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Editor's Notes

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• #4: Venture capitalists are adept at assessing and mitigating market risk, technological risk, operational strengths and weaknesses, and so forth, but don¡¯t know what to make of regulatory and legal risks. One entrepreneur I spoke with used the term gestalt, which means a configuration that can¡¯t be described by just summing up it¡¯s constituent components; said differently, VCs and entrepreneurs use voodoo tactics to try to get a handle on regulatory and legal risks
• #5: See e.g., John Doerr
• #6: See e.g., Josh Hannah http://www.joshhannah.com/2014/03/regulation-and-startups/ Pic from Matrix Partners
• #7: So, what explains VCs¡¯ traditional distaste for companies facing serious regulatory hurdles? I think there are two reasons, at least. The first is that startups already deal with lots and lots of issues; layering regulatory hurdles on top adds a lot of complexity.
• #8: Take as an example Uber, which operates some combination of seven services in dozens of cities in north america alone.
• #9: If each service in each city is subject to different regulatory regime, as is often the case with black cars driven by professionals and uberXs driven by regular people, regulation increases the the complexity of managing Uber by an order of magnitude. Entrepreneurs talk about 10x solutions; regulation cab be a 10x problem for startups
• #10: The second reason, which I actually think is a bigger barrier, is that today¡¯s VCs have skewed expectations about regulated industries.
• #11: Ron Klain, General Counsel at Revolution here in DC, pointed out that the early internet giants ¨C the companies that VCs and entrepreneurs seek to emulate these days ¨C disrupted industries that are virtually unregulated... How we communicate and how we engage in commerce.
• #12: Take a typical web 2.0 business model ¨C two sided market. Replace Google w/ Facebook, eBay, Twitter, Yelp, increasingly Amazon fits this bill, and so forth. Note that on one side of the market, user = ¡°advertiser¡±
• #13: Congress made a policy decision in the mid-90s that proved hugely consequential ¨C specifically, it passed Section 230 of the Communications Decency Act. Section 230 specifically states that internet platforms, like Facebook or Google, cannot be held liable for illegal conduct by their users. So if I run an internet platform, and one of my users is engaging in hate speech, or racial discrimination, or something else that violates state or federal law, I¡¯m not responsible.
• #15: This leads to my second observation, and the bulk of what I¡¯m going to talk about. I think we are at, or rather, we reached and have subsequently passed, and inflection point, and the next generation of transformative startups are going to be in industries that interact substantially with the physical world and are heavily regulated ¨C transportation, medicine, labor markets, finance, and so forth. This will pose a challenge to VCs and entrepreneurs who are not used to evaluating and mitigating these specific types of risks. We¡¯re already seeing hiccups.
• #16: One recent hiccup involves Handy, an Uber-like platform that provides on-demand housecleaning, was recently sued by cleaners for misclassifying them as independent contractors, not employees. Under any reasonable interpretation of U.S. or CA law, the folks who clean houses for Handy are employees, yet Handy didn¡¯t afford the cleaners any of the protections typically afforded to full-time employees. Handy recently raised a $40 million round, and fortunately or unfortunately depending on your perspective, a lot of that $$$ is going to go to settle this lawsuit.
• #17: If this sounds familiar, it¡¯s because a very similar lawsuit against Uber has gotten some traction.
• #18: And if THAT sounds familiar, it¡¯s because FedEx just lost another very similar lawsuit.
• #19: In any event, I think of companies like Handy and Uber as companies that are bringing new assets to existing markets. There was a market for house cleaners or cabs before Handy or Uber; these companies seek to bring new participants or assets into these markets.
• #20: To me, these are the least interesting legal and regulatory questions. While Uber, Airbnb, and similar companies are likely to face new regulatory hurdles in each market they enter, none of those challenges are, on their own, capable of undermining the company¡¯s growth writ large. Uber currently isn¡¯t allowed to operate in Portland OR, or in the whole country of Spain for that matter, but that hasn¡¯t slowed them down. What can companies situated in the bottom-right part of our matrix do to mitigate regulatory and legal risks they face? I think there are a few approaches.
• #21: Boring and obvious, barely worth talking about except to mention that Uber has done a very good job with it¡¯s non-market strategy, particularly at utilizing its scale to generate grassroots interest in local matters.
• #22: Collective insurance ¨C Tim Hwang, now at Imgur, had this idea ¨C describes ¡°uncertainty loop¡± where different regulatory regimes in different geographic locales creates hesitancy to invest, and proposes a form of mutual insurance that reduces the risk to innovators willing to step out on the ledge. He was writing specifically about lawyers providing services that might violate local rules of professional conduct, but the concept can be applied much more broadly. http://www.robotandhwang.com/2014/10/the-legal-innovation-defense-lid-fund/
• #23: Example 2: Aereo > for those not aware, new telecommunications tech that allowed users to record and stream TV otherwise broadcast over airwaves > by May of 2014, had raised about $100M, valued at $800M June 2014, SCOTUS ruled, essentially, that Aereo was, at least for legal purposes, a traditional cable company, not a tech company, meaning that Aereo was violating copyrights of TV broadcasters http://www.technologyreview.com/news/509926/watch-out-for-the-startup-using-tiny-antennas-to-show-the-oscars-on-an-iphone/ http://www.technologyreview.com/sites/default/files/images/aereo.updatex519.jpg http://www.forbes.com/sites/jjcolao/2014/05/07/if-aereo-loses-in-the-supreme-court-can-it-rise-again
• #24: In November, Aereo filed for bankruptcy; went from a company valued at $800M to insolvency in a matter of months. http://www.bloomberg.com/news/2014-11-21/aereo-seeks-bankruptcy-after-losing-supreme-court-fight.html
• #25: Aereo exemplifies a second type of regulatory or legal risks that threaten emerging companies that are bringing new technologies to market, or really creating new markets. Here, think new biotech, drones, and so forth.
• #26: These companies have fascinating, and incredibly challenging, regulatory hurdles that dramatically complicated early-stage valuation. Even putting all of Aereo¡¯s technological risks, market risks, operational risks, and so forth aside, the company¡¯s value was still binary: $800 million in value hinged on SCOTUS¡¯s interpretation of the Copyright Act of 1976. So, how to mitigate these risks?
• #27: Increasingly, opportunities to finance legal risks, which VCs could use as a hedging strategy when investing in a startup like Aereo, which was inevitably going to get sued by the major cable companies...
• #28: All equity shares can be viewed as options on the residual value of the company, and this is particularly easy to understand with startups that face acute regulatory risks. So one approach is to incorporate the regulatory or legal uncertainty into the probability that the option pays off. Image from: http://en.wikipedia.org/wiki/Datar%E2%80%93Mathews_method_for_real_option_valuation#mediaviewer/File:Datar_Mathews_Real_Option_Method_Wikipedia_Fig_4_Comparison_of_Black-Scholes_and_Datar-Mathews_frameworks.png
• #29: This is just a more complex version of the financial analyses VC firms already do, but just more a more rigorous incorporation of the regulatory or legal uncertainty into the valuation model.
• #30: Of course, to do that, you need to have a sense of what the likely regulatory or legal outcomes are, and the market is stepping in to provide a solution here, too. Startups are increasingly taking a big-data approach to legislation, regulation, and litigation; FiscalNote and LegCyte, which is actually an InSITE portfolio company, are developing predictive tools to generate insights into whether certain legislation is likely to pass.
• #31: There¡¯s a third category of companies, that are pushing boundaries even further, where virtually everything about he company and its markets are unproven. Companies in the bitcoin space are a great example here, and I think equity crowdfunding faces similar challenges.
• #32: Companies in these spaces face a lot of threats ¨C equity crowdfunding companies have to think about both the SEC and blue sky laws in all 50 states, not to mention potential regulation from a host of other federal regulatory agencies. But they also face highly acute threats. The SEC is still sitting on its crowdfunding regulations, but as proposed, they¡¯d be a hindrance, not a help. The IRS, to give another example, classified Bitcoin as property, not currency. This subtle difference means that each individual bitcoin is subject to capital gains taxes, based on how long you¡¯ve held the bitcoin and how much it¡¯s appreciated in value. This means that, unlike currency, bitcoins aren¡¯t truly fungible with one another, because each coin has a different tax treatment. So long as this is the case, bitcoin is going to have a hard time gaining wide adoption as a currency in the US.
• #33: Admittedly this is the toughest space to be in, and to an extent, regulatory processes just need to play out. But one interesting idea here came from the newest FCC commissioner, Jessica Rosenworcel, who borrowed a programming term to propose carving out spaces where the typical rules don¡¯t apply. We¡¯re starting to see this in certain states ¨C the beauty of federalism, according to Justice Brandeis, is that states get to be the ¡°laboratories of democracy¡± ¨C and driverless cars can now legally operate in four states. Commissioner Rosenworcel¡¯s proposal suggests that federal regulatory agencies follow suit, which would be a pretty big step for risk-averse regulatory agencies, but it¡¯s a good idea.
• #34: That¡¯s all, I¡¯d love to chat about this so find me afterword or feel free to email. In addition, I¡¯ve posted these slides online at my website if you want to take another look.