Growing the Overlooked Economies: The Potential of Impact Investing Ecosystems
When most people think about entrepreneurship, a few popular hubs immediately come to mind: Silicon Valley. New York City. Boston. Indeed, the data proves that venture capital funding for startups continues to be concentrated in just a few entrepreneurial communities, with California taking the lead. Investors are also funding larger rounds in later stage companies in those same areas, with over 70% of total dollars committed in two regions: the West and Mid-Atlantic.
Although the availability of venture capital is certainly not the only economic measure, it does show us, at a fundamental level, who is benefitting from the technology revolution and the economic benefits that follow. Entrepreneurs throughout the country, from the Midwest, to the American South, struggle to source early stage capital. Many fail. And those that do reach escape velocity and need substantial growth capital often source it from — and move to — the coasts, taking economic opportunity with them. On top of this, not only is there evidence that entrepreneurship is on the decline; some report that venture capital investments today are not performing well: as little as 15% of all venture funds deliver alpha over any rolling 10 year period relative to the Russell 3000.
Taken together, this 'perfect storm' of troubling data suggests that entrepreneurship in America is not working for everyone. Notes the Brookings Institute, “few can now deny that the geography of America’s current economic order has brought economic and social cleavages that have spawned frightening externalities: entrenched poverty, 'deaths of despair,' and deepening small-town resentment of coastal cosmopolitan elites.”
Are we failing to reach and cultivate enough entrepreneurs— or the right ones? Are we also failing our economy as a whole and excluding hundreds of communities from prosperity?
Addressing Underlying Causes: How Place Based Impact Investing Can Cultivate Hope
None of this is new. Investment activity has long been correlated to employment, health, mortality, and other indicators that we associate with community well-being. Also, many of the troubling trends in entrepreneurship have been going on for quite some time. So, how do we reverse the tides?
Place based impact investors, such as community foundations, have been working to combat these inequities for entrepreneurs by addressing some of their root causes. While progress has clearly been made, as evidenced by the rise in impact investing, the opportunity gap for communities around the country remains acute due, in large part, to the absence of sufficient funding supporting a wide audience of entrepreneurial ventures. We tackle some of these root causes and the strategies already being employed to address them below:
Impact investors and entrepreneurs struggle to connect in local economies
Underserved economies lack local infrastructure to connect entrepreneurs with sources of capital. As a result, unencumbered, mobile entrepreneurs join existing ecosystems in search of capital— while those that are not able to move struggle to find capital for great ideas.
Thanks to the Internet, investors and investees are able to connect across the globe. However, most of these platforms are not rooted in place. As a result, economic activity benefits global participants, which are concentrated in larger cities on the coasts. Also, very few of these marketplaces are influenced by impact investors, committed to creating wealth, rather than extracting it. The traditional venture and angel group structures are insufficient to mobilize capital into a diverse enough population of startups, as evidenced by today’s funding gap.
Foundations are increasingly involved in supporting web-based platforms focused on building impact investing ecosystems. For example, the Oregon Community Foundation, Meyer Memorial Trust, and Ford Family Foundation are supporting a platform to match rural Oregon entrepreneurs to potential sources of capital emerging from the Opportunity Zone program. The Legacy Funds is another example of a platform designed to enable the efficient establishment of institutionally-rigorous, locally focused, seed stage venture funds. Ultimately, supporting a wider audience of startups, in a time-efficient and meritocratic manner.
Investor biases can prevent worthy entrepreneurial ventures from accessing capital
Who you know, how you pitch, and where you’re located — versus the quality of your business model or wisdom behind the ideas— drives more venture capital decision-making than should be the case.
Today's impact investors are working to take bias out of the equation. For example, Steve Case, through the Rise of the Rest Tour, Jean Case, through the Case Foundation, and others are working to provide venture capital to underserved communities. Technology can offer powerful solutions to create new venture fund solutions that can both deploy more capital to underserved communities while supporting a wider audience of startups. Through an index-like fund such as Legacy Funds, entrepreneurs deliver standardized operating information, rather than pitching to investors. By focusing on the data, we can reduce many of the biases while investing in more startups.
Investors believe that investing in underserved communities comes with greater risk
Despite the solutions above, some investors still believe that the risks of investing in underserved communities outweigh the benefits, resulting in what has been labeled as “concessionary returns” — nominal returns not commensurate with the risk of the investment. While this may be true in some cases— and driven by bias in others— there are tools, tactics, and tax policies that can mitigate risks.
Project or company-specific risks can be mitigated through prudent diversification that avoids putting “all of your eggs in one basket.” Research on proper diversification of early-stage companies suggests 100-200 companies, so that company-specific risk is mitigated at the portfolio level.
Policies including the Opportunity Zone Program and New Markets Tax Credits incentivize investments to underserved communities by offering tax-related benefits, but there are lesser known tax laws that have not been as widely applied in the development of impact investing products. Specifically, Sections 1202 and 1244 of the tax code can lower the after-tax risks associated with investing in small businesses and make profits potentially tax free. Like Opportunity Zone incentives, these laws were passed to stimulate investment in early stage companies. However, they’ve been largely overlooked by venture, angel, and impact investors.
Sec. 1244 should be of particular interest to impact investors, as it allows for losses on angel/impact investments to be deducted against ordinary income. This deduction is, in fact, more favorable than an equivalent deduction associated with a 501c3 charitable contribution.
Foundations and other impact investors can benefit from fully understanding all of the incentives in place to support small businesses.
A Knowledge Gap Doesn’t Have to Contribute to the Opportunity Gap
Without more collective interventions, economic growth will continue to leave behind vast regions of our country. According to the Economic Innovation Group’s New Map of Economic Growth, gains from growth will continue to consolidate in certain regions and leave other areas searching for their place, compounding the current uneven concentration of opportunity and wealth. With American millennials accounting for a large piece of the workforce, socially and culturally primed for entrepreneurship, it’s important that the system work in their favor, whether they are in Silicon Valley or not.
We have a growing movement of impact investors giving us glimpses of what is possible. With the varied samples of solutions offered above, a knowledge gap in how to allocate well-intended capital to worthy entrepreneurial ventures throughout overlooked communities need not contribute to the opportunity and funding gap these communities experience today.
As the impact investing field grows, we believe that cultivating these local sources of capital will not only become powerful drivers of opportunity; they can help create healthier, happier communities, and foster place-based capitalism that works for everyone.
Visit https://thelegacyfunds.com/#Research to learn more.