Featured Idea: Support a structure for entrepreneurs to support entrepreneurs

by Nathaniel Whittemore

Published December 01, 2008 @ 08:00AM PT

Marc Dangeard, the founder of Entrepreneur Commons, has posted an Idea for Change in America that I'm really excited about. His idea (which is the idea animating Entrepreneur Commons, as well) is that entrepreneurs make the best mentors for other entrepreneurs, and that we should help build alternative startup support structures that bring entrepreneurs together. Check out his informative thoughts below:

What's the idea ?

The idea is to provide a platform to allow entrepreneurs help entrepreneurs through mentorship but also new funding opportunities, with an inclusive funding mechanism for entrepreneurs (instead of just luck or the competition model offered by VCs and Angels).

Where does the idea come from?

The idea comes from having lived in Silicon Valley for many years and having seen the real drawbacks of the current model. And they are 4 fold:

- first the VC model does not work for entrepreneurs. VCs are money managers for their Limited Partners (LPs), and their goal is to maximize the return on investment for these LPs. For this reason they have a very strict selection process that leaves out 99% of the entrepreneurs entering the competition. Typically VCs will tell you that when they receive 1000 applications, they will look at 100 to fund 10 companies (http://news.zdnet.com/2036-2_22-6091724.html). And out of these 10 they also admit that typically 1 will make it big, 3 or 4 will make it ok and the rest will be loosers. Angels in this area do not help much more, because they tend to have limited funds, and therefore they cannot spread themselves into a statistically significant number of deals, which means that they are playing the lottery when they invest, and they know it. So they tend to invest in the 10x potential return companies which are the same 100 companies that VC look at. It still leaves out 90% of the entrepreneurs who entered the competition. And when you know that the 4 years survival rate of small business is 43% on average it means that you are leaving out many viable businesses, just not sexy enough. For these businesses today, what is left is mainly friends and family (banks do not lend to startups with no history), and not everybody has friend and family that can fund the start of a business.

- the second drawback is that while VCs (and Angels) do not really help entrepreneurs, the success they have are well advertise, creating the illusion that entrepreneurs can come to Silicon Valley to shake the money tree and get their buiness started. While all these front page news talking about the Google and Yahoos of the world are great to provide a pipeline for VCs, they are just the light that attract entrepreneurs, and they are getting burned. All this time spent trying to raise funds is wasted and contribute mostly to accelerating their failure if they are not funded. They should be looking for customers to get real feedback and real cash rather than looking for funding (Guy Kawazaki Plan B: http://blogs.openforum.com/2008/09/09/plan-b-for-fund-raising/)

- the 3rd issue with the current model is that it is pushing the idea of equity deals at a stage when it does not make sense. VCs are making their money by investing in stock, and Angels tend to try to do the same, Angel Group best practices are recommending them to do equity as well.

But at an early stage when there is no revenue, the valuation of a company is anybody's guess, which means that somebody is making a bad deal. This is not a good base for a healthy long term relationship. The other problem with equity is that it creates the need for the investor to have an exit. Which means that at some point within the following 5 to 7 years, the company will have to be sold one way or another, creating a pressure to maximize the value before that deadline, which may or may not be good for the business, and certainly cannot be good if you are a social business.

So really what we should use for early stage is debt rather than equity.

- one last issue is that the VC and Angels model do not scale: investing into a startup require due diligence, and currently this work is done by the VC partners, or angels individually or in groups. VCs typically manage large funds (the bigger the better as they get 2% management fee every year from the fund), and they cannot manage more than a limited number of deals. So they cannot invest in deal that are too small. The current funding gap is around $6M, which means that they do not really like to invest less than $6M, not really what an early stage company needs (if you look at the Top 5000 fastest growing companies list from Inc Magazine, the median capital to start one of these companies was $25K, and if you look at the top 500 fastest growing companies, the median capital to get one of these started is still only $75K). Angels do smaller amounts, but they are also limited by time and the amounts they can invest individually. They are trying to get organized in groups so that they can scale, but they are still limited in what they can do. So we need a model that would scale better, and the good news is that there is such a model: microfinance has shown us that you can successfully do many small loans to many entrepreneurs and still be very successful at making very decent returns (especially in the light of what is happening with Wall Street these days, a 12% interest rate would look really good to anybody who has invested in the past few years in the stock market)

A platform offering mentoring and debt financing would therefore make a huge difference for entrepreneurs: it would turn the current competition model into an all inclusive model. There would still be people who do not get funded, but they would not be rejected by a few "experts" from a VC firm. Instead entrepreneurs would work with each other and sponsor their fellow entrepreneurs who deserve to get the funding because they have reached the right level of maturity with their project. The others would get education from their peers instead of rejection.

And because we are talking debt, this model gives social entrepreneurs a real chance to get funded, because the decision is not on how much return they can bring to investor (always a loosing discussion for social entrepreneurs when you talk about equity and the need to maximize profit so that the exit can be good), rather it depends on whether the business can be sustainable and the debt paid off.

What role could the Obama administration have in the project?

The Obama administration has listed on the website change.gov that it is in their agenda to create a network on incubators, to help small businesses create jobs:

"Create a national network of public-private business incubators: Obama and Biden will support entrepreneurship and spur job growth by creating a national network of public-private business incubators. Business incubators facilitate the critical work of entrepreneurs in creating start-up companies. Obama and Biden will invest $250 million per year to increase the number and size of incubators in disadvantaged communities throughout the country."

If they are going to do this, the fund should not be managed by government employees who know nothing about running a business and being "in the trenches", and it should not be run by consultants who would live off the government money either. It should also not be run based on the existing VC model, which is broken as I explained earlier, and as some others have explained in blogs: http://www.slideshare.net/guest1c3ad/thefunded-canarie-presentation?type=powerpoint

Rather, it should be a model inspired by Microfinance, with self help teams of entrepreneurs mentoring other entrepreneurs, with the distribution of funds left to the decision of the group so that it can scale better. If there are 150 entrepreneurs, there are 30 groups of 5 of them meeting on a regular basis, and you just have a minimal staff to make sure they have a place to meet and to address issues as they come up. And then the size of the loans does not matter, on the contrary the more of smaller loans the better because it makes the system statistically relevant.

The good news is that the model is not new and it has been proven. Average default rates with Microfinance are  1 to 5%, which is very good, and clearly much better than the results advertised by VCs (as I mentioned earlier, out of 10 investments, they expect 1 to be really good, and 3 or 4 to be ok with th rest that are loosers, giving you at best a 50% default rate after a selection process leaving 99% of the candidates out).

You can also improve the model on the financial side by using a mutual guarantee fund, which is something that exist in Europe since 1917 and has also proven to be very sustainable (loans made through mutual guarantee funds also have average default rates of 1 to 5%).

The mutual guarantee fund is somewhat of an insurance where you set aside some money for each loan (typically 2 to 8% of the loan) to cover defaults when they happen to minimize the risk of investor. If your guarantee fund represent 8% of the loan made, and the default rate is less than 5% then the fund is sustainable. When the loan is paid off the borrower gets back only what is left of the guarantee, so the borrowers as a group have an incentive to support each other to make sure that not only they are successful but also their fellow entrepreneurs (that they sponsored to get the loan in the first place) are successful. A very virtuous circle.

Why should this be a priority?

It should be a priority (and it is one from what I see in the agenda on change.gov) because entrepreneurs are the ones who create jobs and keep the economy going, they are a very critical piece of the equation.

It is even more critical today because the world is sick and we need social entrepreneurs to help fix it, and if the current funding model is not efficient for entrepreneurs in general it is even worse for social entrepreneurs, so we need to come up with a better model.

I believe actually that the issues that we have to resolve in the world (poverty, diseases, ecologic and economic crisis, wars, etc...) are too big for any one government or for philanthropists to resolve. Entrepreneurs are the ones who change the world, and we have no choice: the only way out is if every entrepreneur becomes a social entrepreneur at his or her level. We cannot afford to keep focusing on maximizing profit, because this is what got us where we are today. Instead we need to focus on (and provide support for) creating sustainable businesses (it is healthy to generate profit) that also contribute to the community one way or another: creating a model where social entrepreneurs have just as much chance as the others to get funded is a first step. Creating a culture of mentoring through self help groups is another good step. Social entrepreneurship should not be a phenomenon on the edge of entrepreneurship, it should become the norm. We need to bring sustainability back into Capitalism!

I have been working on doing just that with Entrepreneur Commons (www.entrepreneurcommons.org), and I think that the Obama administration should consider supporting this effort or something equivalent when they implement their national network of public-private incubators.