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Alternative funding may be the best route to a startup ecosystem outside Silicon Valley

10 min read

I'm asked a fair amount about creating startup ecosystems outside of Silicon Valley. My first startup was founded in Scotland and initially bootstrapped; I was the first employee at another that was founded in Austin, Texas and funded by non-tech angel investors. My third was founded in San Francisco and funded by Matter Ventures, where I also later worked as the west coast Director of Investments. (I have only good things to say about being on both sides of that particular table.)

The level of knowledge outside the tech ecosystem varies wildly. I've been asked if startups should pay to join an accelerator (absolutely not); if a year is a reasonable time between application and funding (it's death); and why investors don't put their money into projects as well as ventures (because they're investments that expect a return, not grants).

Very few people ask about the investment itself, but this is key. While traditional venture capital deals have become the norm in the Silicon Valley tech ecosystem, it's not a given that this should be the case, or that other locations should simply copy the model.

In traditional VC, an investor either buys shares in a company at a certain price, or debt that will convert into shares at an agreed-upon price. In both cases, the investor is betting that the value of the company, and therefore the shares, will wildly increase. Because the company is not publicly traded, they can't simply sell those shares; they have to wait until there's an exit event, where either the company is bought by another one, or it chooses to start selling shares on the public markets. At that point, the investor can liquidate their investment and hopefully see a return. The company might also buy back their shares, or an early-stage investor might agree to sell their shares to a later-stage investor as part of a funding round.

In order to de-risk their investments, VCs rarely invest alone. Instead, they'll join a round where a few investors will put their money in using the same terms. At early stages, when a company has not yet proven itself, the money is more "expensive" for the company and investors get a better price. The expectation is that the company will continue to raise money through increasingly bigger rounds, where the price becomes more favorable to the company and less to investors as the company proves itself in the market. There's no incentive to actually turn a profit; the companies must merely gain value. Often, actually taking money from customers is seen as a point of friction to achieving high valuation growth. (This is one reason why advertising has proven so popular: ads don't ask users to stop and pay for anything before signing up.)

This is risky enough that a very small percentage of companies provide a return to their investors. In turn, investors look for companies that have the ability to become exponentially more valuable. Venture capitalists aren't investing using their own money: they're fund managers who are managing money provided by wealthy individuals, institutions like pension funds, and university endowments. In order to provide a 3X return to their investors, they're looking for companies that can provide more like a 30-40X return to them. All of this is inside a pre-defined time period: usually a venture capital fund is designed to last 8-10 years start to finish.

All of this depends on there actually being other players in your ecosystem: VC investors who can join rounds, companies who can make acquisitions, connectors between them, and a market that can tolerate this kind of insane growth. The incentive isn't to create long-lasting, sustainable companies; it's to create companies that can amass a large amount of value in a short time, and then return that value to their stakeholders. You may have heard of "unicorns" in the startup context: these are private, venture-funded companies that have managed to hit a valuation of a billion dollars or more.

If you're trying to build a sustainable tech ecosystem somewhere new, this might not be the best model to pick. It might be, depending on the characteristics of your location - venture capital certainly has a part to play. But it's worth looking at alternatives.

I'm a huge fan of Zebras Unite - a movement to create a different kind of startup ecosystem. Rather than create unicorns, they're promoting the founding of zebras. As their manifesto puts it:

To state the obvious: unlike unicorns, zebras are real.

Zebra companies are both black and white: they are profitable and improve society. They won’t sacrifice one for the other.

Zebras are also mutualistic: by banding together in groups, they protect and preserve one another. Their individual input results in stronger collective output.

Zebra companies are built with peerless stamina and capital efficiency, as long as conditions allow them to survive.

It's worth double-underlining that while VC is zero-sum - investors are often betting that a company will own an entire market - zebra companies collaborate with each other. When you're trying to establish any kind of community, including a new ecosystem for tech startups, this is a much healthier approach. Nobody's trying to kill each other - they're trying to build something together.

In VC, the incentives are to burn capital quickly in order to rapidly gain value. In the zebra ecosystem, capital efficiency is key: instead of burning money, these companies are attempting to become sustainable while using as few resources as possible. The result is a bias towards profitability.

Wheras an acquisition or exit event releases value into other communities - and possibly straight back to Silicon Valley - profitability ensures that value is retained locally, with few outside strings. These are companies that can call their own shots. And as they grow in value and enrich their founders, they're likely to pay it forward and invest in a new set of local investors.

Clearly, then, this approach needs a new kind of financing that trades the demand for exponential returns for an incentive for profitability - and trades zero sum competition for collaboration.

I think revenue sharing is an obvious route forward. It's beginning to gain traction - for example, I was involved in negotiating Creative Action Network's demand dividend funding. As they put it in their announcement:

Last year, due in part to changes in the retail landscape, and in part to the surge in energy in our artist community post 2016 election, we identified our first real need for outside capital. This time, we knew it wouldn’t be coming from Venture Capital. The problem was, as far as start-up funding sources in the bay area goes, “not VC” isn’t really an option. You can be a non-profit and get grants, you can be established business and get bank loans, or you can be start-up and sell equity in your company to VC’s. Even with impact investors interested in social-impact companies, and with most angel investors acting independently, the core financing infrastructure they rely on is still generally the VC model that puts companies on a path towards exit or bust.

"Exit or bust" is not the only way.

Demand dividend financing pays back investors over time once the company has hit a pre-agreed revenue threshold. There is an equity component: if the company is acquired, the investors see a venture-style return. Otherwise, investors get dividends up to a pre-agreed multiple. Creative Action Network's post notes that this deal was set at 5X, but you can imagine adjusting this and the revenue threshold based on the riskiness of a deal. An early-stage investment might be set at 5X; a later-stage investment might be 3X. ( has a similar model with a 3X return.)

Because the startups are incentivized to sustainably make money instead of grow really fast, the theory is that they are more likely to survive. In particular, the company is not expected to grow to a massive size and hit an exit event before the investor's fund runs out of time. Sustainable revenue is hoped for, which puts investors and founders in tighter alignment. The legacy becomes more companies, lasting longer, and making more money for their local economies.

The change in risk profile means that I also think there's less incentive to raise a round with other investors. An investor could theoretically go it alone and make an investment without anyone else's participation. That in turn means that companies may find it easier to raise using this model - and investors may find it easier to realize a return - in ecosystems where there are simply fewer investors and acquirers. As such, it could be a good way to bootstrap a new ecosystem and differentiate it from Silicon Valley. I think this is particularly true in Europe, where the challenges of the market (lots of small, interrelated markets with different rules and languages; investors with a more conservative mindset; privacy rules that rightly discourage growth at all costs) demand a radically different approach.

Because it's not necessarily obvious to anyone who hasn't walked this walk, I think it's important to explicitly call out two important caveats:

1. Startups are more likely to succeed when they're run by their founders, and when they're invested in by people who have built companies before. Hands-on founders win. Any investor that seeks to remove control from a founder, or install their own management oversight, is shooting themselves in the foot.

2. Early-stage investments are vital for any ecosystem. You can't simply wait until companies have proven themselves. Someone has to go first and take a risk - and those really early investors should be rewarded for taking on that greater risk with a significantly better deal.

As technology becomes deeper ingrained in society, having most of it produced in a single region of the world becomes more harmful. Having worked as a founder and investor in Silicon Valley, and as a founder elsewhere, I care deeply about enabling ventures from everywhere in the world. It would have made a world of difference to me to have the level of support Silicon Valley companies enjoy when I was starting out in Edinburgh. (It has come on in leaps and bounds over the last 15 years, but I'm still personally very emotionally invested in that city in particular becoming a better tech community.) And even here, I think it's important to find ways of funding companies that provide an alternative to the prevailing model. Even if it takes some time to refine a model, it's never wrong to try.

Demand dividends and the zebra movements give me hope, both separately and together. Mission-driven founders give me hope. And I believe that - as useful and inspiring as Silicon Valley has been - we will move to a model where tech is made everywhere, by everyone, in a way that is right for them.