How Essential Capital can align venture finance with public profit

Financing innovation to address public needs can be profitable if we design the model to align incentives to achieve essential aims

Photo by Brett Jordan on Unsplash

Ventures building solutions for the essential challenges we face need capital. A lot of capital. While we should celebrate the tremendous inflows of capital into climate oriented venture capital (VC) funds, data from the past three decades is rather conclusive that the VC model is not optimal for substantial, essential ventures: neither cleantech, nor edtech, nor agritech, nor healthtech, nor govtech — all of the essential systems we will need to upgrade if we are to adapt and build resilience to the changes that are at our doorstep. If we truly intend to finance innovation in essential systems, we need a new logic and structure to align our investments to address public needs.

Essential Capital (EC) posits that tweaks made by new VC funds to incrementally adjust to lessons learned from past clean-tech failures won’t be able to surmount the structural reasons VC has failed to substantially advance essential ventures in the past three decades. Given the stakes of the polycrisis, it would be foolish of us to bet our house on getting different results from doing the same thing over, and over again. Instead, we need to design our venture investing vehicle with the outcome we desire in mind, aligning incentives of the different players with our objectives, and enabling additional actors to join in key roles to accelerate our ability to invent, innovate, validate, commercialize, and finally integrate new technologies into our everyday lives.

This essay lays out a model for how essential capital could drive positive returns to public profit through essential innovations that generate private profits to meet corporate goals. It is based on a systems analysis of our current, VC-driven, instrumental innovation ecosystem, and proposes to complement that system through an essential innovation ecosystem that will align the incentives of creativity and capital towards addressing the massive market failure we are living through today.

How VC works to drive instrumental returns

Before we dive into the model for EC, let’s review why an aligning innovation approach concludes VC is misaligned with essential aims. Without a doubt, Venture Capital is an incredibly powerful albeit risky tool to build instrumental companies whose main outcome is to return capital to shareholders. A VC is judged based on how much money it returned to shareholders (its ‘multiple’), regardless of which companies it invested in and what those companies do. Since those companies are instruments for the fund’s success, a VC is fundamentally agnostic to anything that does not return a sufficient multiple on capital invested. Similarly, it would be fiduciarily irresponsible of fund managers to invest in companies that cannot meet their capital return requirements.

This is complicated by the fact that VC funds need to return capital to their shareholders within a particular time period in order to be considered successful. While VC began as a public, perpetual vehicle for directing funds in particular areas of industrial need, the model evolved into today’s dominant model: time-limited funds backed by limited partners (LPs) and managed by general partners (GPs). The role of GPs, and the professional fund managers they hire to support their effort, is to buy equities in companies and then to sell those equities at market-beating returns.

The organizational behavior of VC professionals is complicated by the incentives of the model: VC fund professionals are compensated based on a 2&20 rule made popular by Private Equity (PE). This 2/20 rule means the professional side of the fund receives 2% of the money invested every year as a management fee, with the additional ‘carrot’ of receiving 20% of the profits from the fund if they do, indeed, return funds profitably to their shareholders (LPs). Setting aside the incentives built into that dynamic — leading GPs to raise ever larger funds to maximize their 2% take-home — the true source of misalignment of VC with achieving essential goals to further the public purpose is rooted in VC portfolio theory and the Power Law.

Contemporary VC Portfolio Theory’s three main assumptions

Contemporary VC portfolio theory instructs fund managers to build a portfolio full of high-risk, high-reward innovations with the expectation that one out of every ten companies needs to earn the fund enough money to pay back the amount invested by their LPs. To achieve this, the overwhelming majority of Venture Capital firms build their investment portfolios along the lines of three major assumptions:

1. A portfolio needs to be constructed of independent companies, each with their own captable
2. The companies in the portfolio cannot compete with one another
3. A portfolio will have many losers and a few winners, and the firm should double down on good ones

Each of these VC Portfolio Theory’s assumptions are meant to increase financial returns: a VC invests in independent companies out of the assumption that doing so diversifies risk. The VC invests in companies which do not compete, out of the assumption that competition between their portfolio companies would create harmful dynamics and end up being bad for business. The VC doubles down on winners and lets losers go because the VC wants to own as much equity in an appreciating stock as possible, while avoiding throwing good money after bad into companies unable to raise their stock price sufficiently for VC purposes.

Yet each of these assumptions, on their own and in aggregate, can and should be questioned. Venture Studios do a good job of challenging the idea of independent companies, up to a certain stage, and as an asset class so far, seem to have shown to be more profitable than VC. Multinationals have, for years, recognized that they should be putting out overlapping and sometimes competing products on the shelves, since competition often leads to learning and improvement and positive drama to motivate teams to achieve. As for doubling down on winners and leaving losers, anyone who has participated in either the scientific process or the entrepreneurial process knows that lessons learned — and technology developed — by failed experiments is often as valuable, if not more valuable, than those from successful experiments.

Given that the VC model spreads thin the expertise aggregated in its fund, discourages collaboration between companies in its portfolio, and is agnostic to the fate of the knowhow and IP developed, they are fundamentally limited in their ability to drive sustainable, systemic change in substantial technological realms. All of this is because, of course, VC is designed to benefit investors and not innovators. What if we could design a capital vehicle with the innovator in mind, where investors are suitably compensated for the risk they take?

How EC helps innovators solve essential challenges

If we are to design a source of capital for new ventures with the goal of fostering essential innovation, the first question I believe we should ask is: how can we best ensure the potential of inventions to fuel innovations to positively impact the world? Fundamental requirements of any model would need to include the validation that such inventions have the positive effect we desire, do not have harmful second and third order effects, and can be economically sustainable in the long-run such that they can repay investors sufficiently for those same investors to be able to reinvest their working capital in advancing additional solutions over time.

If we are to accept this as the guiding mission for Essential Capital, the role of investors would be to enable such ventures to grow to their full potential, and their expectation should be an aggregate return of capital that accounts for the risk they take by locking up their working capital for a number of years, balanced by the cost to them of the problem they’re seeking to solve. An EC fund should therefore generate its financial returns based on its ability to successfully direct financial capital towards solutions to a challenge.

To achieve success according to this definition — returns based on successful solutions — an EC fund focuses on a particular challenge its General Partners (GPs) and Limited Partners (LPs) have a particular expertise in, identifies and invests in a portfolio of inventions and innovations that address that challenge in an overlapping and complementary manner, encourages coopatition among portfolio companies with shared infrastructure, and, if and when some of these portfolio companies stumble or fall apart along the way, enrich the rest of their portfolio using the knowhow, IP, and human expertise available.

In contrast with VC, EC portfolios follow the following assumptions:

Figure 1: Comparing VC and EC portfolio assumptions

Applying EC Portfolio Theory’s three main assumptions

To build a fund based on EC portfolio theory’s three main assumptions, fund managers need not change much in terms of the legal and operational elements of VC. As Peter Senge wrote once, “small changes can produce big results — the areas of the highest leverage are often the least obvious.” In this case, the small change rests on building an interdependent and mutually reinforcing portfolio as opposed to an independent portfolio, one that functions as a garden as opposed to a slaughterhouse.

Whereas a VC is founded on a thesis expressing how its fund managers will pick companies addressing a market with the greatest chances of financial returns, an EC is founded based on a thesis exposing the magnitude of a challenge facing a public or private market segment, and expressing how their expertise will lead them to pick companies with the greatest chance of addressing that challenge from different directions. Once the fund is raised, EC managers go about investing their capital in building a portfolio that differs from VC in the following ways:

1. Force-Multiplying Portfolio: each company in the EC portfolio seeks to solve the challenge chosen by the fund managers in a unique way. Ideally, the companies would be complementary, providing different technological and operational approaches to solving the challenge that can overlap and support one another if they work, or enrich the work of each other if their innovation turns out not to be economically sustainable on its own. To encourage such cooperation, the EC may decide to create an equity pool across companies so that portfolio companies will literally be invested in each other’s success.
2. Coopatition in Portfolio: companies in a VC portfolio end up spending a lot on a core set of functions that have nothing to do with the research and development that transforms inventions and innovations into products and services. Whether it be operational functions (legal, accounting, logistics, regulation, quality management, etc) or field common (business development, government relations, marketing, etc), companies in a portfolio have a lot more to gain by cooperating on expense centers than each building their own. Even competing companies can, up to a point, share core functions without harming their chances at success. An EC makes part of its investment through a professional set of services it either finances in common or provides through a platform to its companies.
3. Transitioning Misses into Portfolio Enrichment: When a company in a VC portfolio closes down, its knowhow and IP often end up in the trashcan of history. Founders and key staff look for other jobs, patents are sold to the highest bidder or left to run out, and core technology is sold when possible or discarded. This is a tremendous tragedy. As anyone who has ever worked in a lab or company engaged in R&D can tell you, even failed experiments provide tremendous value. Moreover, failed companies are not failed technologies. Anyone involved in the innovation ecosystem can name at least a handful of companies with tremendously important knowhow that shut down because of orthogonal reasons (company/investor politics, market downturns, captable mismatch, etc.). Reusing and recycling that knowhow and IP into other ventures is not the job of a VC with instrumental aims. An EC aimed at solving a challenge recognizes that the knowhow and IP, and the people who created it, are essential to building solutions. An EC strengthens their portfolio by recovering those assets. Practically, this means every EC investment agreement includes a clause for right of first negotiation for knowhow in case of a shutdown, and right of non-exclusive license to ensure that knowhow enriches its other portfolio companies.

Integrate Essential Capital Portfolio Theory into Your Work

Shifting from the VC model to the EC model does not require a change in the legal or operational infrastructure for funds. One can use the same fund documents, same basic infrastructure. It simply requires a change in approach. A shift in how we perceive the system. As Donella Meadows wrote, “a system is defined by the relationships between components that work together in a given environment in order to achieve a specific objective.” By shifting the relationships within portfolios we can generate outcomes that have essential value, leading to aligned public and private profit.

For those who aspire to address the essential challenges that face our species and our planet, I hope this exposition of Essential Capital Portfolio Theory helps. For those already running funds or venture builders or companies, here are a few ways to shift relationships towards alignment with essential innovation within existing frameworks:

1. VC fund managers: invest in already-existing companies, taking a larger stake than one would expect but returning to the existing shareholders a piece of the holding company pie in return to diversity risk in return for a ‘recycling’ provision whereby the firm gets the right of first negotiation to knowhow assets if the company’s board of directors decides to abandon the venture.
2. Venture Studios & Builders: Expand your studio or builder as a hybrid fund, each challenge area clustering together alternative and complementary approaches to solving the challenge at hand. Invite in inventor-partners as venture partners with a stake in their own invention, as well as a general stage in the fund.
3. Startup entrepreneurs: Connected to a Generator or create a venture federation by building strategic partnerships with companies addressing the same challenges as your venture addresses. Identify together promising experiments that can be then further invested in through independent teams or studios or builders

Despite the challenges facing us, hope is not lost. The tens of thousands of brilliant inventors and innovators currently working across a range of key sectors have at this very moment the seeds for a better world. All they need is the opportunity to grow those seeds into the solutions we need.