The venture capital business model is built on the theory that if you do ten investments and have one huge return, what happens with the other nine investments doesn’t matter. I don’t take issue with the financial argument of this model. However, I do have an issue with the collateral damage that this investment theory creates. Ninety percent of companies financed under that model are failures. That results in lost jobs, wasted capital, and stalled progress.
In theory, entrepreneurial ecosystems efficiently handle the lost human and financial capital. In the more mature entrepreneurial ecosystems, if you work for a startup that fails, you just go to the next one. Likewise, if you’re accustomed to losing large amounts of money on the VC model, you can stomach the risk. In this ideal ecosystem, both the employees and investors will have a wealth of options, so failures become opportunities.
However, that doesn’t necessarily translate to nascent entrepreneurial ecosystems, such as Birmingham’s. If you’re associated with a failed investment, your career may be negatively impacted. Venture capitalists whose investments fail may become more conservative, depriving the ecosystem not just of needed capital but also of their invaluable knowledge and experience. Additionally, finding ten investments in Birmingham is a challenge. To my knowledge, no one institutional fund has invested in ten Birmingham companies.
Because of these factors, I think we need to start looking at alternative financing methods for Birmingham start-up companies. When companies are funded by SAFEs and convertible notes, you are inevitably putting these companies on a trajectory towards venture capital. At the early stage, this is often the wrong answer. Early-stage ventures are very much about figuring out what kind of company the founders want to create. We need to create mechanisms that allow other options besides the VC funnel, without losing that optionality for the home run. David Cummings from Atlanta offers some similar thoughts about startup financing on his blog.
I think that non-standard financing arrangements would help and are much needed by early-stage ventures. Thankfully, there are some excellent existing resources for both revenue-based and royalty-based funding. A Shared Earnings Agreement could serve as a financing solution in place of SAFEs or convertible notes. Of course, one is revenue-based and one is earnings-based; however, both get there. This New York Times article offers insight into the changing relationship between venture capitalists and startups as well as the rise of alternative financing strategies.
I’m not sure where all this leads, but I’d love to see something with more flexibility for entrepreneurial teams than a SAFE or a convertible note. One idea would be to have a convertible note that automatically convert to royalties after 2 to 3 years. That would help investors get a good return even in a case in which the entrepreneurs decided to stick with a medium-size business instead of pursuing a home-run IPO.
That being said, I’m not sure I want to go first in Birmingham — anyone else interested?