Align Incentives to Solve Recidivism

Align Incentives to Solve Recidivism

Joe|May 15, 2018

With a prison population of 2.3 million inmates, the United States has the highest incarceration rate of any country in the industrialized world. On the face of it, housing one quarter of the world’s prison population costs America $80 billion a year.[1][2] But in fact America’s incarceration nightmare represents a true opportunity cost of hundreds of billions of dollars a year, and unnecessarily devastates many of our most vulnerable communities. A major problem is that prisons are incentivized to “warehouse” prisoners rather than provably reintegrate them into society. A competitive, market-based rewards system for private prisons would encourage talented entrepreneurs to help convicts into society in compassionate, effective ways and allow the very best rehabilitation strategies to spread.

The US incarceration rate multiplied by 700% between the 1970s and the present as America abandoned rehabilitative models of criminal justice for more punitive responses. This surge in convictions was partially precipitated by a global crime wave in the 1980s. But the incarceration rate has remained extraordinarily high even though the crime rate has decreased 45% since the early 1990s.[3][4][5]

 

[6]
To tackle prison overpopulation our country must address a host of issues including aggressive public prosecution, the failure of the war on drugs, exorbitant sentencing guidelines, and the fact that 94–97%[7] of charged criminals opt for plea bargaining over a jury trial. But one obvious strategy for decarceration is to reduce the recidivism rate, or the rate at which criminals reoffend and wind up back in prison. We need to shift from a “custody” model of detention to a “treatment” model. Private prisons, properly incentivized, may be the answer.

Today 8% of U.S. prisoners are currently detained in private prisons (though disproportionate press coverage would lead one to believe that the figure is much larger).[8] The largest private prison operations today are CoreCivic (formerly the Corrections Corporation of America) and the Geo Group, which have achieved a duopoly over the private prison market.

Private prisons gained a poor reputation as early as the late 19th century for subjecting prisoners to barbaric treatment and lax security, but today private prisons are roughly as humane as public prisons.[9] Evidence as to whether private prisons are better than public prisons at reducing recidivism is inconclusive, and a meta-analysis found that private prisons even cost about the same as their public counterparts.[10][11][12] The central problem is that private prisons, like public prisons, are payed on a per-diem/per-prisoner basis. Under this statutory regime, “privatization can come to resemble an exercise in who can better pretend to be a public prison.”[13]

We propose that private prison contracts tie financial incentives to performance measures such as reducing inmate recidivism. If entrepreneurs were given clear lanes to erect new private prison businesses and explicitly incentivized to reduce recidivism, they would experiment with new modes of rehabilitation to find the best ways to reintegrate convicts into society. Operating in a more competitive, transparent environment would force private prisons to rapidly innovate and develop new techniques for rehabilitating the maximum number of prisoners. Private prisons could escape their legacy of mediocrity and brutality by embracing this new mandate.

The first country to experiment with this model was the United Kingdom, which raised a social impact bond in 2010 to fund a rehabilitative program for short-term inmates at a private prison in Peterborough.[14] On this model, investors in the bond were rewarded on the condition that Peterborough Prison reduced the frequency of reconviction events by more than 10% relative to a public prison control group. Investors partnered with the prison to supply paid caseworkers, specialist practitioners, gym volunteers from nonprofit organizations such as the YMCA, and other 3rd parties. These workers engaged in a pragmatic, flexible style of relationship-based therapy, and successfully reduced the recidivism frequency by 11% even while recidivism frequency rose 10% in the control group (2010–2014). Similar programs have been piloted in Massachusetts, New York, Australia, and New Zealand.[15][16][17] These projects are only the beginning — in an evolving market framework the most refined, effective prisoner rehabilitation programs could eventually scale to deliver recidivism reductions on the order of 50% or more.

There are a variety of ways to set up an incentive structure aimed at reducing recidivism. We favor rewarding private prisons with a combination of financial payouts and new inmates to replace the old inmates who will not return to prison. The contract could replace traditional per-diem/per-prisoner rewards with scalar incentive payments that vary with the percentage of the inmate population that doesn’t reoffend over some period (e.g. 2 years). Another possibility is to reward the prison with a flat bonus such as $11,000 per rehabilitated prisoner,[18] or to make upside for prison staff contingent on running successful programs and spreading ideas that work.[19] Many state legislatures explicitly encourage pay-for-success models, and these states should begin experimenting immediately.[20]

Private prisons should only house inmates who will be released in a relatively short time period (e.g. <5–10 years). Prisoners sentenced to life or virtual life would not be eligible for rehabilitation, and it would be unfair to force a private prison to house a convict for whom they have no expected financial upside.[21] Each private prison’s population should be compared against a representative, comparable population in a private prison, or against historical re-offense rates. As a safeguard against mistreatment, prisoners could be allowed to opt out of the private prison and into public prison every 6 months, and would be able to express their grievances in public fora.

Operating in a more competitive, transparent environment would force private prisons to rapidly innovate and develop new techniques for rehabilitating the maximum number of prisoners. Private prisons could escape their legacy of mediocrity and brutality by embracing this new mandate.

 

Strategies for reducing recidivism are virtually endless — the challenge is to create incentives to make sure the best ideas are documented and spread. We strongly believe in the value of prison-work programs where inmates receive either pecuniary or in-kind rewards — for instance better food, more time in the prison yard, better access to books, and more.[22] Educational programming, employment programming, cognitive behavioral therapy (CBT), chemical dependency treatment, sex offender treatment, mental health interventions, domestic violence/family life programming, and prisoner re-entry programs are all time-honored methods for helping convicts reintegrate into normal American life. [23][24][25]

One successful example is the Texas Prison Entrepreneurship Program (PEP), a selective MBA-style educational program for inmates who demonstrate work ethic and a desire to take charge of their own lives.[26] Another is “Code.7370,” a 6-month program at San Quentin Prison which teaches eligible inmates how to develop websites.[27] Graduates of these programs have recidivism rates of only 7%![28]

Programs with no selection bias have also been highly successful. In Saskatoon, Canada a sexual offender treatment program used cognitive behavioral therapy to treat male sexual offenders between 1981 and 1996. In a comparison of 296 treated and 283 untreated offenders, only 14.5% of the treated group reoffended vs 33.2% in the control group.[29] In Hillsborough County, Florida, 18,000 domestic violence offenders were subjected to a tiered treatment program from 1995–2004. The program reduced domestic violence recidivism to 8.4% vs 21.2% in the control group.[30]

As these examples illustrate, the main challenge is not discovering what the best ideas are, it is crafting a market mechanism that rewards innovators for iterating on different holistic treatment regimes until they achieve the lowest possible recidivism rates. The fundamental problem with American criminal justice is not a lack of good ideas, it’s the system itself. We need to literally create a marketplace of ideas — a bottom-up, competitive arena in which the best ideas win. If we reward innovations which demonstrably reduce America’s prison population, bright entrepreneurs will deploy their talents to fix our broken prison system.

Regulators should supercharge this new competitive market by lowering regulatory barriers to entry, which will force CoreCivic and the GEO group to innovate just as intensely as their nimbler competitors. Relationships with state legislatures and regulatory bodies should not be enough for these giant corporations to win procurement contracts. In the medium-term, we hope that the industry will evolve to become more diverse and competitive. In the long-run, we envision a system where transparent, compassionate private prisons have become so successful at rehabilitation that they have replaced public prisons as the dominant mode of incarceration in the United States, and would continue to compete to successfully reintegrate former prisoners into their communities.

Though we’re excited by the prospects of rewiring the private prison market to solve America’s incarceration problem, we recognize that challenges for American criminal justice remain. In his seminal essay on the “prison-industrial complex”, Eric Schlosser wrote that we are fighting an establishment

…composed of politicians, both liberal and conservative, who have used the fear of crime to gain votes; impoverished rural areas where prisons have become a cornerstone of economic development; private companies that regard the roughly $35 billion spent each year on corrections not as a burden on American taxpayers but as a lucrative market; and government officials whose fiefdoms have expanded along with the inmate population.[31]

Dismantling this complex of special interests — which also includes prison guard unions and aggressive, careerist public prosecutors — will be difficult. Fortunately, prison reform is one of the few truly bipartisan issues in our nation today. Harnessing America’s brightest entrepreneurial talent to heal inmates and reduce recidivism could be a powerful antidote to America’s prison crisis.

Joe Lonsdale
Partner, 8VC

A Note for Startup CEOs on Budget Chats

A Note for Startup CEOs on Budget Chats

Joe|January 23, 2018

CEOs shouldn’t worry about their budget all the time — on a day-to-day basis they should work on managing their company, building an awesome product, developing key relationships, identifying distribution channels, etc. But CEOs should carefully review their company’s financial numbers at least once a quarter, even when there is plenty of funding in the tank.

The reason we have so much talent in Silicon Valley building and investing in for-profit technology companies is that markets richly reward successful ideas, no matter who invents them. But to remain competitive in a free market, companies must exercise discipline to meet quantitative goals, and eventually become cashflow positive. As we have written elsewhere, metrics synthesize a huge volume of information about how efficiently and effectively you are accomplishing your mission. A clear budget and a comparison of spending to revenue reveals whether your project is being sustainably managed, and whether it will add value to our economy in the long term.

A common mistake among new entrepreneurs who have raised large rounds is that they have essentially infinite resources. As a new entrepreneur who is extremely confident in the product you are building, you may wonder: why waste time on precise budgeting and defining goals? But building an intuition for how your burn-to-output ratio is evolving is important for any CEO.

A good place to start is your monthly spend. Any CEO who doesn’t know to within 5% error how much they spent in the last few months and how much they will spend in the next few months is not doing their job. A reasonably mature company must track both expenditures and, on the other side of the equation, incoming cashflow (not bookings — cashflow).

Engineering is the art of managing scarcity — it’s easy to design and build a massive bridge that will last forever if cost is not an issue. Similarly, to build a new company you must manage scarce resources. Almost any company would be easy for talented people to build if you could spend an infinite amount of money to get to where you want to go. The challenge is to keep your monthly burn at a sustainable level, and punctually achieve your milestones.

Before you meet with a board member or senior advisor who is going to talk to you about your budget, you should familiarize yourself with the following data points:

· Current cash in bank (not projected cash, actual cash). If the cash hasn’t hit your bank account, don’t count it — that’s tantamount to lying to your investors. You should also note any large expected near term changes such as money you hope hits soon, or major payments due.

· Monthly gross expenditures, gross receipts, net burn over past several months, and projected monthly burn in near-term and a year from now. For businesses with high volatility in their monthly numbers, quarterly numbers may make more sense.

· How much you plan to spend over the next year. At your current pace, how many months do you have left before you are out of cash, if you don’t raise more? If you plan to raise, how many months will the new round last you?

To illustrate the point, let’s take an unnamed startup in December 2017, and see what the CEO knows:

· Annual recurring revenue (ARR) is $25M at the end of ’17, with contracts paid annually upfront. This figure will grow to at least $42M next year.

· Cash receipts have been about $2.5M a month in the past 3 months, and are trending upward

· Monthly spend has been about $5M a month, burn has been about 2.5M a month.

· With hiring targets, spend will reach $6.5M a month by the end of ’18. Given current goals, burn will stay around $2.5M net.

· The goal for December ’19 is to get to $65M ARR, and only raise spend to $7.5M a month, meaning that at the current rate of closing deals, the burn should actually fall to $1.5M a month by the end of the year.

· The goal for December ’20 is to reach $90M ARR, with an annual burn of $12M and a near-breakeven run rate at the end of the year.

As an investor and an advisor, I might respond to this information by noting that this burn rate and hiring plan is slightly, but not unacceptably high for current ARR. This looks like a platform-esque company, not a lean enterprise solution, but the fact that the CEO has a handle on ’18, ’19, and ’20 makes this burn manageable.

With $35M in the bank from a $50M round in mid-2017, this company has about 14 months left, and is going to need to raise a big round in the middle to late part of the coming year. For a good CEO, 9 months is yellow alert, 6 months is red alert, and 3 months means you screwed something up and may need to start looking at other options like selling or merging your company. This CEO should start thinking seriously about the next round, and what she’ll achieve in the next six months, to convince investors that her plans for the next three years make sense and that her company is valuable.

The CEO originally intended to raise spend to $7M a month, but after mapping out how spend and burn would evolve in the coming years, agreed it was prudent to keep it at $6.5M maximum (and hopefully a bit lower). According to the current plan, another $50M round should be enough to take the company to profitability and an IPO in ’21 or ’22. But if the price is good, I would advise this entrepreneur to raise a safe $75M just in case things don’t work out according to plan. If the entrepreneur wants to build a new division onto the company in the future, and chooses to raise spend again vs going to break-even, they will require a larger round and an investor who shares their vision.

It’s vital to get a sense of how burn and spend underpin the budget decisions which largely determine everything else in the business. A CEOs core responsibility is to ensure her company will succeed, and measuring these changing data points is the only way to stay informed.

Of course, this thought exercise has nothing to do with the most important parts of the business: the product strategy, the marketing strategy, the technology culture, the shifting competitive landscape, the leadership, vision, internal culture, etc. But in discussing all of those, it’s important to have the numbers as a backdrop.

Before you meet with your board, consider getting a sheet together of your cash-in-hand, spend, and monthly or quarterly revenue from year or two ago to a few years in the future. Learn the numbers and develop opinions about them! As with any business conversation, budget chats should be conducted with rigor.

Innocent Until Proven Guilty

Innocent Until Proven Guilty

Joe|January 3, 2018

Most of our generation lacks historical perspective on justice and persecution, so we’ve put together a brief paper on how these ideas have evolved in the context of Western Civilization.

“The law requires a double testimony to convict…the principal reason undoubtedly is to secure the subject from being sacrificed to fictitious conspiracies…”[1]
– William Blackstone, 1769

The cornerstone of Western criminal law is that the accused is presumed innocent until proven guilty beyond a reasonable doubt. The presumption of innocence (PoI) is justly regarded as “axiomatic and elementary,” a triumph of rationalism over arbitrary persecution.[2] Like all due process protections, the PoI took shape against the specter of tyrannical violence. In particular, history suggests that the PoI emerged as an antidote to the tyranny of mob violence against marginalized figures including “heretics, witches, and Jews” — and sometimes even kings themselves.[3]

Few have analyzed persecution as deeply as René Girard. Girard argues that communities routinely commit acts of insensate violence against innocent individuals. These victims of collective aggression are “scapegoats” — symbolically equivalent to the he-goats that the ancient Hebrews would slaughter to atone for their sins.[4] For Girard, social groups are driven by an intrinsic logic of “mimesis” — mimicry of other people’s desires. Because human beings absorb our values from others, we are prone to bandwagoning, herd instincts, the madness of crowds, and sometimes a “blind instinct for reprisals.” [5] This trait occasionally drives us to demonize others as monstrous scapegoats that must be ritually slain to restore peace to the community.[6]

Girard argues that Christ’s crucifixion permanently exposed the scapegoat’s “guilt” as a lie, inaugurating progress towards more rational criminal justice. Christ is perfectly innocent. Pilate can find no case against the “Lamb of God”, who cries out from the cross “Father forgive them, for they know not what they do” (John 1:29, Luke 23:24). This most famous miscarriage of justice reveals the entire practice of scapegoating to be morally bankrupt and forces humanity to reason about guilt prior to punishment. In this way, the synoptic gospels give birth to the rational criminal trial, due process, and, by extension, the presumption of innocence. In Girard’s phrase, “the invention of science is not the reason that there are no longer witch-hunts, but the fact that there are no longer witch-hunts is the reason that science has been invented.”[7]

As a matter of historical fact, variants on the PoI surfaced in the West well before the death of Christ. The principle that the burden of proof is on the plaintiff dates back to the Twelve Tables, and in Roman law the defendant’s guilt had to be as “clear as daylight” in order for the judge to convict.[8],[9] Well before Judeo-Christian thinking penetrated Rome, Emperor Trajan said “it is preferable that the crime of a guilty man should go unpunished than that an innocent man be condemned”. Furthermore, Judaism itself endorsed the principle that “at the mouth of two witnesses, or three witnesses, shall he that is worthy of death be put to death; but at the mouth of one witness he shall not be put to death” (Deuteronomy 17:6).[10]

It is nearer the truth to say that both church and state helped cement principles of due process in the West. After all, the Roman world had the most robust legal system of any classical civilization. But Girard may be right that Christianity helped to “rationalize” the Abrahamic tradition. It was the fusion of the two traditions — Roman law and Canon law — that ultimately produced modern due process protections. 1215 was a watershed year for criminal justice: in a span of months, the Magna Carta codified the rights of a free man to the “lawful judgment of his equals or by the law of the land,” and the Fourth Lateran Council overturned pre-rational modes of trial (combat, ordeal). In trial by ordeal, for instance, defendants burned themselves with molten iron, boiling water, or glowing coals, and then clerics assessed their guilt based on the pace at which their wounds healed.[11]. Under growing pressure from Scholastic thinkers, Pope Innocent III decreed that appeal to heavenly signs (combat, ordeal) was not adequate to determine guilt. Instead, guilt had to be assessed by using human reason to grapple with the facts of a case to the best of our ability.

Unfortunately, legal progress marches to the unsteady canto of two steps forward, one step back. While Pope Innocent’s reforms were a dramatic advance in Western criminal justice, atavisms persisted into the modern world. Inquisitorial trials were “generally permeated by a presumption of guilt in the guise of mala fama, a doctrine which allowed a person to be brought to trial if they were collectively presumed to be guilty.[12] In addition, torture was used as a mode of fact-finding and an unimpeachable form of proof as late as the 18th century. As a result, the medieval criminal trial was often little more than a formalized scapegoating ritual.

Eventually the Western world clawed its way to a moral high-ground, immortalizing the presumption of innocence as a central pillar of due process. Blackstone famously expanded Trajan’s principle to “it is better that ten guilty persons escape than that one innocent suffer.” The “beyond reasonable doubt” standard found first expression in the trials of redcoats after the Boston Massacre, and the phrase “presumption of innocence” first appeared in an American court opinion in 1850. Of course, it took many years for our country to extend the principle fairly and evenly to all men and women, black and white. In the middle of the 19th century, Frederick Douglass caustically noted that slave owners espoused a hideous variant of Blackstone’s principle.

“Mr. Gore acted fully up to the maxim laid down by slaveholders, — “It is better that a dozen slaves should suffer under the lash, than that the overseer should be convicted, in the presence of the slaves, of having been at fault.” No matter how innocent a slave might be — it availed him nothing, when accused by Mr. Gore of any misdemeanor. To be accused was to be convicted, and to be convicted was to be punished; the one always following the other with immutable certainty.”

But over the course of the 20th century, due process protections were gradually extended to all Americans. In 1970 the Supreme court elevated the “beyond a reasonable doubt principle” to the status of constitutional law.[13],[14] As the concept of the plaintiff’s evidentiary burden evolved from “clear as daylight” to “moral certainty” to “beyond a reasonable doubt”, courts continued to refine the ideas of “rationality” and “reasonability” which guide the criminal trial. Borrowing an idea from Hegel, one might say that the spirit of Western rationalism animating criminal law has become increasingly self-conscious.

Whether Girard is right about the causal link between the synoptic gospels and Western rationalism, he is certainly right that we are always in danger of relapse. Our highest court once ruled that unless the right to bail before trial was preserved, “the presumption of innocence secured only after centuries of struggle would lose its meaning.”[15] The Rehnquist court destroyed this protection in Bell v. Wolfish (1979), ruling that pre-trial detention of presumptively innocent parties is permissible. The extension of this precedent has eroded the rights of those accused of sexual crimes and justified “civil asset forfeiture,” or the blatant seizure of an innocent person’s property.[16]

James Thayer once argued that the PoI has the “peculiarly important function…of warning our untrained tribunal, the jury, against being misled by suspicion, conjecture, and mere appearances.”[17] Today, social media and search algorithms corral us into the kinds of ideological pens that make suspicion and knee-jerk reactions to “mere appearances” more probable. In 2017 we made real progress in resisting the predations of the powerful — inspiring people to stand up for themselves, and making it clear that certain behavior is unacceptable in our society. As we move into the new year, we would do well to remember our civilization’s foundational wisdom and find new ways to support the downtrodden. As we continue important conversations about justice and our identity as a people, we should ensure that we do not cast stones in new cycles of public scapegoating. As Girard reminds us, a core element of our Judeo-Christian heritage — and the crucifixion story itself — is the belief that no one should face persecution at the hands of a mob, and that the presumption of innocence is the soul of rational criminal justice.

[1] Blackstone, William. “Blackstone’s Commentaries” Abridged version, ed. William Sprague, 9th edition, 1915. p. 523

[2] Coffin v. U.S. Justice White’s majority opinion. 156 U.S. 432, 1895.

[3] Pennington, Kenneth. “Innocent Until Proven Guilty: The Origins of a Legal Maxim.” The Jurist, 2003.

[4] Leviticus 16:30

[5] Girard, 86.

[6] Girard’s theory of mimesis is that individuals competitively imitate each other until they become so similar that they are driven into a cycle of escalating violence which terminates in the cathartic, sacred murder of a “scapegoat.”

[7] Girard, ibid. p.96

[8] Mousourakis, George. “The Historical and Institutional Context of Roman Law.” Routledge, 2003.

[9] Cicero. “Against Verres” in Selected Works, Trans. Michael Grant. Penguin Classics, 1971.

[10] However Judaism is conflicted on the issue of PoI. When Abraham asks “wilt thou destroy the just with the wicked?” God replies that the entire population of Sodom and Gomorrah is presumptively guilty unless Abraham can find 50 innocent people therein (Genesis 18:20–26) — an inversion of the principle that “it is better that n-guilty people go free than 1 innocent person be punished.” …By contrast, one may interpret Adam’s demand that God punish Eve for tricking him into eating the apple as a demand for a fair adjudication of guilt.

[11] McAuley, Finbarr. “Canon Law and the End of the Ordeal.” Oxford Journal of Legal Studies, Vol. 26.3, 2006.

[12] Van Damme, ibid.

[13] Commonwealth vs. John W. Webster. 59 Mass. 295, 1850.

[14] In re Winship, 397 U.S. 358 (1970)

[15] Stack v. Boyle, 342 U.S. 1 (1951)

[16] Pernell, LeRoy. “The Reign of the Queen of Hearts.” Cleveland State L.R., 1989.

[17] Thayer, ibid.

Tax Reform: A Silicon Valley Perspective

Tax Reform: A Silicon Valley Perspective

Joe|November 10, 2017

When an employee of a privately held technology company leaves the company and exercises her stock options, she typically has 3 months to qualify for favorable tax treatment. However, if there has been a run up in the value of the company since the options were originally granted, the employee may face enormous tax obligations. Since secondary markets for shares in privately held companies are often difficult to access, company common stock may only be valuable “on paper,” but the departing employee must pay the taxes on her options in real cash. As a result, many Silicon Valley engineers face “golden handcuffs” scenarios, where they literally cannot afford to leave their companies without surrendering their stock options and sacrificing large fractions of their net worth.

Suppose that as an employee of a large privately held tech company you were granted stock options for 200,000 shares of stock at a strike price of 10¢ per share, and suppose that your stock has appreciated to $3 per share. You’re ready to leave your company and want to exercise your options. You want to pay the $20,000 necessary to purchase your shares at their original strike price and realize a paper gain of $580,000, but at the typical marginal tax rate in California, you must also pay $200,000 or more in taxes. Since you don’t have $200,000 in cash lying around, you reluctantly accept that you won’t be able to leave your company without forfeiting a lot of your compensation – and thus your prospects for taking a sabbatical, buying a house, starting a family, etc.

Today it is common for Silicon Valley companies to remain privately held even with valuations well above $1B. “Unicorns” such as Uber, AirBnB, SpaceX, and Palantir may remain privately held for indefinitely long periods of time. The current tax environment not only makes it difficult for tech employees to realize the fair value of their labor, it also makes it prohibitively difficult to bootstrap new ventures or move to companies where they can follow their passions and deliver superior performance. Current tax laws are stunting innovation and hurting American technologists.

Fortunately, lawmakers are aware of the problem. Congressman Kevin Brady (R-TX) recently proposed an amendment to the GOP tax bill released in the House last week which would indefinitely defer taxes due on the exercise of the most common kinds of stock options – “incentive stock options” (ISOs) and “restricted stock units” (RSUs) – until their owner ultimately decides to sell their stock. The amendment would allow employees who exercise a rarer form of stock option – “non-qualified stock options” (NSOs) – to defer their taxes for 5 years, or, if earlier, until their company IPOs or changes hands. This reform is a welcome improvement over current law.

An even better option is for Congress to amend the Tax Cuts and Jobs Act to allow employees to indefinitely defer taxes on any kind of stock option they have exercised until they sell their shares to another party. On Congressman Brady’s proposal, employees who exercise their NSOs would still be liable for large tax burdens after the 5-year deferral period elapses. Many employees will correctly realize that if they can’t afford to pay the taxes now, they may not be able to pay them later. For a software engineer with a family, risking a $260,000 tax burden is often financially irresponsible, which means that the engineer must accept a somewhat ameliorated version of the classic golden handcuffs scenario. Taxing the sale of stock rather than the exercise of stock options would solve this problem for ISOs, RSUs, and NSOs alike.

Our proposed reform allows employees to exercise their options without risking massive taxes on phantom money that they never actually possess, and boosts innovation by freeing top talent to move freely between companies and allocate time as they see fit. It is a natural extension of the spirit of Congressman Brady’s plan.

Golden handcuffs distort incentives and prevent technologists from freely deploying their talents on projects they are passionate about. Universally deferring taxes until an employee sells their stock will loosen golden handcuffs, tax individuals at rates which reflect their true (not notional) income, and stimulate increased mobility and innovation in the technology sector. We hope that the Ways and Means Committee will seriously consider the proposal.

In Defense of Private Equity

In Defense of Private Equity

Joe|October 17, 2017

The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does. The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

From the green revolution to the present, technological innovations and centralization of farming operations enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant. This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services.

As the example of agriculture illustrates, there are multiple ways to increase economic productivity. One is to build and finance companies with entirely new innovations, typically the domain of the entrepreneur and the venture capitalist. Another is to improve the way existing companies work, often by merging many smaller companies to form one large one, or restructuring management goals and employee incentives within a company. This is typically the domain of the “private equity” firm or a large acquisitive corporation. The two methods sometimes complement each other: when a VC-backed entrepreneur develops a new technology, corporations or PE-like firms often scale the product and quickly spread it throughout the economy.

How Private Equity Works
Today, a private equity or “PE” firm is a company that raises funds from institutions and wealthy individuals and then invests that money in buying and selling businesses. PE firms are usually “activist” investors, which means that rather than pursuing a passive buy-and-hold strategy, they are involved in managing (fixing…or screwing up) the internal operations of the businesses they acquire.

Imagine you’re an investor who wants to make the economy run more productively by improving as many businesses as you’re able to, starting with those with the most potential for improvement. You pore over a map of the economy that shows how different sectors have evolved, which business models have proven effective, where consumer demand is trending, and rafts of other economic data. You want to do more with less – but how? The leaders of private equity firms find themselves in exactly this position, and employ some of the following strategies:

1) Combining back offices of multiple firms to cut redundant costs. Sometimes PE firms will bundle several companies within an industry vertical to reduce supply chain costs. They may also combine an ailing company with a healthy company so that the former can develop better processes and become more productive.

2) Aligning incentives by increasing CEOs’ and operational officers’ stakes in their business. This technique rewards management for increasing company growth and performing a successful company exit.

3) Rescuing and restructuring businesses that are squandering their resources. PE firms commonly target older companies that lack financial discipline, particularly those with inefficient middle management, or where executives spend money on private jets and extravagant parties. These kinds of organizations benefit immensely from the tutelage of private equity firms experienced at leading and running capital-efficient businesses. By aligning rewards with performance (rather than nepotism or habit), PE firms can make portfolio companies much more productive.

4) Locating great sectors and geographies to invest in. PE firms may be able to spot undervalued industrial sectors or localities that others have missed. When these areas are capitalized to their potential, they can fully develop and thrive.

5) Using equity capital more efficiently. The capital markets are highly competitive, and securing loans (“leverage”) for deals requires finesse. Though the popular press often disparages “financial engineering”, reorganizing a company’s capital structure can free up money to deploy to other parts of the business or the economy. Of course, irresponsible leverage makes a firm more likely to fail. But the market accounts for this possibility – investors in private equity firms carefully monitor their investments. A PE fund with failed portfolio companies will have trouble raising as much money and freely determining how to allocate it next time around.

A good example of how PE can positively impact an industry is Carlyle’s buyout of Hertz Corporation in 2005. After the buyout, Hertz improved operational efficiency in a variety of ways – for instance locating car cleaning and refueling services in the same parking lots. Not only did these improvements raise Hertz’s value by $3B, they forced the entire car rental industry to respond with innovations of their own. During the same period, Avis-Budget and Dollar-Thrifty profit margins and labor productivity increased substantially. Another example of private equity techniques at work is the brewing industry. The average worker at a North American brewing company is 7x as productive as his counterpart in 1950. Private equity groups such as 3G Capital, which merges and restructures brewing operations (recently, Anheuser-Busch), have made the industry much more efficient.

Private Equity and Its Discontents
The classic critique of private equity is that its success derives from financial engineering tricks, such as increasing leverage and minimizing tax liabilities, rather than real operational improvements. Michael Moritz recently claimed, for instance, that PE is akin to
“making a small down payment on your neighbors' house; paying for the balance by taking out a mortgage secured by their savings, jewelry, silverware and car; selling off the contents of their property; and then siphoning off some of the loan for yourself.” Similar invectives were leveled during the 2012 presidential campaign of Mitt Romney, who helped create Bain Capital. Like any industry, PE is occasionally corrupt – as when it partners with crony state and local governments to charge exorbitant rates on water utility bills, ambulances, and inmate phone calls. But the image of private equity purely as a parasitic form of business completely misses the point.

The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long-run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, the PE firm ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them. Furthermore, enabling companies to do more with less allows workers to specialize at other tasks, and frees up wealth with which investors and management can capitalize internal improvements or ventures in other regions of the economy. PE firms succeed to the extent that their portfolio companies succeed, and to the extent that their portfolio companies succeed, America prospers.

Another conventional critique made by Moritz is that PE destroys millions of jobs when cutting costs at portfolio companies. This is empirically false – the private equity industry as a whole is responsible for large job creation as well as destruction, with only modest net job losses. But the deeper fallacy with this argument is that full, constant employment is a kind of summum bonum in America’s economy. If we wanted to create full employment it would be easy: we could simply ban 20th century agricultural technology, immiserating millions of Americans and forcing them back into farm labor. It’s easy to intuit that this would be a bad idea, but it’s harder to imagine the economic progress that layoffs and labor migration imply. The truth is that creative destruction of antiquated jobs and invention of new forms of labor is what drives productivity growth, and PE firms are integral to this process.

Finally, some argue that PE only enriches a select few at the expense of ordinary Americans. In fact, the largest investors in PE are American pension funds, which have committed hundreds of billions of dollars to the American private equity industry. PE assets make up 9% of CALPERS portfolio, for instance, and have generated an annualized net return of 12.3% over the last ten years. When private equity firms succeed, every state government pension plan, university endowment, and large philanthropic endowment shares in their profits. It’s no stretch to say that the primary beneficiary of the private equity industry is the American public.

Private Equity and Venture Capital
Private equity and venture capital have much in common, and The Economist is partly correct to characterize VC as “private equity for fledglings”. Like their counterparts in PE, VC funds have long lifespans, allowing partners to cultivate long-term growth in portfolio companies rather than focusing on quarterly showings. Also, like private equity firms, the modern VC is actively involved in coaching and advising its portfolio companies (though ironically, PE is often more hands-on and entrepreneurial than VC because the latter has the more limited discretion of a minority shareholder).

Jim Coulter of TPG noted that whereas VC is in the business of mutation, PE is in the business of evolution. Where VCs fund “mutant” start-ups that offer completely novel technological innovations, private equity firms facilitate the process of ensuring that only the “fittest” companies survive. This is an important distinction between the two industries, and there are other technical differences. But broadly speaking, you can’t believe in the fundamental value proposition of the venture capital industry unless you believe in the basic paradigm of investment, assistance, and economic repair pioneered by PE.

We believe that in the coming decade, segments of the private equity and venture capital industries will converge and adopt similar strategies. Returns will disproportionately accrue to firms that combine the best of each. In the 1980s – the heyday of the private equity industry – firms such as KKR, Blackstone, Carlyle and Apollo tapped the under-deployed resources of banks to purchase, restructure, and resell corporations. But leveraged buyout (LBO) techniques are now “commoditized,” and the industry is extremely saturated: PE backs 23% of America’s midsized companies, and 11% of its large companies. The private equity industry remains valuable, but in order to generate unusual returns it must “evolve” itself.
PE firms have always tried to harness new innovations, but a surge of new information technologies has made it increasingly valuable for some private equity firms to partner with leading entrepreneurs and technologists – many of whom are located in Silicon Valley. Commercial data is exploding in volume and variety, and metrics are becoming much more precise. Private investors of the future will use technology platforms to evaluate formerly uninteresting assets as hidden stores of data, which will make their businesses and industries more efficient. New information will allow top investors to better assess consumer demand, supply chain logistics, and industry-level shifts, as well as determine where to open channels of communication and dedicate resources. Data-driven PE firms will limit waste, increase their margins, and become more valuable to their partners.

Venture capitalists able to draw on the top networks of talented leaders and builders in Silicon Valley were among the first to develop an armamentarium of data-driven procedural improvements for their portfolio companies. Hybrid groups such as Vista pioneered these techniques in the buyout space. Private equity firms working closely with venture capitalists and technologists may be able to unlock assets that others have not leveraged and build technology cultures to iterate on solutions that make those assets more productive. Some may even reclaim 1980s or 1990s-level returns. At the same time, the best VCs will begin to imitate and adopt PE strategies. Scaling major technological breakthroughs in certain industries requires armies of people and significant resources – private equity’s bread and butter. VCs may also begin to increase their return on equity capital of late-stage portfolio companies with debt financing, drawing on the private credit divisions of investment banks, PE firms and more.

There is still a large cultural rift between the two worlds; the culture of Silicon Valley is very different from the “Wall Street” mentality of the American financial establishment. Fortunately, open-minded individuals in each field are establishing rapport and exchanging insights. We have been lucky to add luminaries including Henry Kravis and Geoff Rehnert as investors and advisors to 8VC, and Sir Deryck Maughan as a board partner. Communication and cooperation between our industries will only continue to improve as the distinction between elite private equity and venture capital investors becomes less meaningful.

Conclusion
Critiques of PE reflect a naïve understanding of what creates economic prosperity. No industry is perfect, but private equity is an integral part of the economy, and should be celebrated for making our country wealthier overall. The confluence of the venture capital and private equity industries will only make each more productive, strengthening and fine-tuning the economy. Savvy, competitive investors able to build, buy and fix companies will continue to stimulate growth by allowing us to do more with less – the only way to create prosperity.

Joe Lonsdale
General Partner, 8VC
8VC is a San Francisco based venture capital firm which invests in industry-transforming companies. For more information or to sign up for our newsletter, visit www.8vc.com

Don't Just Donate, Innovate

Don't Just Donate, Innovate

Joe|October 16, 2017

“You’re working because you want to change the world and make it better; if the company you work for is worthy of your time, why not your money as well?”[1] — Larry Page

For most, the word “charity” evokes concepts of altruism and justice completely divorced from considerations of efficiency and profit. The distinction between the spheres of charity and commerce is reflected in the unique legal status accorded to each, and the kinds of people each sector tends to attract.

Today, this way of thinking is misleading and insidious. Our philosophy at 8VC is that many of the companies that present the greatest economic opportunities also create the greatest value for society. “For-profit philanthropy,” or altruistic investment guided by principles of accountability and return on investment (ROI), is often a compelling alternative to non-profit models.

Many of humanity’s most intractable challenges will only be solved through market-driven innovation. For-profit companies can attract top talent with the promise of equity, engendering a positive feedback loop: as talented people build and scale a business, they can leverage their expanding capital to hire more talented employees. Because the private sector has evolved processes and metrics for growth over many generations, for-profit models are more likely to efficiently accomplish their goals. Finally, viable business models easily attract capital and offer the best chance for systemic, durable solutions to social problems.

Wealthy donors typically fund 501c3 non-profits to address important social challenges. In the past year, Steve Ballmer and Michael Bloomberg have received attention for their civic charitable efforts — Ballmer recently launched USAFacts.com and the Ballmer Group, and Bloomberg’s What Works Cities initiative has done much to advise and improve America’s cities. I admire these men for their impressive acumen and good intentions. But Ballmer and Bloomberg are not taking full advantage of their experience and abilities. These icons of business are too quick to accept traditional non-profit models, and could use their skills to achieve greater social impact in these areas.

It’s true that certain causes require traditional charitable solutions, for instance disaster relief, and helping those in need who cannot help themselves.** Many “collective action,” “tragedy of the commons,” or “market failure” problems are best solved through government or non-profit action. But philanthropists consistently fail to grasp that there is a class of humanitarian projects where innovation is critical, and where solutions should be structured to create economic incentives. Instead of profit or social impact per se, donors should focus on “shared value” — creating economic value in a way that also addresses social needs and challenges.[2] Bishop and Green, who describe this paradigm as “philanthrocapitalism”, point out that “a profitable solution to a social problem…will attract far more capital, far faster, and thus achieve a far bigger impact, far sooner, than would a solution based entirely on giving money away.”[3]

My experiences building Palantir and running Addepar made me aware of serious problems with government, and inspired me to build a non-profit to look into state spending. Along with a team of several Stanford students, Zac Bookman and I created some of the first online transparency portals, and earned extensive press for our data and insights. We began receiving inbound interest from city officials and policymakers who wanted to compare and contrast their spending in similar ways, yet it was nearly impossible to do this with existing, decades-old systems. In fact, the officials we were working with barely understood their own data. We quickly realized that not only was this going to be an expensive problem for a non-profit, but that releasing studies and advising the leaders was unlikely to have a scalable impact. Only a for-profit corporation could attract the talent and capital necessary to build the technology solutions to power core government processes around budgeting, operational performance, and transparency. Only this kind of technological platform could scale to hundreds or thousands of governments at once.

We ultimately built a company called OpenGov, which fuses a for-profit model with a mission of making governments more effective and accountable. OpenGov powers governments across the country with a new “operating system” that enables agencies to make evidence-based decisions that drive better performance and improved outcomes for communities. It frees data currently trapped in complex legacy software and paper records, making the data available for streamlined budgeting, reporting, ad-hoc analysis, and citizen engagement in the cloud. OpenGov also networks customers together, providing them with the ability to understand key performance indicators compared to other similar government agencies.

We didn’t realize how many top city managers, CFOs, budgetary experts, and city councils would become excited about our innovation. Because OpenGov delivers a valuable public good as well as upside to stakeholders, it was possible for us to attract a bipartisan group of elite investors, advisors, and board members including John Chambers and Marc Andreessen.

The OpenGov team now numbers well over 100, and has created a big data platform and product setthat is used by more than 1,600 governments in North America. In 2015, OpenGov took the state of Ohio from 45th to 1st in the nation in a survey of transparency on government spending data. I have been thrilled to watch OpenGov continue to engage with government customers to determine how to innovate our product and boost sales — even as we deploy in city after city. OpenGov’s innovation promotes the public good, and its philanthropic impact has been far greater than that of a traditional charity. By helping local governments save money, we have improved the lives of citizens across the country while also advancing the interests of our shareholders.

Bloomberg’s What Works Cities initiative, which supplies cities with consultants and grants of millions of dollars to invest in data governance, is a truly necessary program, and is complementary to our work. Often, cities lack the resources or wherewithal to expand their data collection and analytics departments to create more effective policy. The technology that encodes best practices in government goes hand in hand with policy innovation encouraged by initiatives like this one. Unfortunately, most non-profit staff in general are instinctively skeptical of for-profits, reluctant to share their mission or align closely to build toward similar goals. Bloomberg, an entrepreneurial founder himself, should consider working directly with companies fixing the technology stack to improve city’s processes. His involvement in the details and his considered advice as a knowledgeable ally would accelerate adaption of new technology and make the core processes of perhaps the most important industry — government — more efficient.

OpenGov is just one example. Today we are witnessing a blurring of the boundaries between for-profit and non-profit initiatives. Eco-tourism and alternative energy production aim to achieve the twin goals of ROI and environmental sustainability. In education, income share agreements (ISAs) are making it possible for underprivileged kids to attend college, and some charter schools rely on for-profit models. Advances in Bio-IT have inaugurated a new age in medicine, and leading academics are encouraging their top students to build for-profit companies to harness their breakthroughs to cure diseases and save lives.

Here in Silicon Valley, Google.org — the for-profit charitable arm of Google Inc. — has made enormous strides as a philanthropy, leveraging data to improve educational opportunity, fight racial injustice, and develop remittance infrastructure for the world’s poorest people. And as the pull quote indicates, Larry Page recently intimated that he would prefer to fund one of Elon Musk’s for-profit companies than donate to a traditional charity, because he believes corporations such as SpaceX and Tesla are some of the most powerful engines for social progress.[4]

In general, for-profit philanthropy may be an important complement to a traditional 501c3 for several reasons:

  1. 1) For-profit philanthropies can raise more money from prospective investors because they offer a return on investment. This makes it easier to grow and scale an organization and increase the overall capacity of the giving sector.
  2. 2) For-profit companies focus on results and substance; non-profit employees often lack clear objectives or KPIs, leading to slower progress and lower efficiency. This structural problem can stall non-profit efforts relative to performance driven cultures.
  3. 3) “Market discipline” holds for-profit charities accountable for wasteful spending. Customer relationships generate direct feedback, and the boards, management, and technologists at for-profit companies are investors with “skin in the game”. Empirically, equity, and metrics-driven, for-profit cultures encourage employees to work harder, iterate faster and deliver innovation.
  4. 4) For-profit philanthropies are more responsive to new developments and shifts in demand than relatively slower moving non-profit charities. They can help cover gaps in the market more swiftly than their traditional counterparts.
  5. 5) For-profit companies are typically better able to attract people with proven track records of success in growing enterprises, and to maintain execution-driven cultures over long periods of time. This sustained, positive-feedback loop is necessary to scale and maximize the effect of a philanthropic endeavor, and will deliver exponential results.
  6. 6) Non-profit organizations are reliant on recurring donations, which makes it difficult to engage in long-term planning, and completely subjects non-profits to the direction of their (usually opinionated) board members. Whereas for-profit companies can build recurring revenue to ensure their survival, tackle problems with longer time horizons, and operate with relative autonomy; non-profits must focus on capital preservation and pleasing their donors.

For-profit philanthropy won’t solve every social and humanitarian problem, but it is often superior to a 501c3 approach. Donors such as Michael Bloomberg became wealthy by bringing together top talent in for-profit, mission-driven cultures that figured out how to build and deliver technologies which transform core processes in large industries. Entrepreneurs build successful enterprises in the face of scarcity, and they should consider carrying this mindset with them as they pivot to charitable endeavors. If billionaire donors had more time and energy, but less money to address these important missions, they might be more likely to consider the ROI of helping to build for-profit companies which can both attract talent and achieve sustainable social impact in the spaces they care about. I encourage more great entrepreneurs and investors to consider partnering with mission-driven businesses as part of their philanthropic efforts, so we can ally, learn, and benefit from what they create.

Joe Lonsdale
General Partner, 8VC


* (From Above) We truly believe in many traditional non-profits in addition to innovative, mission-driven businesses. For instance, we strongly support Ashton Kutcher’s Thorn, which works with tech innovators to stop child-trafficking and to help law enforcement find and rescue abused children. Arthur Brooks is doing incredible work at AEI to encourage free enterprise policy that lifts the bottom of society and restores dignity to America’s least well off. The International Justice Mission has done much to alleviate desperate poverty in the Philippines. Leaders we admire such as Bill and Melinda Gates, Michael Bloomberg, Laurene Jobs and others have done much to save lives around the world, positively influence education and immigration policy, support the natural environment, and contribute to other important social missions. The list goes on. There are hundreds or perhaps thousands of other worthwhile non-profits that deserve charitable donations, and our intent is to complement these efforts in some cases with mission-driven, for-profit cultures, but not to replace them.


[1] Yarrow, Jay. “Larry Page: I Would Rather Give My Billions To Elon Musk Than Charity.” Business Insider, Mar. 20, 2014. http://www.businessinsider.com/larry-page-elon-musk-2014-3

[2] Porter, Michael and Mark Kramer. “Creating Shared Value.” Harvard Business Review, January-February 2011.

[3] Bishop, Matthew and Michael Green. “Philanthrocapitalism.” Bloomsbury Press, 2008.

[4] http://www.businessinsider.com/larry-page-elon-musk-2014-3


8VC is a San Francisco based venture capital firm which invests in industry-transforming companies. For more information or to sign up for our newsletter, visit www.8vc.com