My home town of Portland was invaded by Uber this month. People seem pretty split on it, as am I. On one side you have a company seemingly run by jerks completely ignoring the law as it introduces a product that a lot of people love. On the other hand you have a city trying to enforce a set of laws ostensibly designed to protect citizens but which now seem pointless at best and corrupt at worst.
My old boss is an investor in Uber (Old in that he was my boss some time ago, not that he is particularly old.) We’re still Facebook friends and trade emails occasionally and as far as I can tell he is a tremendously nice person who cares about his family and his neighbors and the entrepreneurs he in whom he invests. The reason I mention this is to point out that the only person I know who is actually connected to Uber is a lovely human being and, as such, this is not going to be a screed about how Uber is run by jerks. I have no idea whether Uber is run by jerks, and my n of 1 suggests that it isn’t. Instead today I am going to wonder out loud why Uber the company and companies like it act like jerks, whether this is an entirely bad thing and, if so, if anything can be done about it.
I have been working in and around technology for a long time, briefly as an entrepreneur and then ever since as an investor. There are plenty of historic examples of the open-source, generous spirit of the internet. Probably the most widely shared example is Wikipedia, in which a few hundred (now a few thousand) obsessives built into a massive shared resource for no personal gain. The founder of Wikipedia, Jimmy Wales, once told me something like, “The single greatest decision I ever made was forming Wikipedia as a non-profit. And the single greatest mistake I ever made was forming Wikipedia as a non-profit.” By this he meant that volunteer editors would have been unlikely to make Wikipedia their life’s work had it been a for-profit entity. But at the same time, it meant that one of the highest traffic websites in the world had to (and still does) beg for donations to pay for bandwidth when similar-traffic sites throw up some ads and watch the money roll in. Despite that somewhat rueful statement, he seemed to appreciate that he navigated a complex web of stakeholders and that it was important to have a structure that preserved the value of their contributions. At the time, non-profit seemed like the better of two flawed options because it better represented the relationship he needed to have with his key stakeholders, Wikipedia’s volunteer editors.
For a while, I worked for Pierre Omidyar, the founder of eBay and someone who has some of the same libertarian tendencies as me (although he takes his much further than I) As he tells it, one of his key insights in founding eBay was that people are mostly good. (A related insight for later is that while people are basically good, organizations made up of good people often act like jerks) Online auction was not a novel idea in 1995, but people were tying themselves in knots trying to figure out how to stop people from defrauding each other. eBay started with the thought that, “Yes there may be some cheats in the system, but it will be a tiny fraction, and you don’t want to screw up the whole system building it to focus preventing a minor bug. Optimize it to have a lot of cool stuff for sale, and then fix fraud using all of the information you collect as you go.” Put another way, don't choke the life out of an ecosystem trying to stop the rare bad actor.
As a lay person, and a closeted part-libertarian, regulation around taxis and hotels looks like the counter-example to eBay's light touch. Governments appear to have created a Kafka-esque bureaucracy which places an unreasonable burden on operators and hurts consumers, all in the name of protecting those same consumers. A few other examples:
- The SEC has delayed allowing individuals to participate in private investments
- The IRS makes most community currencies illegal
- Many states prohibit car companies from selling direct to consumers
The list goes on and on. I know the issue of is more nuanced than that, but for the purposes of this post today, let’s just accept: If we’re going to make the leap to a more distributed economy many of these rules need to be broken.
But who deserves to break them?
The companies that break these rules are by nature aggressive. But in whose interest are they directing that aggression? The new generation of “sharing” companies - Uber, Lyft, AirBnB et al - took the opposite path from Wikipedia, not just forming as for-profits but as venture capital funded for-profits, the most for-profit-y for-profit there is. If you accept that there were only two choices, this was the clear best option. Hundreds of millions, now billions, in investment capital has flowed in, allowing them to extend services to more markets, faster than anyone thought possible. Even the granddaddy of them all, couchsurfers.org, took venture funding from the aforementioned Pierre Omidyar and rebranded as couchsurfers.com. However, these companies navigate a web of stakeholders more complex than anything Wikipedia ever faced, including:
So let’s be clear, these venture-funded C-Corporation “sharing” companies have selected an organizational structure that REQUIRES that they place the interest of investors above all those other stakeholders. Not only that, but they have taken capital from investors who want them to swing for the fences, move fast and break things (including laws). They are careening into new markets at a breakneck pace, ignoring the existing (stupid) rulebook and then turning to every other stakeholder, people whose active participation in their business is ESSENTIAL for their success and basically saying, “Hey, trust us.”
That sounds like something a jerk would do.
So where does that leave us?
I think the distributed economy (I’m going to stop ironically calling it “sharing” now) will create huge benefits for us as a society if implemented fairly. We have companies innovating at a speed at which it is unreasonable for regulators, who normally are responsible for protecting all the relevant stakeholders, to be able to catch up. So, I believe that some level of rule-bending or breaking is necessary, and I think we want the companies to stay innovative and aggressive. However, these companies are structured to prioritize investors’ needs over all other stakeholders. Companies need us to trust them, but have picked a structure that makes them inherently untrustworthy, regardless of whether they are run by seemingly nice people (Lyft) or assholes (Uber). Focusing on the individuals at the top ignores the basic structural issue.
These companies need to make binding, verifiable commitments to other stakeholders, commitments which will allow regulators to give them the leeway they need to keep aggressively innovating. And because it is the 21st century, we actually have some options for how to do this.
Bare minimum, these companies should all be B Corps, or another form of benefit corporation. The structure allows of them to make explicit commitments to other stakeholders. Etsy.com, which shares at least one investor with Uber, is a registered B Corp that has shown that you can incorporate values beyond just profit and still create value for VC investors. Kickstarter is another certified B Corp with happy VC investors. I don’t think anyone has ever tried to use B Corp status as a way of getting around regulation, so there would be some work to be done to get it right, but it would be a step in the right direction.
The answer could be to also be to think more creatively about ownership models: What about co-op models?. Imagine an Uber competitor that was 50% owned by its investors and 50% owned by its drivers. How would this company act differently? How would we respond to it differently? What if these companies were partially owned by the communities in which they operate?
The answer could also be to think more creatively about governance models: why couldn’t these companies fund and consult with third parties on acceptable business practices. The Center for Financial Sector Inclusion has played this role in payday lending. Now imagine a company saying, “We are going to agree ahead of time to adhere to the standards set by this third party, even if they negatively effect our bottom line.” Imagine a Fair Trade-certified Uber.
I don’t pretend to know what the exact answer is, but the problem is one of structure and incentives, not personalities. We now have the tools at our disposal to build companies that stay creative and aggressive while benefitting all stakeholders, but we need to move beyond the outdated for-profit/non-profit dichotomy of late 20th century capitalism. Entrepreneurs and investors need to show the same creativity and risk-taking with organizational structures that they have shown with these distributed business models. And customers and regulators should reward companies that get it right. It won’t be simple, but it’s more productive than guessing at the personalities of 20-something and 30-something entrepreneurs.
Qualified investor rules have never made a lot of sense to me. I have met a lot of sophisticated investors who aren’t particularly wealthy. I have met a lot of wealthy people who aren’t particularly smart about investments. More importantly, it has always bothered me that there is a thicket of regulation designed to stop small investors from investing money however the hell they want to, especially given all the apocalyptically horrible yet SEC-approved products are already available to any small investor who wants to commit financial suicide. Not to mention government-run lotteries.
So, for the libertarian in me, the JOBS Act, which theoretically legalized non-wealthy individuals making equity investments in private companies, seemed like a no brainer to me. Of course people should have a right to do this. For the impact professional in me, it means that all of these cool social ventures and businesses in my community would have a whole community of fellow travelers to draw upon - people who would invest in early stage, risky businesses with positive social impact that didn’t fit the risk/return profile for venture money or bank loans. And for the Kickstarter addict in me, all the companies I give money can now give me a tiny sliver of ownership instead of a t-shirt. In fact, the only part of me that WASN’T excited about equity crowdfunding was the investor.
Because these are going to be terrible investments. Per my previous posts, I am not even sure investment is the right term for them. And because we call them “investments” we will decide 3 or 4 years from now that equity crowdfunding was a failure despite all of the positive community, economic and social impact it will have in the interim. And then, I fear, it will go away.
It’s hard to get reliable data on venture capital returns, but the data we do have suggests that professional venture investors as a group have pretty lousy returns. Even folks who are high on it agree that all of the returns come from a handful of superstar investments, your Googles and Facebooks. VC firms work very hard to identify those potential superstars, they drive as hard a bargain as they can on the initial terms of investment, and then they support (and push) that company with all of their might to get to a high-multiple exit in 3-5 years. (This push to exit is something a lot of people forget. Your ownership in a profitable private company is not a good investment until it is acquired, goes public or finds some other way to return money to you.) It is not a profession devoid of knuckleheads, but a lot of them are very good at what they do, the best companies come to them first for investment and and they put a lot of brainpower and resources into maximizing their returns. And most these firms return less than an index fund. Many actually lose money.
I have been listening to the Start Up Podcast. It’s worth checking out as it’s basically like watching a slow motion car crash as it happens. In a recent episode, the narrator, who is also the entrepreneur, who is also raising money from individual investors, states on multiple occasions that the great thing about equity crowdfunding is that it gives normal people the ability to invest in the next Facebook. I can’t say this strongly enough - the next Facebook does not want or need crowdfunding. You will not be an investor in the next Facebook. The next Facebook is happily taking investments from professional VC investors, who are seeking out those companies and providing them with all of the capital and networks they need to attempt that kind of explosive growth.
So, a crowdfund investor won’t have access to the big hits that make a professional VC portfolio work. They also likely don’t get great terms on the investment in the first place, since one of the nice things about crowdfunding is that it puts much of the control back in the hands of the entrepreneur. (Not necessarily bad for the universe, just bad for returns.) They also won’t have any leverage on their own to drive their companies to quick exits (Again, this is probably great news on many fronts, but it hurts returns.) Finally, I expect and hope that people will invest outside of traditional sectors in businesses that interest them and/or are in their communities. Taken in aggregate, this means that the return on a portfolio of crowdfund equity investments is almost always going to be horrible. Like lose half your money horrible. Like lose all your money horrible.
I’m not going to spend any time explaining the absolute crap-fiesta that has been the SECs rollout of the JOBS act. Others have done that better than I can. I will say that, understandably, as an agency in charge of regulating investments, they are framing these transactions as investments. I assume one of the reasons they are dragging their feet is because they see the coming apocalypse - individual investors committing significant chunks of their net worth to finding the next Facebook and losing it all.
OK, now I am super sad. The four of you should be too. Let’s cheer ourselves remind ourselves why equity crowdfunding is awesome:
Literally the ONLY significant bad thing that I can think of is this: almost all investors will get less money back from their crowdfund equity portfolio than they put in. That’s it. That’s all the bad news. But because we are talking about them as investments, and regulating them like investments, that is the only metric which will matter. And by that metric, they are guaranteed to fail. They might fail badly enough that we make them illegal again.
So, how could it be different? I think the SEC ship has sailed and, frankly, it probably wasn’t realistic to believe we would regulate them differently. It would help if people stopped talking about the next Facebook and started talking about it like Kickstarter with a chance to get some of your donation back. I think the patronage lens of Kickstarter is a better lens than investment lens than regulators are giving it. I am proud to say that my home state of Oregon is framing it explicitly as a community building, rather than capital accumulating, tool, but my inner libertarian still gets fired up because Oregon places a lot of restrictions on what consenting adults can do with their money, and that blunts a lot of the potential in the process.
I guess this relates to my earlier post about investment being a false analog for what we are trying to do with our impact-oriented money. My hope, to the extent that I have any, is that the first people who jump into this world for impact will find the right opportunities and be able to articulate why this is a great tool for them before the “next-Facebook” crowd loses their shirts and that terrible press starts rolling in.
So, a few weeks ago I wrote that impact investing needed its own investment banks. Someone I respect very much immediately emailed me with a string of rhetorical questions all enquiring after what he assumed was my recent head injury. What I had been trying to argue (and probably didn’t take enough time to edit) was that a set of services were needed to develop new impact investing opportunities and if I looked at those services and though about who could provide them, the closest analog I could find in traditional finance was investment banks (well, old timey investment banks anyway) What he read was an otherwise sane person advocating that the most destructive, toxic, avaricious part of late 20th century capitalism be transferred over to the still emerging field of impact investing.
I thought about it over Thanksgiving, and, Paul, you were right. I was wrong. Two months into blogging and I am already reversing myself.
I have been either investing or courting investments for almost 20 years now in a variety of transaction types and sectors and every successful new idea I have ever seen has been presented as an analog of an old idea. “You put it in your high yield allocation, but it’s financing Russian circus equipment!” “It’s like eBay, but for loans!” “It’s a socially responsible fund, but it performs just like an index fund!” “We’re an RIA, but for impact investing.” I’m sure part of this is due to good old fashioned risk-aversion. Part of it is because of the nature of asset allocation - no matter how good your idea is, if it doesn’t fit in one of your client’s existing buckets, they can’t invest. Part of it it is because investing is filled with pattern matchers, people who are giving you a very limited window to explain yourself and if you can’t link it back to something they already understand, they have no framework to make a quick decision to keep talking to you.
I like the analog as a sales strategy. I actively counsel people to use it. I even get annoyed with people who reject the analogies I use to try to understand them. Have you ever been in the meeting with the guy who is blathering on about paradigm shifts and new modalities, then something clicks and you say “Oh, I get it, you’re a blah blah blah, but for blah blah.” and he yells “No, it’s not that at all! It’s something completely new!!” Well, I’ve had a lot of meetings, and I hate that guy. (Side note: I have never had a woman entrepreneur yell at me that I am not getting it. They sigh and explain it again. They are usually right. I prefer women entrepreneurs.)
So, having had a few weeks to stew on Paul calling me dumb, I think I have realized my error. Analogs are a great way to sell something you have already built. They are a terrible tool to build something that doesn’t exist yet, let alone something that will participate in an ecosystem that isn’t fully formed. Take the investment bank example. I stand by my list of services that are needed, and I believe we need to build institutions that can provide a suite of some or all of these services. However, just by calling it an investment bank, we are including assumptions about how and how much it gets paid, who owns it, the nature of its relationship with funders and fundraisers, and the skill sets of people working there. And you are more or less committing to hiring assholes, burn-outs and asshole burn-outs. Oh, and because assholes are expensive you need $15 million to start it. That all comes, more or less, from choosing an investment bank as your analog.
Another analog: A while back I outlined the tough row of the impact investment focused advisor. You get people to hire you by saying “We’re just like your existing advisor, but we help you with your impact investments.” Good, you’re hired! But I expect to pay you in the same way I pay my other advisor. I expect the work will be done in a similar fashion and the opportunities you bring to me will look more or less like the rest of my portfolio but, you know, impact-y. Oh and they better all be investments, after all you’re not my philanthropy advisor.
Take another analog: the impact investing fund. You have identified a number of projects to support. You want to raise money to support them. You say “I’m a fund!” Ok, so you have now locked yourself into a 2/20 compensation scheme, which means bare minimum you need to raise $15 million (and maybe $50 million) to cover your expenses. You have to return capital in 7 to 10 years. You have to provide a return on that capital to investors according to whatever bucket they are putting you in (probably VC, good luck with that) Oh, and since you have never managed a venture capital fund, no one is going to invest in you. Good luck in your future endeavors. I personally think there is tremendous opportunity for impact if you create pools of capital that make smart, risky investments in genuinely impact-focused high growth companies and aim to return somewhere between 50 and 90% of principle. These pools could invest in a whole host of high risk, high impact businesses that can’t (or don’t want to) fit venture economics, but if they deprive themselves of the big exits that make venture firms work, there’s no way they’re returning principal . But we don’t have these pools at least in part because there is no equivalent in the traditional investment world and so we don’t have a short hand way of talking about them
Finally, what if impact investing is a false (or at least misleading) analog too? We’re investing money into projects to help them grow and do more good stuff. We’re trying to leverage our own funds with other sources (including traditional investors). We want to get some, all or more funds back so that we can do more good stuff and/or commit a larger portion of our funds to it than we could afford to with just philanthropy. That's a great way to have impact, but what if that isn’t really “investing” and we’ve been shooting ourselves in the foot calling it that? If that were the case, it would start explaining to me why impact investing has been poised for explosive growth without really seeing it for ten years. IT would start to explain why it’s so difficult to bring impact investment products to market that make philanthropists or investors happy, let alone both. It would explain why it is so hard to successfully integrate smart good hearted people from the investment world into impact investing. It would start to explain why, when something like microfinance goes into the investment mainstream, the impact side of it seems to go entirely off the rails. It would start to explain why whenever I tell an investment banker what I do for a living, they wrinkle their nose and say “That’s not really investing.”
What if impact investing isn’t investing at all, and that’s part of the problem? I don’t know. I don’t want to be that obnoxious guy yelling about paradigm shifts and new modalities telling people they don’t get it. But I’m starting to wonder.
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.