The Case for a Different Kind of Capital in EdTech
I’m a venture investor in K12 education, so it might seem strange for me to advocate for a different kind of capital other than traditional venture capital. After all, I benefit from my current work making venture investments into early stage, high growth companies. I’ve been fortunate to invest in many outstanding entrepreneurs who have subsequently raised tens of millions in venture capital and are growing highly successful companies that serve the education market. So, why would I advocate for a different kind of capital?
Several years into doing this work, I see a number of signs that traditional venture capital is not a fit for many entrepreneurs who are focused on building companies that create long-term positive social impact in education, especially in K12 where innovation is slow, sales cycles are long, and measurable impact takes time and patience. Edovate Capital, LLC, which is my holding company, has allowed me to approach investing from a patient capital/long-term perspective, but this structure isn’t the norm in our industry. Most funds are backed by Limited Partners (LPs) who are looking for significant returns within five to seven years or so of the initial investment. This type of structure is not aligned to the needs of most K12 entrepreneurs who are looking to create long-term value and impact for students, parents, teachers, and school leaders.
This is the first in a series of blog posts focused on the need for new capital structures in K12. Here are some of the key reasons why we need a different kind of capital.
- Just 1 percent have access to traditional venture capital (VC).
About 1 in 100 or 1 percent of entrepreneurs successfully raise traditional VC. As an investor, I’ve met more than 3,000 K12 entrepreneurs over the last 5+ years and have made 16 investments to date. That’s less than a 1 percent rate. Among the other 99 percent, there are many entrepreneurs who are building sustainable, impact-focused businesses, but they don’t meet the hurdle rates required by VCs so they don’t receive investment. While Edovate can take a longer-term view, many other VCs cannot, so despite our ability to be flexible, we have to incorporate access to additional capital into how we evaluate investments. This leaves many entrepreneurs undercapitalized without the ability to grow more quickly if they had access to more capital.
An early stage software company growing 50 percent+ annually is not going to return a venture fund, but many can become sound, sustainable companies that deliver systems-changing impact. Building the product and team to grow to a $10M-$20M ARR company requires upfront capital that does not exist in the market at scale. There are examples of patient capital funds (Edovate and Redhouse Education are two such funds), but this segment of the investing market is largely overlooked due to misaligned fund structures.
2. Traditional VC favors white men on the coasts.
Most venture investors are white men like me and they tend to invest in other white men. Fortunately, VC is becoming more inclusive, but there’s still a long way to go. Geography is another form of exclusivity. As of 2018, just a third of VC invested falls outside of the major coastal hubs of the San Francisco/San Jose Bay Area, New York, and Boston, making it difficult for entrepreneurs in the middle of the country to attract funding. These topics are extremely important and we’ll write more about this in a future post so that we can better understand what needs to happen to allocate capital in an optimally inclusive way.
3. VCs are chasing unicorns and they’re elusive, especially in K12 edtech.
VCs, especially those with larger funds, look for unicorns, which are those companies that achieve $1B+ valuations. Fund economics dictate that outsized returns from a few very large exits (e.g., unicorns) will return the fund principal and profits to limited partners. The challenge is that unicorns are exceptionally rare, especially in K12 education where there’s a limited Total Addressable Market (TAM) of approximately 14,000 school districts that have relatively constant and predictable annual budgets. Aside from Quizlet, we haven’t seen one in the U.S. K12 edtech market (and Quizlet doesn’t want to be called a unicorn). I believe we’ll see more in the future, but they will always be rare. The K12 industry is just not conducive to unicorns. It’s better suited to camels, which are companies that are tough and sturdy, need less capital, and are aligned with the markets they serve for the long haul.
4. Speaking of camels, we’re entering the desert.
The Great Recession was a reckoning for an earlier generation of edtech companies as school and district leaders navigated their organizations through a prolonged period of budget cuts. What exactly will happen in the wake of the COVID-19 crisis is uncertain. Some K12 entrepreneurs are seeing a massive increase in demand, especially those that enable remote and virtual learning in essential ways. Companies including Pear Deck, Paper, EveryDay Labs, Kiddom, and LearnPlatform provide critical infrastructure and workflow for remote and virtual learning, but for many K12 entrepreneurs, it’s likely to be an even tougher budget environment for them, especially those that rely on onsite school environments for their products and services to be in demand. For these entrepreneurs, the journey is a bit like traveling through the desert, and for them to survive, they will need to be tough, resilient, and capital efficient. Camels with sound unit economics are better prepared to go through the desert than unicorns.
5. VCs have arbitrary exit timelines.
Most traditional funds raise capital from limited partners, make investments, and then expect to exit or sell the investment in five to seven years so they can return principal and profits to their limited partners. For an entrepreneur looking to make lasting change in education, the timeline might be 10, 20, even 30 years. In many cases, the entrepreneur is better aligned to deliver impact when backed by longer-term, more patient capital.
So, if an alternative to traditional venture capital is needed for impact-focused EdTech entrepreneurs, what would it be? There are already alternative forms of capital serving the market. They include revenue-based financing, venture debt, factoring, and grants in various forms including convertible and recoverable grants. To learn more about these alternative forms of financing, check out this overview by Aunnie Patton Power at Impact Alpha.
All of these alternative forms of capital have their uses, but we believe an evergreen fund structure is suited for both long-term, focused entrepreneurs and patient, impact-focused investors. Both Edovate Capital and Redhouse Education are structured as evergreen funds, and as a result we’ve experienced the benefits of this structure firsthand. Our funds are “open-ended,” unlike “close-ended” traditional VC funds and better align investors with entrepreneurs who are focused on addressing long-term systemic issues in K12. For more about evergreen funds, this Toptal article provides some excellent context.
Based on our experience as investors, here are our observations why an evergreen-fund structure is ideally suited to meet both the needs of EdTech entrepreneurs and long-term, patient investors:
- Flexible, open-ended timelines give impact-focused entrepreneurs what they want.
K12 education systems are relatively slow to change and adopt even the most impactful innovations. As a result, entrepreneurs whose mission is to create meaningful systems change within K12 education need many years to deliver. While still VC, an evergreen fund is structured to give these entrepreneurs an open-ended timeline that’s aligned to their long-term ambitions to deliver impact and aligned to the slower pace of change within K12.
2. It’s a more inclusive capital.
In K12 EdTech more than many industries, founding teams are women-led and/or are led by people or color. Traditional VC passes on so many of these founders because they don’t believe the idea could be a $1B+ business. Currently, black founders receive less than 1% and female founders receive less than 3% of venture capital. An evergreen fund could back these founders and give them a permanent home. In addition, an evergreen fund could back more entrepreneurs between the coasts where access to capital is more limited. Success begets success, and as an evergreen fund grows it will catalyze additional inclusive capital to the market and increase founder and geographic diversity.
3. Alignment with long-term minded investors.
Limited partners in search of steady, lower-volatility placements with both consistent above-market returns and positive social impact would benefit greatly by backing an evergreen fund. They don’t have to choose between market-based returns and lasting change in K12 education — they can have both.
4. The COVID-19 crisis has created an opportunity.
Because schools are closed and teachers and students have no other choice but to adopt remote learning, tech adoption and an equity-focus in schools is accelerating. The crisis has exposed the growth of the digital divide in our schools and new capital is needed to support lasting solutions to these challenges.
Our education system has just begun to leverage technology to reimagine instruction and school operations and the benefits remain inaccessible to many K12 students. With COVID-19, K12 has seen the biggest disruption in the history of our industry and it’s time for a new kind of capital to fuel system-changing innovations. An evergreen fund aligns the interests of both long-term, impact-focused entrepreneurs and patient, long-term investors who want market-based returns and lasting educational change.
About the author
Graham Forman has been an early-stage investor and entrepreneur for 20 years and he is the founder and managing director of Edovate Capital, a seed and early-stage venture capital company that invests in innovative startups in the education market.