in the venture capital industry as a decision-making framework or at least as a mental model to assess the risk and return characteristics of a start-up—constricts the definition of value, enforces market conformance, imposes arbitrary timelines, reduces business model choice, encourages predatory business behavior and raises unreasonable return expectations.

I also describe how cookie-cutter investment approaches—e.g. GP/LP fund structures with seven to 10-year lifespans—limit the diversity of financing instruments to a single, predominant form: Cash investments in exchange for some equity-like preferential ownership rights in a limited liability company. (NB: I have written about the issues around LLCs here).

Others have recently taken similar positions. Alex Basu and Per Anell of Industriefonden blame the behavior of VC firms for technology stagnationNathan Schneider of the University of Colorado Boulder advocates for new exit routes, and the founders of Zebras Unite have set out to develop a venture capital model capable of funding profit and meaning. Clearly, I’m not the only one who believes venture capital is in need of an overhaul.

So how can we better leverage entrepreneurship as an innovation practice to address those societal challenges that require structural, systemic change?

 

New words, please!

This journey starts with recomposing the language of investing. Our words shape culture and identity. They invite and exclude, define and restrict. They create biases and anchors and set priorities and expectations.

Words like start-up, money multiple, elevator pitch, growth model and exit belong to an outdated industrial vocabulary. They suggest that all problems are complicated in nature and can be overcome with smart engineering and shrewd management. They imply that the pathway to value lies in spending big and growing fast.

This language feels inappropriate for tackling complex societal challenges. I suggest we substitute start-up for entrepreneurial initiative—not as catchy, perhaps, but more spacious and tolerant; and that we change venture capital for financial support—vaguer, sure, but better encapsulating the idea that investment capital is primarily meant to help entrepreneurs, not multiply itself. Let’s replace revenue model with value modelcustomer with beneficiary, and product with solution. Let’s also speak more about collaborators than about competitors, and more about systems than about markets.

 

The design space

I believe that any investment programme will generate its impact through the choices made in different domains of a design space. This space is shaped by a set of fundamental questions that designers must address:

Who should be part of the investment partnership? Which vehicle is best suited to host the programme? What type of entrepreneurial initiatives should be supported? How should financial support be provided? And how can we make the whole greater than the sum of its parts through deliberate portfolio composition, field building, and nesting within a broader systems intervention approach?

Collectively, these choices combine to form not only an investment strategy but also an investment culture, mindset, and community.

 

Loci of impact in a Transformative Entrepreneurial Finance Programme (TEFP)

 

At EIT Climate-KIC, our ambition is to make these choices in a way that creates an entirely new asset class: The transformative entrepreneurial finance programme (TEFP). Not the stickiest of names, I admit, but let’s worry about branding and acronyms later.

Here is what a TEFP (pronounced: teffpy) looks and feels like:

 

1 — Investment partnership

A TEFP convenes people who align behind the shared intent of systems change. Intent matters because what investors set as their priorities determines what they care about. Systemic investors will interrogate the universe of investable assets with different frameworks, using different metrics to evaluate potential, success, and failure. They will also bring a different mindset to their investment practice, embracing collaboration, community, inclusion and humility over competition, tribalism, exclusion and ego. Such a partnership will feel friendly, lighthearted, hopeful, creative, ambitious and empathetic.

 

2 — Vehicle

A TEFP favors a legal and operational umbrella that offers a large degree of flexibility with respect to financing instruments, time horizons, accountability frameworks, and the blending of different types of capital. Following the fractality principle, these considerations apply both to the vehicle that hosts the programme as well as to the legal wrappers around individual entrepreneurial initiatives.

 

3 — Selection framework

At the level of the investeea TEFP selects entrepreneurial initiatives that have the potential to generate system-transformative outcomes. More on this below.

 

4 — Toolbox

A TEFP engages a diverse range of financial mechanisms to maximise an entrepreneurial initiative’s systemic impact potential. It carefully matches these instruments to the needs of the initiative (‘smart investing’), often deploying multiple instruments at once and replacing them over time as the nature of the initiative’s risk profile evolves.

Instruments in the toolbox include revenue-sharing agreements, outcome-based financing, convertible debt, collateralized loans, preferred and common stock, carbon credits, and asset tokenisation through blockchain, among others.

 

5 — Field building

Within a portfolio, a TEFP offers an opportunity to unlock combinatorial effects by selecting individual assets not just based on their inherent merits (‘single-asset paradigm’) but based on how they strengthen the portfolio overall.