Brad Hargreaves | startup adventures in nyc

The smart money says there’s plenty of capital out there. And from the perspective of near-term return optimization, they’re right. In fact, there’s probably too much capital out there, especially in major centers of innovation like New York, Boston and the Valley. If you were to seed fund the “marginal 10%” of companies — the companies that barely miss the current threshold for funding, if such an objective measure were to exist — the financial returns would surely be dismal.

But that’s not the only way to look at it. I argue that — from a long-term perspective — more companies should get funded.

Running a funded startup is an incredible education unlike any other. As someone who has run (a) bootstrapped startups that I couldn’t get funded, (b) bootstrapped startups that purposefully didn’t raise money, (c) angel-funded startups and (d) venture-funded startups, the learning experience delta between {(a),(b)} and {(c),(d)} is incredible. Taking money increases the volume of things going on and pushes your company to the next level. It increases the amount of stuff you have to figure out. It opens doors and enables conversations that few bootstrapped startups can have. If you pick the right investor and leverage it, the things they say about “opening their rolodex” can absolutely be correct. And you learn a lot of critical stuff about how to build a business from those people. Even taking “dumb money” can make it an order of magnitude easier to get in the door.

And most importantly, it’s a guaranteed lifetime addiction to entrepreneurship.

Even if the companies built with this seed money don’t succeed, these entrepreneurs are the foundation for successful companies in five or ten years. Every entrepreneur that fails to raise money and is forced to go back to the day job is a potential groundbreaking innovation that will never see the light of day. Claiming that “real entrepreneurs will always persevere” is bullshit. The people who create awesome, world-changing things are not always the people who are willing to work eighteen hours a day for no salary for years. They may be people without savings, with mortgages and with families. Creativity and innovation isn’t the just domain of scrappy 20-somethings, so why is entrepreneurship?

In economic terms, there’s a huge positive externality to all of this connecting and learning. That means that more of it should happen than will actually happen if every player is simply looking to maximize profit. If more startups are going to get funded, investors must believe in the positive social benefit of funding.

And I think it will happen. The comps are changing — more wealthy independent investors are looking at seed funding as philanthropy rather than a component of a diversified investment portfolio. A certain group of investors are considering their seed investments in the same pot as their patronage at the Met or contribution to an off-Broadway production rather than their private equity assets. This is a really, really important distinction, as it makes the returns of these capital deployments less of a factor. Wealthy independent investors aren’t blind — they see need for funding and innovation as the savior of our nation and economy. This isn’t just an investment; this is a moral imperative. And you can’t ignore the sexiness and cocktail party benefit of being in on the ground floor of a new hot startup.

There are good counter-arguments to be made here, but I think they are outweighed by the curation of a future generation of entrepreneurs. For instance, it is absolutely true that more capital will lead to more competition for the means of production (e.g., developers), driving up prices and making it more difficult for “good” startups to hire. This is absolutely true, but higher salaries for developers in startups isn’t a bad thing for the startup environment as a whole. After all, the world — even the world of hackers — operates by the rules of supply and demand, and higher salaries from startups will draw more developers from established tech companies and banks, for instance.

Seed funding is entering the world of philanthropy, and I think it’s a very good thing.

I don’t usually like pointing out others’ failures (I prefer to focus on my own), but one particular demo by a startup at this past Tuesday’s New York Tech Meetup is particularly instructive in How to Fail at Presenting to Hackers.

A brief guide to failure, courtesy this demo:

Expect your connections to high profile individuals will build credibility: Exceptions include Richard Stallman, Cory Doctorow and probably Steve Jobs. Don’t rattle off a list of Silicon Valley investors and expect us to be impressed. We’ll just wonder why you’re not showing us a product.

Put the conclusion before the story: It’s fine to say that you’re raking in cash or you have amazing clients, but do it after you show us the product you used to get there. Otherwise the story seems backwards and you seem full of yourself. Explain how something was built from the ground up, gained traction and eventually convinced people with money to buy your product and support you. That’s a story that resonates with hackers.

Ignore the allegiances and perspectives of the audience: This is more of a general presentation rule, but this company couldn’t have blown it worse with a hacker crowd. For instance: if your product has applicability to hiring for both Fortune 500 companies and early-stage startups, don’t show examples of how Fortune 500 companies can use it to gain leverage over potential employees. You seem to be enabling a corporate culture that your audience is rebelling against.

Send someone who isn’t a cultural fit with the audience: I’m sure your company has hackers. Even an executive CTO or VP of Engineering. Send them, not the business development executive you just recruited out of an investment bank.

Like any audience, presenting to hackers isn’t hard. But just as it wouldn’t be a good idea to wear jeans and Birkenstocks when making a presentation to the board of a Fortune 500 company, pitching a crowd of hackers requires a level of understanding and respect of the group’s culture. Anything less is simply going to waste everyone’s time.

As an entrepreneur, a big part of my job is figuring out what people want and building products that meet those needs. Even if I think a product is really cool, I’m not going to invest time and money making it better if the market doesn’t seem to care. There’s a slim chance that I’ll fiddle around with the product long enough that I can get people to understand what they didn’t know they needed, but such is a fool’s errand unless there’s a clear path to success.

Unsurprisingly, people with backgrounds in iterative software development aren’t running education in America. It’s a shame, really, because I think consumer web startups could provide some good lessons to improving K-12 science education. Let me start with one premise: Our nation’s cultural values, especially in middle and high school environments, are strongly aligned against science and technology. And most distressingly — and has Dean Kamen has recognized — this is contagious. When a student’s most respected peer is the football captain, they are likely to realign their interests away from science and education and towards things that are less productive to society.

Yet like an entrepreneur without a good grasp of the audience, we continue to focus on shifting the product — fiddling around with different ways to present information — rather than the market. While there’s certainly value in iteration and superior presentation, I can’t really envision a secular change in performance and output taking place without a fundamental change in the market’s attitude toward science. We have to make science sexy to high-potential K-12 kids. All the product iteration in the world is for moot unless we can figure out a way to make smart students actually care about science, math and engineering.

Logically, there are two ways to make this happen:

Change the attitudes of society as a whole. This is Dean Kamen’s strategy with FIRST — turn science into a sport, engaging larger segments of the populace by framing science students in the same verbiage as football players.

Change the attitude of a subset of society, and immerse qualified science students in that subset. This is a controversial one, and — other than a few specialty schools such as TJHSST — isn’t commonly employed in a meaningful way.

While I love what FIRST is doing, I’m not convinced that the former is feasible. Getting hundreds of thousands of high school students engaged in competitive science — as FIRST has done — is awesome. But it’s not changing our culture’s attitude toward science as an unpopular, unsexy, geeky, male-dominated field. And there’s a decent argument to be made that such stereotypes are hard to dispel because they’re true. Fixing that problem — well, that’s another debate. Regardless, I don’t see brilliant science students gaining the fame, notoriety and sexiness of their peer athletes in my lifetime. And if you rely on the societal change model, this is a massive problem: science and engineering students have been promised a reward in exchange for their work that they’re not going to get. In other words, FIRST could be selling a lie.

Disturbingly, our best bet to stay competitive as a nation may be to ghettoize high-performing students, placing those with real potential to be our nation’s next generation of scientists and engineers in environments where their interests won’t be misaligned by the skewed perspectives of a nation fascinated by D1 college football and Justin Bieber. There are a lot of downsides to this proposition — namely, the fact that a majority of students are stuck in downward-spiraling groups of non-qualifying kids. But is this significantly different than our nation’s current private school structure, except with academic performance as opposed to financial means as the selector?

Regardless of the method used, I’d love to see our nation’s policymakers and educators focus a bit more on the market they’re trying to reach.

As anyone who has tried to raise angel capital knows, there are strict restrictions on taking money from individual investors. Unless, of course, those individuals are Accredited Investors as defined by federal securities law. That is, unless they are rich enough. If you don’t have more than $1 million in assets or income over $200,000 per year, the law reasons, you aren’t sophisticated enough to understand private equity and should thus be banned from making those investments.

But this goes way beyond startup fundraising. In fact, securities law as it is currently written represents one of the largest transfers of wealth in human history from the middle class to the upper class and is against the principles of our society.

First, some (simplified) background. There are two types of equity (stock) investment: public and private.

Public equity is stock in companies that are “publicly traded” — typically, on stock exchanges. Most of the big companies the average American knows (Google, Apple, Coca-Cola, Boeing, et cetera) are public companies, and their stock is public equity. Mutual funds, options, futures and most other derivatives contracts are forms of public equity. Anyone can buy public equity.

Private equity is stock in companies that are not publicly traded. Facebook, for instance, is a private company, and there are major restrictions on who can invest in such companies. While there are exchanges for this equity — such as SecondMarket — purchases must be tightly controlled to comply with securities law. “Private Equity” also includes the funds that invest in private companies, including venture funds, buyout funds, growth and distressed capital funds and a menagerie of other stuff. With a few exceptions, only accredited investors can invest in private equity.

Yet private equity, as a broad-based asset class, has traditionally outperformed public equity. Data around this is difficult to capture, since private equity is a complex field and there are no requirements for firms to report returns. However, State Street’s Private Equity Index is a good place to start, and they have regularly reported private equity markets outperforming public.

And how were those returns generated? Often, at the expense of publicly traded securities — whether it’s a venture fund selling its interest in a private company to a public entity via an acquisition or a hedge fund creating outsized returns by shorting the market or making algorithmic trades. These abnormally large returns must — by federal law — accrue to wealthier individuals.

The argument for the accreditation requirement goes back to the inherent riskiness of private equity. But given the catastrophic losses individuals have repeatedly taken in public markets, there is simply no longer any logical reason behind the distinction. From John Maudlin‘s testimony to Congress in 2007:

“Why should 95% of Americans, simply because they have less than $1,000,000, be precluded from the same choices available to the rich? Why do we assume those with less than $1,000,000 to be sophisticated enough to understand the risks in stocks (which have lost trillions of investor dollars), stock options (the vast majority of which expire worthless), futures (where 95% of retail investors lose money), mutual funds (80% of which underperform the market), and a whole host of very high-risk investments, yet deem them to be incapable of understanding the risks in hedge funds”

I couldn’t have said it better myself. But at least both public and private equity asset classes have positive internal rates of return — the government actively sanctions lotteries, casinos and other means of fiscal speculation with a negative IRR. In fact, the government actively targets lower and middle class individuals with these schemes — just see all the ads for the New York lottery in the subway. Federal and state governments are telling the lower and middle classes “You aren’t smart enough to understand private equity. Why don’t you put your money in the lottery instead?” This exacerbates the gap between rich and poor, further eroding the middle class.

Not only is this a massive transfer of wealth from the middle to upper classes, but it is fundamentally at odds with a mobile and meritocratic society. Why should the government restrict access to a certain class of investments by wealth? Lots of things are financially risky, like quitting your job and starting a company. Should the government save us from ourselves by requiring everyone to meet certain asset requirements before we can form an LLC, or even quit our day jobs? To take an example from outside of finance, driving a car is extremely risky. The government manages that risk by making all prospective drivers take a test to verify their driving skills. Perhaps those wishing to take part in high-risk investments should take an SEC certification exam such as the Series 7, which is required for those selling securities.

But that is still an imperfect analogy. If a clueless driver is on the road, they put everyone else at risk. If a clueless investor is buying and selling equity, they risk only themselves — especially if they are a smaller player. But at least an exam is meritocratic in nature, whereas an asset requirement is simply oligarchical.

Yet not only will the accreditation requirement be kept, but it is likely to be raised to a minimum requirement of $2.5 million in assets, stripping access to private equity from even the upper middle class. This is clearly a bad piece of legislation, and there are a lot of people betting it will change. Given our leadership’s tendency to respond to specific problems with ham-handed reform, I’m not holding my breath.