Tag: Startups

All value created by venture capital, in any vintage and every category, is downstream of the industry’s ability to recognise brilliant individuals and ideas. 

It is an investment strategy built on discovery. Large pools of institutional capital are diffused through thousands of individual firms, providing broad coverage across industries, geographies and technologies. The failures mostly flare out as cheap experiments, while a handful of outliers produce extreme value. 

Implicit in this arrangement is venture capital’s need for a healthy market of small firms and emerging managers. Individuals who bring a unique perspective to deployment, with differentiated sourcing and varying models of the world.

This is the ragged edge of the venture market, maximising the surface area of opportunity.

Over the past 15 years, venture capital has been augmented with a second pool of capital, as much larger LPs entered the strategy when rates were low.

This flood of capital spawned the “money for winners” megafunds, whose strategy is to double-down on the obviously attractive companies.

The scale of megafunds has contributed to companies staying private longer, pulling more capital into private markets. At the same time, their LP base is less sensitive to liquidity, able to tap other assets like treasury bills, money-market funds or index holdings for near-term cash needs. 

Indeed, if you divide the market into funds below $1B as a proxy for “money for experiments”, and funds above $1B as a proxy for “money for winners”, only the latter has really grown. The same is true for rounds above $100M, now clearly the majority of the market —  having been closer to a quarter of total volume a decade ago. 

This increasing top-heaviness is the result of a recursive function where smaller LPs rely on regular liquidity to recycle into new commitments while the larger LPs just want to hold for steady IRR growth — so weak exit markets become a ratchet on fund size. 

i.e. Small firms started to wash out of the market due to poor liquidity ➔ the venture landscape became narrower ➔ concentration accelerated IRR growth as more capital funneled into fewer companies ➔ megafunds metrics appeared healthy ➔ the top end of the market expands ➔ liquidity weakens further… And on it goes.  

As a result, the venture market is now awash with “money for winners”, while the discovery layer actually responsible for finding those winners has withered. 

There is more money than ever for a shrinking number of targets, with much less intellectual bandwidth to ensure it is allocated with care and diligence. This has resulted in inflated prices, herd behavior, and a market that feels increasingly unhinged — with companies like Instinct raising $1B at a $10B valuation, pre-revenue and sans-moat.

Essentially, if there is no real pressure to regularly reconcile your marks with reality through an exit, you can keep marking your own book as long as you like. Eventually, and inevitably, that spirals until all contact with reality is lost. 

Up to now, the megafund concept has been justified by the need for large LPs to make large individual commitments, where many smaller commitments would create a burden of admin and management. However, their divergent priorities (lower hurdle for performance, effectively no real need for liquidity) have created an imbalance in the market, and whatever metrics they do generate are increasingly divorced from reality. 

There is a simple and well-established remedy to this: the fund of funds. 

“Venture FoFs offer a streamlined alternative, often providing better access, superior diversification, and historically strong net performance, despite the additional fees. They also provide the benefits of operational efficiencies, downside protection, and vintage year diversification.”

John Felix, Pattern Ventures

Traditionally this intermediary structure has been looked down on for adding another layer of fees between the LP and the GPs. However, there’s a growing body of evidence that FoFs offer slight outperformance, net of fees, by applying a specialist focus to the otherwise intensive challenge of sourcing and picking managers — a process which few LPs resource properly and even fewer truly understand.   

Another proposition of the megafunds is access to the most attractive growth opportunities, which may be challenging to reach directly. 

However, as LPs become more sophisticated about co-invest opportunities, they can get a similar level of access with little of the usual fee drag. Indeed, the shift toward much more substantial co-invest would dramatically lift performance across the market, which is why private equity also evolved further in that direction. 

Finally, there is the simple truth that small funds outperform large funds, across every fund industry and in every study. According to analysis by Santé, funds of less than $350M are roughly 50% more likely to achieve returns above 2.5x, versus funds of $750M or more. Smaller funds generate a cumulative IRR of 17.4%, versus just 9.7% for the larger bracket.

“Mega-rounds have a higher floor & lower ceiling. They are less sensitive to improvements in exit rate & exit value. For traditional VC investments, a 10% increase in exit rate & 20% in average exit value generates an incremental 0.43x and 0.44x in Fund TVPI, compared to just 0.19x and 0.35x for funds investing in mega-rounds. Finally, mega-rounds are highly sensitive to the Market Regime and require an active IPO window to achieve the exit performance outlined here”

Why Venture Capital Does Not Scale (2023)

So, a fund of funds offers net outperformance already versus direct fund investing, it also enables a larger co-invest book for access without fees, and you make access to better-performing small funds viable for large LPs. In turn, the lower cost of capital is passed on to founders and reduces the risk associated with raising venture capital. 

“Strategies for investing in direct funds may be constrained by limits on fund access or manager selection skills. We show that VC FoFs often outperform direct investing handicapped by these limitations.”

Financial intermediation in private equity: How well do funds of funds perform? (2018)

The outcome is a broad-based performance lift for LPs, and a more competitive industry that is better structured for finding and funding outliers. Stronger short-term returns by eliminating selection difficulties and fee drag, and a market structure that preserves long-term value creation rather than fee extraction.

Another interesting possibility arises out of this; the great hope of an algorithmic approach to venture capital.

The extreme idiosyncracy and unpredictability of venture investments means that systematic decision-making can at most exclude predictably bad investments. You cannot find succssful investments with a data-driven approach, because the successes are inherently outliers.

However, the same may not be true for investing at the LP level. Success as a venture capitalist may involve predictive traits or features which allow an algorithmic approach to offer an edge.

“Measures of fundraising success, although correlated to most fund characteristics, are not related to future performance. Meanwhile, machine learning tools can use qualitative information to predict future fund performance: the performance spread between the funds within the top quartile and the lowest quartile of predicted probability of success is about 9% per annum.”

Limited Partners versus Unlimited Machines; Artificial Intelligence and the Performance of Private Equity Funds (2024)

The implication here is that the fund of funds model is scalable in a way that venture capital is not. These vehicles may be the elastic buckets of market beta which large LPs have been looking for, and they don’t run the risk of cannibalising the long-term growth of the market.

On top of that, there’s a good argument for an intermediary layer which separates large institutional LPs from the managers. They aren’t exposed to reputational backlash if a manager they have selected invests in dystopian sex work platforms, crypto schemes or exploitative gambling applications.

This is not to say megafunds are going anywhere; they offer risk-averse institutions the big-brand trust of a KPMG or PwC. However, it seems inevitable that (as in other fund industries) their fee percentage is going to have to compress in recognition of the reality of their performance — which also raises questions about the persistence of their “access” edge.

If the market returns to its earlier balance, with more capital being funnelled into small and emerging managers via fund of funds products, alongside the lower fee megafunds, it will be able to settle into a productive equilibrium. Whether that will look more like the mix in 2020, or in 2015, it’s hard to say, but the status quo seems unsustainable. 

Top image: The Great Day of His Wrath, by John Martin (1851-1852)

What does a founder friendly investor actually do?

Is it…

• …the firm that is the most pleasant to work with?
• …the firm with the most capital to deploy?
• …the firm with the most powerful network?

Or is about alignment with a founder’s long-term succes?

The answer ought to be obvious, and yet the revealed preference of the industry is to broadcast founder friendly vibes structuring the market to undermine their future.

For example, a puzzling feature of venture capital that has appeared recently: investors telling (AI) founders that now is a good time to sell their companies.

They’re probably not wrong, but who is that advice for?

It’s not for any founder pursuing their life’s work. Nobody who wants to retain control, stay in “founder mode” and build a company of generational importance.

Instead, this attitude seems to be aimed at mercenaries; companies destined for a quick flip to an incumbent. Indeed, the majority of exit activity has shifted from IPOs to “BigTech acquisitions”, as larger VC firms have become more cowardly.

“In this paper, we argue that this focus on exit, particularly exit by acquisition, is pathological. It leads to concentration in the tech industry, reinforcing the power of dominant firms. It short-circuits the development of truly disruptive new technologies that have historically displaced incumbents in innovative industries. And because incumbents often buy startups only to shut them down, intentionally or not, it means that the public loses access to many of the most promising new technologies Silicon Valley has developed.”

Exit Strategy (2020)

What happened to finding founders who were on a mission to change the world?

Isn’t venture capital supposed to support the most important companies, driving progress, creating prosperity?

Where are they supposed to turn, otherwise?

It’s tragic that the dominant firms in venture capital have switched from financing creative destruction to the safer and easier role of serving incremental solutions to incumbents.

Of course, this is likely the natural consequence of venture capital firms themselves becoming bloated, risk-averse incumbents. The product they serve to LPs is stability and predictability, not risk-seeking alpha.

So, if a company does not choose to exit to an incumbent, or that option isn’t readily available, what then?

Increasingly, they are only funded into the later stages if they are a useful vessel for allocation — a vehicle by which VCs can justify fee income on ever-larger pools of capital. Private market sponges, with failing health and indefinitely postponed exits.

This also ends badly for the founder.

This is where the VC market is in a real pickle.

The case is crystal clear and yet nobody can admit to it, because it’s both extremely proifitable and hostile to founders.

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

Upton Sinclair

Raising more private capital is correlated with worse long-term performance, and it gets increasingly worse with scale. Of the 12 companies who have raised >$3B and listed in the US, 11 have (dramatically) underperformed the index.

These were the darlings of venture capital, the companies which raised unprecedented amounts. Then they were dumped on public markets and left to struggle.

The reasoning is simple: Private and public markets have different goals, reflected by how they value companies.

• Private companies are valued on their fundraising momentum, which is a result of ARR and market narratives. Thus, companies are rocket ships with weak economics.
• Public companies are valued on a relatively thorough examination of their financial health. Narratives matter, but hype competes directly with pressure from short sellers.

As a result, the longer a company stays private, the more of a struggle it will be to adapt to public markets.

It even appears that giant growth-stage rounds don’t even perform particularly well for VCs, but the goal isn’t performance, it’s allocation. Capital at work. AUM. Fees. Rent-seeking. And then inventing new ways to dump these bags on others.

It’s great that we’ve moved on from the era of replacing founders and rushing companies to IPO for grandstanding purposes. But what has replaced it is arguably much worse.

Consider that tech is still dominated by the Mag-7; companies mostly founded in the 70s or 90s. Companies that are now worth trillions, who originally raised peanuts and went public in a median of less than six years.

So, founders appear to have two main choices if they take VC:

• Take a quick flip to an incumbent if your future looks dicey.
• Stay private and absorb capital until it becomes toxic.

The default used to be a sensible middle path: raise the capital you need to build a great business, take it public, and thrive.

Unfortunately, this outcome does not serve the platform firms whose main challenge is allocation at scale. So, liquidity has evaporated, smaller firms have suffered, and founders are more often stuck with these incentives.

Of course, founders have agency. They are able to determine their future, providing they are fully aware of the options and consequences.

Indeed, some founders may understand the importance of hitting an exit at the right time, and in the right shape, to maximise the future of their company. They have the potential to do exceptionally well.

However, their advisors on financing are usually venture capitalists, who are not incentivised to understand why too much private capital is bad for a company.

In fact, they are incentivsed to keep stuffing capital into attractive assets until they are no longer attractive assets.

So, the smart path isn’t easy or obvious, for the founder.

Getting an exit right requires nothing short of good timing, brilliant execution, and awareness that their future interests will eventually fall out of alignment with even the most “founder friendly” venture capital firm.

(top image: Michelangelo’s “The Torment of Saint Anthony” )

Why the most investible founders might have the least fundable ideas

“What do you look for? Grit — sure… everyone likes to say that… intelligence… obviously — the right balance of taking feedback & independence — sure. But you have to go deeper — have a deeper framework on really what makes for great founders who are going to stick it through and be winners AND what is the shorthand you can share with your partners / each other on WHY you as a lead investor actually believe in this person / the bet you are making.”

Sam Lessin, GP at Slow (Draft letter to LPs)

Four basic premises for early-stage investing:

• Non-consensus investments produce stronger returns
• Proactive origination strategies drive outperformance
• Founder attributes create antipatterns for investment
• Track record isn’t a reliable signal of future success

Accepting all of these means acknowledging that first-check VCs should generally source their own deals without relying heavily on signals like traction, market activity, or credentials.

This is the torturous reality of being the first money in: reaching conviction on little more than a story.

And you must be able to do that in a thoughtful manner that can be explained to others, and learned from in future.

A Complicated Package

The “jockey’s versus horses” debate goes back to the very beginnings of venture capital. It has also become painfully reductive: given a choice between markets, technologies or people, being explicitly pro-founder has the best optics.

Of course, it’s never that simple. All information is useful in the decision-making process, and each aspect tells you something valuable about the others.

• The approach described by Peter Thiel is to consider the whole pitch as “some kind of complicated package deal,” combining people, ideas and technology.
• Or, as Nabeel Hyatt puts it, the way to “separate hucksters who do a good pitch from people who are real executors is to look at the thing that comes out of their hands”.
• Indeed, Sam Altman described the Y Combinator screening process as looking closely at the “non-obvious brilliance of the idea” being presented.

Indeed, the problem a person chooses to solve, and how they approach solving it, can tell you a lot about the person..

Another way to frame this is outlined by Mattia Bianchi and Roberto Verganti in “Entrepreneurs as Designers of Problems Worth Solving“:

“Finding meaningful problems to address is a critical driver of innovation and entrepreneurship in today’s turbulent environment, possibly even more so than problem solving.”

“Designing a problem is mainly based on inventively reframing a situation through its expansion, elevation, and prospective sensemaking. The outcome is a more meaningful problem when it aligns the entrepreneur’s purpose with how society, technology, and culture are changing.”

Entrepreneurs as designers of problems worth solving

Bianchi and Verganti’s suggestion is that the act of identifying important problems is itself indicative of potential, and a precursor to “designing problems”: the addition of novel aspects which weren’t part of the original problem scope.

This process demonstrates that a founding team has a deep understanding of a particular problem (and the universe around it) and a novel and thoughtful solution.

Finding Outliers and Avoiding Hucksters

Understanding and evaluating qualitative traits is obviously very difficult, especially when the playbook of what VCs say they look for is now wide-open for study.

However, while there’s a strong canon of common wisdom about the attributes of “good founders”, very few VCs have build a framework for recognising, documenting and reflecting on them.

An example framework that overlaps with the “problem design” approach is the list of attributes used by 1517 Fund, as described in Michael Gibson’s book, ‘Paper Belt on Fire‘:

• Edge control
• Crawl-walk-run
• Hyperfluency
• Emotional depth & resilience
• Sustaining motivation
• The alpha-gamma tensive brilliance
• Egoless ambition
• Friday-night-Dyson-sphere
• Wily & wondrous
• Alchemy

(Descriptions and examples for the first 8 are included in the book. The final two may be included in a forthcoming update.)

If you study these attributes, and the story behind them, you will understand an important qualification: they reflect markers of outlier behavior. The intent is to seek out extraordinary people, rather than create template for ordinary brilliance.

Indeed, the industry’s more common reliance on gut-feel and credentials is likely to exclude outliers, and limits the potential for constructive reflection on (and true accountability for) investment decisions:

“For example, VCs often discuss the ‘chemistry’ between themselves and the entrepreneur. The deal often falls through if the chemistry is not right. Such intuitive, or “gut feel”, decision making is difficult to quantify or objectively analyze.

The added complexity from subjective information further clouds the decision making process and invites the decision maker toward more biases. Due to the complexity of the decision and the VCs’ intuitive approach, VCs may have a difficult time introspecting about their decision process. In other words, VCs do not have a comprehensive understanding of how they make the decision.”

A lack of insight: do venture capitalists really understand their own decision process?

There are two typical outcomes of this laziness:

• Investors resort to simple patterns in their understanding of founder potential, falling prey to exactly what Kahneman describes in The Hazards of Confidence, and producing predictably worse outcomes.
• In the absence of an objective process, the analysis of founder potential is displaced by homophily, where investor ego equates “high potential” with “similar to myself” across everything from facial features to political beliefs.

Instead, the best way to understand something like determination or clarity might be to look for founders with a well-designed problem. For example, making humanity multi-planetary, making energy too cheap to meter, tapping atmospheric rivers, or building the telescope for drug discovery.

• If a founder has designed a problem which seems high on importance and low on popularity with investors, they’re likely in it for the right reasons.
• If they can articulate the problem in a novel and coherent manner then there’s a good chance they’ll be able to find a solution where others will fail.
• If the story of that “problem design” process feels deeply personal (it keeps them awake at night, and busy on weekends) there’s a good chance they will persevere.
• If their approach to the problem shows a willingness to go back to basics and do the work to learn whatever is required, they likely have the agency required for entrepreneurship.

It doesn’t matter if the founder ends up pivoting. That may even be desirable. It doesn’t alter the value of what you can learn from their approach to designing and solving problems.

Thus, some of the least obviously “fundable” ideas may be the most deserving of investment, if you use the right lens. Investors should seek founders that have picked good quests over those that choose lower friction.

Conspicuous Consumption

At the opposite end of this spectrum are rage bait startups and the blight of limbic capitalism.

It is no coincidence that these companies are always at the dead-centre of consensus. The playbook is simple:

1. Build in a competitive category
2. Pursue viral stunts that make you unignorable
3. Raise a huge round to fund more virality / growth

This exploit a basic premise of scaled venture capital: the largest firms cannot afford to miss potential winners.

A startup can look like a potential winner by having a track record of success, a density of technical talent, or by commanding enough attention to become an object of desire; the ‘conspicuous consumption‘ of venture activity.

As long as they pass one of these legibility tests, they get onto the treadmill of “tier-1 VC” convention bidding where success is hitting milestones to earn staying on the treadmill. Capital feeds growth on hype-adjusted multiples, producing fuzzy venture math which is capable of any conclusion you desire.

The only problem these companies truly solve is scaled capital allocation and systematic AUM growth for venture capital firms. The founder becomes a minor player in a largely commensal relationship designed to support the VC’s ambitions.

“The hyper-normative world of consensus-seeking is dripping with incentives that would make you their slave. And if you don’t have anything, in particular, that you believe, then they will likely succeed.”

Build What’s Fundable

Fund Good Quests

Without revisiting the topic of bifurcation yet again, it is clear that one of the models described above works for traditional VCs, while the other is geared toward the scaled allocators.

So, if you are an early stage investor, one of the best things you can ask yourself in the early stages of evaluating a company is whether the founders are designers of a problem worth solving.

It may not lead you to companies that grow rapidly, which may make raising your next fund more of a challenge. But, like proper risk management, it’s the right approach if you really care about maximising returns and building a durable legacy as a venture investor.

(top image: “Astronomer Copernicus“/ “Conversations with God”, by Jan Matejko)

Relying on market efficiency while investing in idiosyncrasy

Venture capital is the hunt for outliers; ideas that are not well understood by the wider market. This strategy is rooted in the need for risk capital to finance frontier businesses.

You can see how this played out in previous generations of tech: Amazon, Airbnb, Canva, Coinbase, Dropbox, Google, Shopify, Slack, Uber… All of these companies faced an uphill battle with investor interest, and went on to produce incredible exits for the early believers. Similarly, there are many examples where the founder’s own capital paved the way: SpaceX, Tesla, Palantir, Anduril…

On the other hand, it seems relatively more difficult to find stories of competitive early rounds leading to great outcomes. Stripe, perhaps?

This understanding of venture capital is reinforced by the data:

We find that consensus entrants are less viable, while non-consensus entrants are more likely to prosper. Non-consensus entrepreneurs who buck the trends are most likely to stay in the market, receive funding, and ultimately go public.

The Non-consensus Entrepreneur: Organizational Responses to Vital Events

Despite this, today’s venture capitalists have an absurd reliance on the market as their lens to understand value. Herd behavior drives investor attention, and (what passes for) valuation is primarily derived from relative measures like ARR multiples.

Investors set out to generate alpha with their unique ability to recognise novel opportunities, but rely on broad market sentiment as a lens to understand what is worth pursuing.

This paradox has stumped observers.

This heavy reliance on comparable companies in the VC valuation process is perhaps unsurprising, given that relative pricing methods are not uncommon in M&A markets overall. What is less clear, however, is the exact driver behind this method, and the understanding of why a relative pricing methodology will impact startups’ valuations.

What Drives Startup Valuations?

Whether it’s marketplaces, crypto or today’s AI boom, capital herds into the category and drives up prices, and those prices then become “comps” for others.

Ultimately, the surge in deals creates a greater volume of market data for that category, reducing information friction for investment, allowing for more deals to be made more quickly. This compounding influence quickly overheats activity.

In addition to competition driving up prices and compressing due diligence timelines, there’s a further pernicious consequence: while information friction is reduced around the consensus, it is increased elsewhere.

Founders building truly innovative products find themselves facing a wall of blank-faced investors programmed with category multiples. The difficulty of raising capital becomes so great that many simply reorient their ambition to lower quality projects closer to the experience of venture capitalists. This is clearly a fundamental failure:

Information frictions in valuation can lead startups to select projects that align with the expertise of potential venture capital (VC) investors, a strategy I refer to as catering […] where a startup trades off project quality with the informational benefits of catering.

Startup Catering to Venture Capitalists

Fundamental Value

If all of this was to hold true, we should see an increase in performance by the few VCs that maintain a lens on fundamental (rather than relative) value. In theory, these investors would be better able to recognise outlier value and unique opportunities.

Indeed, that does appear to be the case. Multiple studies on venture capital investment performance and decision making processes have reached the conclusion that VCs would benefit from a better understanding of fundamental value:

Venture capital funds who base their investment strategy on fundamental values and a long-term view seem to have a measurable advantage over those who engage in subjective short-term trading strategies.”

How Fundamental are Fundamental Values?

Ideally, a startup would combine a full fledged fundamental cash flow-based approach with a thorough comparable companies analysis to cover both its intrinsic value and a market-based measure.

What Drives Startup Valuations?

So, the paradox is laid bare and the remaining question is why this is the case. There are two potential explanations:

1. VCs do not understand valuation. A decade of ZIRP-fuelled spreadsheet investing has destroyed the institutional understanding of risk and the purpose of venture capital.
2. There are other incentives at work which explain this phenomenon; reasons why VCs would be reluctant to closely analyse fundamental value.

Explanation 1: Hanlon’s Razor

Unsurprisingly, there’s plenty of evidence to make the case that this is unintentional; a result of simple incompetence and herd behavior. Indeed, herding is a well-studied phenomenon in professional investment, particularly when insecurity is high:

Under certain circumstances, managers simply mimic the investment decisions of other managers, ignoring substantive private information. Although this behavior is inefficient from a social standpoint, it can be rational from the perspective of managers who are concerned about their reputations in the labor market.

Herd Behavior and Investment

Chronic groupthink, and the atrophy of independent reasoning, further explains why VCs are also often unable to clearly articulate the process that goes into their investment decisions:

The findings suggest that VCs are not good at introspecting about their own decision process. […] This lack of systematic understanding impedes learning. VCs cannot make accurate adjustments to their evaluation process if they do not truly understand it. Therefore, VCs may suffer from a systematic bias that impedes the performance of their investment portfolio.

A lack of insight: do venture capitalists really understand their own decision process?

Many VCs have simply emulated the practices of their peers without fully understanding why. Indeed, those peers probably couldn’t provide a rationale either. It’s an industry of investors copying each other’s homework while pretending to be original thinkers.

Action without understanding purpose naturally erodes standards. Not only does this make VCs bad fiduciaries, it also precludes any learning and institutional development.

Almost half of the VCs, particularly the early-stage, IT, and smaller VCs, admit to often making gut investment decisions. We also asked respondents whether they quantitatively analyze their past investment decisions and performance. This is very uncommon, with only one out of ten VCs doing so.

How Do Venture Capitalists Make Decisions?

Explanation 2: cui bono?

The alternate theory is that there may be some genuine motive for VCs to avoid looking too carefully at fundamental value. That somehow they are able to profit from a reality in which it is not an important driver of activity.

Perhaps it is simply because today’s VCs behave more like traders, rather than investors. That the easier opportunity is to glom onto hot categories and ride the exuberance to an overpriced exit somewhere down the line, rather than trying to find good investments.

This is also not an original accusation:

For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns.

Putting the (Insta)cart before the Grocery (horse): A COVID Favorite’s Reality Check!

Venture capital, as a discipline, runs an existential risk of invalidating itself by becoming institutionally what crypto is colloquially. If venture capital is just about “[creating] the impression [of] recoupment”, then its no better than the pump and dumps of the crypto bros.

Institutionalized Belief In The Greater Fool

Yet again, there’s evidence that this is the case.

VCs are heavily influenced by market conditions, optimism and FOMO. None of these are original accusations, although it might be interesting to learn this has been demonstrated in research:

The optimistic market sentiments and fears of missing out in hot markets can significantly shift VCs’ attention towards cheap talk, such as promises of high growth. Such conditions may even prompt VCs to neglect costly signals such as the profitability of new ventures.

Venture Capitalists’ Decision Making in Hot and Cold Markets: The Effect of Signals and Cheap Talk

This is confirmed by research looking at this question from the other side, where it is demonstrated that VCs are commensurately less likely to herd in periods with greater uncertainty and less optimistic momentum to channel capital:

The study finds a significant negative relationship between economic policy uncertainty (EPU) and herding behavior, indicating that venture capitalists are more likely to make independent judgments when EPU rises.

Economic policy uncertainty and herding behavior in venture capital market: Evidence from China

Even when a VC talks about wanting to find category winners, they are also implicitly talking about riding a category. Were they hunting for genuine outliers, the category wouldn’t matter. There is a reason, for example, why some VCs widely publicise the categories they invest in as great opportunities, and others choose to keep any alpha for themselves.

The final reason is simple: subjective, market-based pricing is opaque and open to manipulation. VCs can collectively produce and support higher marks regardless of underlying value. They can also choose to be “opportunistically optimistic” about a portfolio company:

During fundraising periods the valuations tend to be inflated compared to other periods in the life of the fund. This has large effects on reported interim performance measures that appear in fundraising documents. We find a distinctive pattern of abnormal valuations which matches quite closely the period up to the first close of the follow on fund. It is hard to rationalize the pattern we observe except as a positive bias in valuation during fundraising.

How Fair are the Valuations of Private Equity Funds?

Indeed, much of the fallout post-2022 involved LPs feeling fairly miffed that managers weren’t being honest about underlying portfolio company value. As long as VCs broadly maintained marks, there was still hope to raise another fund on those mostly meaningless proxy metrics of performance.

In Conclusion,

• Many VCs choose to play a short-term trading game
  By focusing on market momentum, rather than companies, through relative valuation methods, VCs operate more like traders.
• Most VCs take the path of least resistance when adopting practices
  While analysing fundamental value offers outperformance, relative value is easier to understand and offers strategic advantages.

Most VCs identify as investors, and some of them still are. Mostly the smaller, boutique firms who were quick to realise that they could not compete in consensus categories against the multi-stage platforms.

There is value in being a trader if you have multi-billion dollar funds and can both manifest and then coast on the beta of technology markets. They behave like market makers on the way up, extracting opportunistic liquidity, and can aim to concentrate resources into the handfull of winners before the market turns.

This strategy is toxic to smaller investors, many of whom are simply washed out in the boom-and-bust cycles that this amplifies. Instead, these investors, focused on identifying true outliers, need to consider polishing their lens on fundamental value.

(top image: Ascending and Descending by M.C. Escher)

The two faces of what we sometimes call venture capital, and the cognitive dissonance they create.

This blog started out as a place to write about the intersection of science fiction and technology. The first article about venture capital, and the opium of consensus, emerged from watching VCs herd into thinly-veiled crypto scams in the name of “web3“.

The influence of consensus remains poorly understood, and the subject of distracting counterfactuals, despite being widely discussed for as long as “investor” has been a profession.

Words must have meaning

Venture capital is the practice of identifying nascent business opportunities with radical potential; the application of process to extract outsized value from extreme idiosyncratic risk.

In this context, venture capital is clearly not a consensus-oriented discipline. Both theoretical and quantitative perspectives support this reality; the intention, goals, behavior and performance.

We find that consensus entrants are less viable, while non-consensus entrants are more likely to prosper. Non-consensus entrepreneurs who buck the trends are most likely to stay in the market, receive funding, and ultimately go public.

The Non-consensus Entrepreneur: Organizational Responses to Vital Events

Simply look back at the early-days of venture capital’s largest outcomes, where the majority did not have investors competing for access, driving up the price. Fundraising was a struggle for those founders, and in that struggle was the opportunity for those on the other side of the table.

It’s very hard to make money on successful and consensus. Because if something is already consensus then money will have already flooded in and the profit opportunity is gone. And so by definition in venture capital, if you are doing it right, you are continuously investing in things that are non-consensus at the time of investment.

Marc Andreessen, a16z

Indeed, if consensus were to play a meaningful role in venture capital, it would fail on the only two things it sets out to achieve:

• Maximise ROI for LPs through idiosyncratic risk
• Finance the development of novel innovations

In addition, there is no such thing as a downstream supply of “non-consensus capital”. If you fund non-consensus companies then you have to be able to support them to the point where their potential is obvious and larger/later generalists can be convinced. It’s paradoxical to believe that other investors will share your non-consensus viewpoint.

Cognitive dissonance

The root of the confusion about consensus (and entry price, portfolio construction, attention, relationships…) is the mixing of two different private market strategies. One is venture capital, and the other is something else that just falls into the venture capital allocation bucket.

This other strategy emerged in the period from 2011 to 2021, enabled by low interest-rates, as described by Everett Randle in “Playing different games“:

Tiger identified several rules / norms / commonly held ideas in venture/growth that are stale & outdated and built a strategy to exploit the contemporary realities around those ideas at scale.

Everett Randle, Kleiner Perkins

The capital mechanics of this strategy were explained further by Kyle Harrison, in “The Unholy Trininty of Venture Capital“:

So you have massive capital allocators looking for places they can farm yield and they don’t want to be slinging hundreds of $30M checks. Capital agglomerators represent the perfect solution. Hit your 7-8% yield target, be able to park $250M a pop without being the majority of the fund, and sit back and relax.

Kyle Harrison, Contrary

Versions of “bigger/faster/cheaper capital” have since been employed by other multi-stage platform firms, and the consquences are dramatic:

• The platforms pay a premium between 63% and 171%, depending on stage.
• The most active platform led 61 Series A rounds since 2022, compared to 12 by the most active “boutique” firm.
• The platforms both scaling up and increasingly concentrating on “obvious” investments, e.g. AI, or San Fransisco/Software.

If success in venture capital is driven by non-consensus investments, in less competitive ecosystems with more rational pricing, why would an investor pursue a strategy directly to the contrary?

The answer is indicated in Martin Casado’s episode with Harry Stebbings, in which he described missing the category winner as the greatest sin of investing.

This hunger to capture the most extreme “power law” category leaders is a requirement of the exit math involved in multi-billion dollar funds. Consequently, these platforms also raise substantial early-stage funds to index any emerging theme, putting an option on the future of those companies.

A mega-VC with $5-10B annual funds is really searching for only one thing: a company they can pile over $1b into with a potential for 5-10X on the $1b. With this, seed fund is inconsequential money used to increase the odds of main objective.

Bill Gurley, Benchmark

The startup industrial complex that has emerged is not optimised for non-consensus investing, and nor does it need to be. Investors at these platforms are hired to compete and win in known areas — and have attitudes to match:

Successful startups fit into a mold that investors understand, and that more often than not those startups attracted meaningful competition among top investors.

Martin Casado, a16z

If a company has tons of hype and seems overvalued, don’t run away. Run towards it. Hype is good. Means they’ll raise, exit at higher valuation. And the price likely won’t feel overpriced after the startup exits.

Andrew Chen, a16z

The output is a rough index of high-growth private technology companies. The platforms are harvesting the beta from innovation, rather than finding the alpha in outliers. Even the giant outcomes become so well/over-priced that their returns risk converging with benchmarks.

Categorically, this is not venture capital in any meaningful sense.

The only reason we call this venture is because LPs need to call it venture so CIOs can hit annual allocation targets they promised boards. This is venture allocation, not venture returns.

Will Quist, Slow

Venture Alpha and Venture Beta

To repeat a point already well-hammered, the platform strategy is entirely different, with a different LP base, a different return profile, and different rules.

The difference between the Andreessen quote above, and the more recent quotes from Chen and Casado, is simply that in 2014 Andreessen Horowitz was a venture capital firm. Today it is an asset manager, an RIA with a multi-stage platform strategy, perhaps best described as a venture bank.

Many VCs have sought to assimilate “tier 1” multi-stage behavior, acting out what they believe LPs and peers expect to see despite the fundamentally incompatible models. This herding around identity and behavior reflects the extreme level of insecurity in venture capital, a product of the long feedback cycles and futility of trying to reproduce success in a world of exceptions.

Venture Banks

There is no harmony with venture capital, and the behaviors of these platform investors should not be emulated by venture capitalists — whether or not they also call themselves venture capitalists.

To put a point on this: The platforms explicitly benefit from consensus and price inflation. Both are toxic to venture capital.

As long as both strategies are discussed under the banner of venture capital, we’ll keep wasting time on pointless debates about markets and incentives, and investors will keep making dumb, confused decisions.

(top image: A Steam Hammer at Work, by James Nasmyth)