Tag: Startups

  • The Rot of Short-Termism in VC

    The Rot of Short-Termism in VC

    Venture capital is a seriously long-term game, with investments taking somewhere between 8 and 16 years to return liquidity.

    The distance to that horizon creates a lot of eccentricity.

    For example, VC does not reward following patterns or navigating market movements, neither of which is relevant to decade-long cycles. Consensus of pretty much any kind is toxic, as the more people agree with something the less profitable it becomes. Investment experience is like comfortable entropy, slowly eating-away at your ability to remain objective.

    In a sense, success itself is antimemetic: the better the outcome of an investment, the more likely you are to try and repeat it through pattern matching — destroying the calibration which allowed you to find it in the first place.

    Can you imagine how maddening that is?

    This is why the best GPs are oddballs. They live with the paradox that being a ‘good investor’ is a process of constant discovery, and the more lost you feel the better you are probably doing.

    It takes a certain madness to do well, and that is not something you can pick up on the job. You cannot be taught how to think in a contrarian manner. Nobody can give you the confidence required to wait a decade to see if you have good judgement. You have it, or you don’t.

    This is why great VCs earn a lot of respect. The role they play in financing entrepreneurial dreams is critical. From the semiconductor origins of Silicon Valley to SpaceX and our future on other planets, someone had to be there to write the check.

    If the incentives were well aligned, that’s where this story would end — as a fan-letter to weirdos. VC would remain a cottage industry investing in wacky stuff, offering strong returns for LPs.

    Unfortunately, that is not the case.

    Over the past decade we’ve seen the emergence of a new type of VC: one who moves between trends with the swagger of a heat-seeking missile, investing as if their money might go bad. This behavior is contrary to pretty much everything that we know about venture capital, and yet the trend has only accelerated.

    To understand why, we have to look at VC compensation:

    The ‘2 and 20’ structure of VC compensation is pretty well understood and has remained unchanged for a long time: You get 2% of the fund per year in ‘management fees’ to pay your bills and support portfolio companies, and 20% of ‘carried interest’ as a share in any profits made.1

    For people passionate about the outliers, carried interest is the hook. Secure enough big wins and you can make a vast amount of money, in contrast to management fees which aren’t exactly lucrative for a small fund. It’s also nice that carried interest aligns success of the firm with success of the founders.

    However, as capital flooded into private markets over the last couple of decades, and exits took longer to materialise, some cunning individuals recognised an opportunity: the 2% is guaranteed, independent of performance, and it is possible to ‘hack’ venture to maximise that income.

    You can do things the old fashioned way, raising (for example) two $100,000,000 funds in a ten year period, with the implied annual income of $4,000,000. Alternatively, you can squeeze three funds into that period, at double the size, and scale your income to a mighty $12,000,000. All without really needing to worry about underlying performance.

    To build that second scenario, you need to do three things:

    • Invest in the most overheated, capital-intensive industries, which allow you to justify raising and deploying larger funds ever more quickly. These industries are also an easy-sell for LPs, who want something to talk about at dinner parties.
    • Systematically undermine the understanding of valuation by promoting crude and illogical practices, and calling people nerds if they say things like “free cash flow”. Venture is a craft, not a science — which basically gives you carte blanche, right?
    • Pour capital into brand and status building for your firm, which LPs love. Celebrities, political figures, impressive offices, big events… Anything that shows them you’re a serious institution (with the perks that entails) and not some garage-band firm.

    Instead of looking 8 to 16 years in the future with your portfolio, you want to focus on the next 2 to 3 years in order to align with your fundraising cycles. You want companies that are likely to grow in value rapidly in the near future, so hype and consensus are powerful allies.

    The aim is to invest in a company at Seed and propel it to a Series A within 2 years at a 4-5x markup, which — if you can repeat it often enough — will look great to LPs. If they ask about DPI just talk about how the IPO markets should open next quarter next year.2

    It doesn’t even matter if you don’t think your portfolio companies are attractive investment with that markup, as there’s no obligation to participate. You have the growth on your books to help you raise the next fund, and some compliant downstream bag-holders, that’s all that matters.

    You can even build this strategy into how you price deals. Rather than try to objectively value the business, just tell founders to think about what a reasonable Series A price would look like for them, and then divide it by 3 for the Seed. That way, you’ve got the expectation of at least a 3x markup already built-in to the investment!

    You want to make sure the heat persists, to ensure prices at later stages remain frothy and your markups get better and better. So consider a bit of thought leadership to keep interest on your chosen sector. As long as LPs believe the hype, and keep investing in other funds on that theme, capital will keep piling in. Amplify that market momentum as much as possible. Volatility is your friend, and over time it can even help you wash out smaller managers that offer an unfavourable comparison on performance.

    Obviously the actual investment returns from this strategy are likely to be terrible, unless you’ve somehow timed another ZIRP/2021 exit phenomenon and can unload all of your crap on the public markets just before the music stops. It doesn’t really matter, because the median return in VC is so poor that you might just luck your way into top quartile anyway. Keep the paper marks strong, keep bullshitting LPs about the market conditions and the insane potential of whatever it is you are investing in, and you can probably keep buying back in with a new fund.

    It’s going to be toxic to founders, as they watch huge piles of capital being incinerated chasing hype instead of genuine innovation.

    It’s going to be toxic to innovation, as founders increasingly choose to pursue ideas that they think VCs will back, rather than real passion projects.

    It’s going to be toxic to VCs, as good practices around markups, pricing and portfolio management are ditched in favour of capital velocity and short-term incentives. It’s already frighteningly clear how much basic investing knowledge washed out of VC during ZIRP.

    It’s going to be toxic to LPs as already pretty shitty performance metrics for venture capital get even worse.

    1. The management fee is often frontloaded and scales back after the investment period. The 20% carried interest may also have a hurdle rate (e.g. 8%) which guarantees some return on investment for LPs before they split profits with the VC. [↩]
    2. It might not matter though, as many institutional LP allocators collect their bonuses on markups, so their incentives are totally aligned with yours. They’ll probably have moved on to a new job in a few years anyway. [↩]
  • VC has trust issues, not a liquidity problem

    VC has trust issues, not a liquidity problem

    In a strange twist for an asset class built on patient capital and outsized returns, finding liquidity for investors has become a matter of urgency for VCs.

    On the surface, this is a story about venture capital’s evolution and fund managers adopting more sophisticated liquidity strategies. Pry a little deeper, and you’ll find LPs reneging on capital commitments, pushing VCs to secondary markets and expressing disappointment with activity over the last few years. Now, some just want to cash out. 

    Gradually, and then suddenly

    The average age of private companies exiting through an IPO has advanced from 7.5 years in the 1980s to 11 years in the 2010s, as both regulatory and macroeconomic factors have brought more capital into private markets.

    The cash-rich environment allowed companies to grow into loftier valuations with relatively little scrutiny, while benefiting from the scrutiny of their public peers. For many this seemed like a winning strategy, with projected outcomes that were often jaw-dropping, and some VCs began talking about 15 year liquidity horizons. Significantly, there was no outcry from LPs; distant horizons were the name of the game, and the theoretical scale of returns bought a lot of patience.

    Large private firms are thriving in part by freeriding on public company information and stock prices. Such firms’ astonishing ability to attract cheap capital may last only so long as public companies continue to yield vast, high-quality information covering a broad range of companies.

    Elisabeth de Fontenay, Duke Law: The Deregulation of Private Capital and the Decline of the Public Company

    So why the sudden pivot to seeking liquidity in the last two years? Why are investors now so concentrated on returning capital? Is there more to this story than interest rates?

    Overheating the market

    The basic proposition of venture capital is that LPs commit a certain amount of capital to a VC fund and are returned some multiple of that over the following decade.

    There are two unique considerations for potential investors in venture capital:

    1. VC firms will typically deliver weaker returns over subsequent funds, with many top performers being emerging managers with smaller funds. 
    2. The asset class lacks a meaningful standard for measuring current fund performance, with firms ‘marking their own homework’ to some extent. 
    Pitchbook: Private market fund performance

    This combination makes it challenging to identify promising VC funds; track record is unreliable and performance is opaque. What remains for LPs is networks and trust, explaining why so much focus is put on relationships. These relationships, and over a decade of ultra-low interest rates, have allowed VCs to get away with longer periods of illiquidity and slipping rates of return. 

    The assurance offered, in place of returns, centred on the mounting theoretical value of venture portfolios. Venture-backed companies were raising vast sums from investors who thought of valuation as an ‘arbitrary milestone’ in the process. As long as the number kept going up with each new round, the investment looked good. This approach allowed VCs to raise ever-larger funds, extract more in fees, deploy more capital to inflate valuations further
 and the wheel kept turning.

    In theory, LPs were set for historic returns, as soon as those companies hit an exit. 

    The venture funding freeze 

    How many poorly-performing tech IPOs does it take to put public market interest on ice? In 2022, we found out. 

    While some point the finger at interest rates for spooking investors towards the end of 2021, the evidence of a correction was there from earlier in the year as many high-profile tech IPOs saw a rapid collapse in share price. There was a clear disconnect between tech valuations and a public market which no longer had faith in what they were being presented. 

    Crunchbase: The Biggest IPOs Of 2021 Have Shed 60% Of Their Value

    This was the consequence of venture capital’s exuberance. Shifting the focus to crude measures of current value had corrupted pricing discipline to the extent that exits were no longer viable. Any path to liquidity required coming to terms with huge markdowns, backtracking on the promised returns and damaging the trust of LPs.

    To say that, in hindsight, it would have been a good idea to sell more stock in 2021 is to ignore the underlying irrationality. Had VCs been inclined to sell, valuations wouldn’t have been so high to begin with. 

    It was not that the strategy was bad, it was that there wasn’t one. 

    The path ahead for venture capital

    VCs created this liquidity squeeze by exploiting an opaque market and increasingly divorcing price from value. This is precisely what needs to change in order to foster a healthy secondary market: greater transparency, discipline on valuation.

    Specifically, a secondary market will only work if it is perceived to be where VCs sell their winners at a reasonable price, to account for shifts in risk profile outside of their portfolio focus. In this scenario, the incentives are built on transparency. Conversely, if the perception is that secondaries are for firms to offload companies that investors have lost faith in, then the incentives are built on obscuring or misrepresenting performance. That asymmetry leads to adverse selection and the slow death of any market it touches. 

    The future of venture capital has to involve greater transparency and stronger standards, to rebuild relationships with LPs, enhance market efficiency and access to liquidity. That vision requires the careful consideration of incentives, built on a fair and rational approach to understanding the value of venture investments. It means eliminating trust from the equation. 

  • The failure of due diligence (in Fintech)

    The failure of due diligence (in Fintech)

    For as long as there has been business, there has been fraud, and ‘cooking the books’ is about as old as it gets. In recent years, the extreme focus on revenue has produced dangerous incentives for founders and investors to cut corners. Those chickens are now coming home to roost.

    Now a regular feature in tech media, we’ve seen a growing number of cases in which startups have been caught fabricating revenue (and associated metrics like accounts, deposits, transactions, etc). Given the focus on financial performance for venture backed businesses, it has left the impression that you might escape scrutiny if your numbers look good at a glance. 

    The most recent examples include Banking as a Service (BaaS) up-and-comer, Solid; financial aid startup, Frank; notorious cryptocurrency exchange, FTX; and mobile money interoperability provider, Dash. It’s not deliberate that all of these examples are Fintech companies, though it does appear that Fintech is the sector most commonly associated with revenue fraud.   

    (source: Contextual Solutions)

    Is this a consequence of the fundraising environment? Is there a deeper problem in Fintech?

    The pressure of hypergrowth

    While venture capital has taken a much more moderate tone towards growth in 2023, with mentions of ‘quality revenue’ and ‘sustainability’, this wasn’t always the case. Up until early 2022 the strategy du jour was raising huge amounts of capital at inflated valuations in order to fund aggressive growth to try and justify said valuations.

    Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis.”

    Bill Gurley, GP at Benchmark

    Nowhere has this been felt more keenly than in the Fintech industry, a darling of the venture capital industry since the post-financial crisis wave of evolution kicked off around 2010.

    (source: Pitchbook)

    The startup-led digitalisation of financial products, including the ability to scale at a rate far surpassing incumbents by using a different playbook (see how Revolut has scaled internationally by adhering to just the regulatory minimums), has driven incredible revenue growth for Fintech in recent years. 

    After achieving more than 500% growth in 2021, the juggernaut Fintech growth finally began to stall in November. We can speculate on the reasons, but the chief suspects are the impact of COVID’s Omicron variant on business confidence, the beginning of the current surge in inflation, as well as growing fears of deeper economic woes spurred by the pandemic. 

    None of those factors will be much comfort to founders who will continue to try and live up to the expectations of the extreme growth demonstrated in 2021. For many investors, the benchmark has been set and the goal is to return to it, for the sake of their fund performance.

    Smoke and mirrors 

    Even at the best of times you will see a range of behaviours, from subtle manipulation to outright fraud, in startup financials. With so much on the line, and relatively little accountability, there’s a clear incentive to cut corners.

    Combine that with the heights of ZIRP-drunk behaviour in 2021 and you will see real problems – even unintentional. An example of this would be PayPal’s admission that 4.5M fake accounts had been created to abuse their sign-up bonus schemes at the time. This admission was shortly followed by revised revenue projections, as they realised the huge outlay of capital was not going to yield the returns they had hoped.  

    (source: PayPal quarterly reports via American Banker)

    Consider also how startup investments have been priced in recent years, with revenue multiples becoming the easy shorthand for valuation. In a 30x industry, as Fintech was at the peak, $1M in revenue became $30M in value – and due diligence wasn’t keeping up. Revenue was poorly scrutinized to begin with, and now it was having an outsized impact on fundraising.

    The magnification of value produced a powerful incentive for founders to exaggerate revenue with any trick imaginable
  of which there are many: ‘round tripping’, reporting gross revenue rather than net, sketchy definitions of ‘booked revenue’, or treating discounts and refunds as expenses rather than contra-revenue events. For many, it became common practice to fudge revenue reporting (to varying degrees) in order to inflate performance and exaggerate potential.

    When I joined Flexport as co-CEO in September 2022, I found a company lacking process and financial discipline, including numerous customer-facing issues that resulted in significant lost customers and a revenue forecasting model that was consistently providing overly optimistic outputs.

    Dave Clark, former co-CEO of Flexport

    Unfortunately, conditions only worsened when the ZIRP-hangover began. After the leg-sweep of funding early in 2022, investors were briefly forgiving about slowed growth in the new environment but it didn’t last long. Today, founders are expected to live up to the kind of growth they had previously promised investors, without necessarily having the available venture capital dollars to afford it, all while angling more aggressively towards profit. 

    The crunch is real, and it will lead many founders to make bad decisions. 

    Challenges for investment due-diligence 

    A much discussed side-effect of the ZIRP-era coming to an end, with the collective tightening of belts in venture capital, is the resumed focus on proper due diligence with startup investments. This will include things like debt, leases and contracts, as well as the startup’s current and projected revenue. 

    This may already be catching out the lies from startups that exaggerate revenue to bump their valuation in a previous fundraising round, but it’s not always as clear cut. For this, we can look at the sordid history of GoMechanic, a startup caught in a revenue-faking scandal despite previously having sign-off on its accounts from Big Four accountants PwC and KPMG. The third time was the charm when EY finally managed to nail down where things were going wrong, including all kinds of accounting chicanery in a partially cash-based business. 

    This begs the question: how realistic is it for investors to catch-out revenue fraud for private companies, when there is so little in the way of enforced standards? Public companies are expected to adhere to GAAP (Generally Accepted Accounting Practices), but no such obligation exists for private companies. ASC 606 and IFRS 15 exist as revenue recognition standards for both private and public companies, but will continue to be ignored by startups for as long as they aren’t required by investors or properly scrutinised by board members. 

    For Fintech investors especially, this prompts the old debate about whether investors need to be experts in the industry in which they invest. If you are a partner at a financial services company (venture capital is really just a peculiar financing product), investing in financial services startups. should you not therefore have at least a minimum of financial literacy? 

    To go deeper down the rabbit-hole: there are questions about how much investors knew about some of these cases, before they were brought to light. When is it of interest to an investor to intervene, and go through the messy process of righting the ship, even when it may mean revising value downward for other investors, founders and employees? What if they just kept quiet, and let it be someone else’s problem?

    Diligence isn’t cool; do it anyway

    Increasingly, issues appear in the world of private company investment (and are amplified in the high risk/reward world of startups) which relate to a stark lack of transparency, accountability and regularity. 

    If venture capital firms invest in startups with the expectation that they will one day exit via IPO (and thus adhere to GAAP), why do they not require prospective investments and  portfolio companies adhere to those standards from day one?

    Startups are volatile in performance and unconventional by nature, making it impossible to standardise much about how they operate. In fact, I’d go so far as to say that conventional business wisdom is a plague on founders. However, much can be standardised about the ‘unsexy’ aspects of the fiduciary duty between founders and investors. 

    Founders are probably not jumping at the chance to apply accounting standards to their business. It is far easier, unless obliged otherwise, to sketch out an income statement with a  degree of improvisation. A certain amount of poetic licence goes a long way for VCs, too.

    However, it’s clear we are entering a new era for startups, with fresh scrutiny across the board – especially for Fintech. The world of startup investment is, slowly and painfully, moving towards greater levels of accountability. 

    We should also think carefully about the operating system of startup fundraising, and whether it really incentivises the best behavior and the best outcomes. I am a ‘techno-optimist’ in that I believe in the power of efficiently allocating capital to innovation… but that means real innovation, not monkey jpgs.

  • Deus Ex Machina

    Deus Ex Machina

    The success of AI is existential for venture capital

    Imagine entering VC in 2020, full of enthusiasm about a the unstoppable wave of technology. Your peers are impressed; it’s a prestigious industry that is perceived as commanding a lot of power through capital.

    You have to put aside your personal thesis in favour of the firm’s strategy on crypto, micromobility, rapid delivery, creator economy, and web3. Each of those sectors are benefitting from venture capital enthusiasm and weaponised capital, driving prices through the roof. It’s an exciting time, though you’re not feeling as involved as you would like to be.

    In fact, you’d quite like to make the case for investment in other industries; overlooked opportunities which offer larger ownership stakes and cleaner cap tables. It’s difficult to justify the change of strategy when the biggest markups are all coming from a few hot sectors, so you avoid the friction.

    Andreessen and Sequoia can’t be wrong, right?

    Capital is flowing into the asset class from LPs at an unprecedented rate. Rather than pressure to justify and properly diligence investments, you are pressed to ensure capital is deployed and opportunities aren’t missed. Access to hot deals and co-investment with the tier-1 firms is how you stay relevant to LPs. Success is now largely dependent on your relationships across the industry.

    It creeps up on you that your colleagues have stopped talking about exits. TVPI looks phenomenal. There’s no rush for any portfolio to go public. Now the conversation is about pricing and the appetite of downstream investors. Beyond that, it’s someone else’s problem.

    For the first time, your spidey-senses start to tingle.

    Early in 2022, concern ripples across the industry. Worries of recession, interest rates on the rise, and a weak public market that has lost interest in recent VC-backed IPOs. In simpler times, you would have papered over the cracks by highlighting fund resilience. Now, the idea fills you with dread. None of your portcos are growing much and auditors are on your tail to correct markups.

    With surprising speed, the tables turn. An era of unprecedented growth and optimism comes to an end. Y Combinator writes the eulogy with an open letter to their portfolio companies. Venture-backed hypergrowth is shelved in favour of finding a path to profitability. The red-hot sectors which had promised game-changing returns are quietly scrubbed from websites and bios.

    By Mid-2023, venture capital feels like a fever-dream. Many of the most exciting investments from 2020 and 2021 have imploded or recapitalised. Layoffs are the norm, even for many VC firms. Nobody in the arena wants to talk about why.

    Fortunately, nobody has to dwell on the cause of the downturn for too long: exciting new tech from companies like OpenAI and Midjourney provides the perfect source of distraction. A whole new gold rush to sell to LPs.

    The incredible possibilities offered by powerful, accessible AI models will spawn companies with growth potential not seen since the early years of Google and Amazon. It promises to easily turn-around a few years of poor performance for the venture asset class.

    Of course, there are nay-sayers. Not the doomers who speak of an AI-driven apocalypse, at least they buy into the incredible scope of the technology. They are believers. The real problem are the cynics.

    The cynic’s claim is that today’s “AI” is just an evolution of decades-long work on machine learning, neural networks and natural language processing. Yes, the hardware is a lot better, processing at scale is much easier, but fundamentally not a huge amount has changed. Models will be commoditised and commercial applications will favour incumbents who have data and distribution. It’s not the generational game-changer that venture capitalists claim.

    Those who believe the hype (or those whose career depends on it) preach the gospel of salvation for an entire generation of managers. The narrative battleground is shifted to the conflict between these two groups, the doomers and the boomers, away from the cynics who offer nothing but grim reality.

    Evangelism reaches new heights. Marc Andreessen who led the charge on the 2011 – 2022 bull run with his essay, “Why Software Is Eating the World“, proclaims even greater optimism with the publication of “Why AI Will Save the World“.

    It gnaws at you. Do you really believe? Do the numbers make sense, or is venture capital back at its usual bullshit? Is it your responsibility to just blindly support this as an insider?

    Worse, what if this fails too? The consequences for the venture asset class are difficult to contemplate.

    At some point, you are sure the music is going to stop.

    Until then, the only path you can see is to continue following your peers. As long as you are all doing the same thing, no failure can be pinned on you.

    …Right?

    Each day you scramble to find the hottest AI deals in your network and secure allocation. You keep making the same promises and assurances.

    You lean into the identity, blend into the herd. Any sense of irony in wearing the uniform disappears. You begin to believe.

  • Larian’s unfair advantage

    Larian’s unfair advantage

    This post was inspired by two things I saw recently:

    • Jonny Price of WeFunder, sharing their newly designed raise page, featuring some giants of tech like Substack, Mercury and Levels.
    • Xalavier Nelson Jr. of Strange Scaffold, commenting on the seemingly extreme success of Larian Studios, with the upcoming release of Baldur’s Gate, and imporing consumers that it not “raise the standard”.

    The connection between these two items is not obvious, but it is interesting.

    The lemon problem

    WeFunder, for the uninitiated, is a crowdfunding platform for (primarily) technology companies. It allows community-oriented startups to sell a small % of ownership to their users and supporters.

    Unfortunately, crowdfunding faces a stigma which some refer to as ‘the lemon problem’. Essentially, “why are you raising from unsophisticated retail investors when you could get backing from a top tier venture capital firm?”

    This signalling issue then discourages the best startups from pursuing crowdfunding, which (in theory) lowers the overall quality available there, reenforcing that crowdfunding is a negative signal.

    The problem with that concept is that it is dumb, and built on a decade of putting venture capital on a pedestal.1

    Crowdfunding, or ‘community rounds’ as Jonny would prefer, offers a path for users and supporters to become advocates with ownership and incentives aligned with your own. You can offer them perks, you can treat them as your Customer Advisory Board, and you can usually rely on them to help disseminate your message.

    Unfair advantages

    So where does this connect with Xalavier, and Larian?

    We’ll begin at the end, with Xalavier’s comment:

    Like a lot of people, I’m deeply excited about what the lovely folks at Larian accomplished with Baldur’s Gate 3, but I want to gently, pre-emptively push back against players taking that excitement and using it to apply criticism or a “raised standard” to RPGs going forward.

    Xalavier Nelson Jr. on the expectations set by Baldur’s Gate 3

    He goes on to cite a number of reasons why Larian has been advantaged in the development of Baldur’s Gate. Particularly, their experience with this style of game, and the importance of the IP they have secured from Wizards of the Coast.

    He’s right on all counts. Larian is – today – in an unparalleled position as a developer of RPG games. They have great experience, multiple studios, a supportive community, and a huge IP.

    You could, if you were a peer of Larian’s, a fellow game developer, feel a bit like they are operating in a league above you. That there’s an unfair advantage, and any comparison between their work and yours would be unfair. Punching down.

    Unfortunately, Xalavier stopped there. He didn’t finish the thought. He never asked why Larian has this advantage, to determine whether or not it is unfair.

    Kickstarting a dream

    Back in 2013, Larian was a relatively small games studio. They did ‘mercenary’ work for other studios to help pay their bills while developing their own string of medium-budget RPG titles.

    Their work was quality, but they couldn’t compete in the big leagues. Studios like Bethesda, Obsidian and Bioware were effectively household names, and threw resources into pushing the envelope of what RPGs were offering.2

    Larian were ambitious, though. Swen Vincke, the studio head, had been an RPG fanatic all the way back to Ultima 7, and he wasn’t done trying to carve a path in the genre. As they began developing their next title, Divinity: Original Sin, they ran into a problem: it was more game than they could afford to make, but they couldn’t afford to make any less. They needed a break.

    Funding for games is notoriously difficult. All of the costs come before you make a penny in revenue, and there are usually few indications that you’ve made something players want until release. Many games flop, and many studios fold. It’s not an attractive area for institutional investors. So Larian turned elsewhere, to their community, and the wider community of RPG fans.

    In 2013 they launched a Kickstarter campaign for Divinity: Original Sin. They aimed to raise between $400,000 and $1,000,000 to support development, by offering everything from ‘gratitude’ to an invitation to the launch party depending on how much was contributed. They clearly laid out what each benchmark in funding would mean for the game, and the player’s experience.

    They didn’t quite hit the $1,000,000 mark, but they did raise $944,282 from close to 20,000 individuals. An average contribution of almost $50 each, from a vast but not cash-rich audience, into the dream of a great RPG.

    It gave Larian the cash they needed to get Divinity: Original Sin out of the door, and it was everything they had hoped for: a landmark RPG which put the studio on the map, and laid the groundwork for everything they would do in future. Ultimately, their work inspired sufficient confidence from Wizards of the Coast to give Larian the rights to develop the Baldur’s Gate franchise with this hotly anticipated sequel.

    Community driven growth

    Over the next few years, covering the eventual launch of Divinity: Original Sin in 2015, the even-more-succesful sequel in 2017, and up until the imminent release of Baldur’s Gate 3 today, Larian has experienced the benfit of that crowdfunding round.

    More than any other factor, raising money from an audience of customers (and potential future customers) has meant that Larian has never had to compromise. They were not at the mercy of institutional investors or publishers to hit hasty development milestones or add supplementary revenue streams. They could build the game as they wished, by a group of RPG enthusiasts; for an audience of RPG enthusiasts. They are self-sufficient, and happily so.

    We’d tried multiple times with third parties and we listened to them every single time, and we had to learn that it was important that we took our own fate in our own hands. And since then, things have been going on the upside for us.

    Swen Vincke on developing Divinity: Original Sin

    This alignment of incentives between product and customer is fundamental. It’s how companies should work at the best of times, but the need for external capital can often complicate the relationship. Larian went right to the source.

    And that is their ‘unfair advantage’, that they were able to focus entirely on their vision to build a fantastic product.3 Exactly as every company should, in theory.

    Equity in the equation

    Larian’s crowdfunding success was built purely on the promise of what their product could offer to customers, and how additional capital would strengthen that proposition.

    In the world of startup financing, equity crowdfunding takes this concept and injects it with steroids. Revolut’s crowdfunding round in 2016 has since created more than 100 millionaires, and the company has attracted more than 4,000 retail investors to date.

    These may not necessarily all be users of Revolut, but they are individuals who believe in the future of the company, will recommend it to others, and will contribute to the future growth of the company.

    This is why I’ve long been enthusiastic about crowdfunding as a source of capital for startups. And while that includes the obvious consumer companies with network effects and tangible investor perks, it also includes many successful raises from business-facing deeptech companies who are producing radical innovation.4

    Be like Larian. Make community your unfair advantage.

    1. How is that going, by the way? [↩]
    2. And each had, in their own way, at a previous point in time, earned that place in the ‘big leages’. [↩]
    3. It has also allowed them, more recently, to build this supportive community into their development pipeline. Early access for Baldur’s Gate 3 will have lasted for an unprecedented three years before official release, during which time they have relied on that community for feedback and vital testing capacity. [↩]
    4. Why VCs are failing that sector is another subject, but if you’ve read many of my recent articles you may be able to piece that together yourself. [↩]
  • It’s all about identifying outliers

    It’s all about identifying outliers

    What startup investors can learn from sports betting

    Early stage investing is a complex and relatively new practice, which makes it fertile ground for analogies which can help explain the more abstract concepts to both newcomers and veterans alike. 

    In this particular case, grappling with the intrinsic value of pre-revenue startups, there’s an interesting parallel to sports betting. Fundamentally, both involve looking at the strength of a team and the competitive landscape and making a judgement on future potential.

    What we’re considering here is the idea that a startup – even a pre-revenue startup – has a determinable value even before that value has been tested in the form of a market transaction. This is also what you might call a ‘fair market’ valuation, which is what we aim for at Equidam. 

    MOIC vs. betting odds

    In early stage investing, investors will look to benchmark potential returns using a metric called the multiple of invested capital (MOIC). MOIC is calculated by taking the total potential return on an investment and dividing it by the amount of money invested. For example, with an investment of $100,000 in a company with an expected MOIC of 10, the company should have the potential to return $1M.

    In sports betting, participants measure their potential returns using the odds of winning, which represents the probability of success. For example, if the odds of a team winning a basketball game are 9:1, it means the team is assumed to have a 10% chance of winning and the return would be a multiple of 10. 

    Rewarding the earliest participants

    In both examples, the earliest (successful) participants receive the most lucrative returns. In investing, this is because early investors are able to get a lower share price than later investors. In sports betting, this is because early participants are able to secure better odds.

    In both cases, this is for the same reason: At the very beginning there is the least available evidence to indicate an assumed outcome, thus a greater level of perceived risk associated with the choice. This is true both in terms of signals from other participants (other bets or investments made) as well as actual progress in terms of milestones achieved, such as games won or revenue secured. 

    Qualitative and quantitative measures

    In early stage investing, investors use a variety of qualitative and quantitative measures to judge the potential of a company. Qualitative measures might include the management team, strategic relationships, and the competitive environment. Quantitative measures include things like the company’s projected financial performance, market growth and associated risk. This is reflected in the form of the valuation, which ultimately informs the potential return on investment.

    In sports betting, participants use similar measures to judge the potential of a team. That might include the team’s roster, their experience together, track record of the coach, and the threat posed by other teams. This is reflected in the form of a perspective on what the betting odds should be to provide appropriate upside for that level of risk.  

    What this means for early stage investors

    According to some, a startup does not have a valuation until it has been priced in an equity transaction. To an extent (in a strict and formal sense) that is correct. It does not itself have a valuation, because value is not an objective concept. Like beauty, it lies in the eye of the beholder. However, we shouldn’t pretend that an equity transaction represents an ‘objective’ read on value either; it’s also just the opinion of an investor.

    What this analogy illustrates is that you, as an early stage investor, should have your own personal read on valuation as a reflection of future potential. You need to understand the qualitative and quantitative factors involved, and determine a practical framework to run your own analysis. It’s the best way to sharpen your judgement on future potential, take an informed perspective on risk vs return, and put your money to better use.

    If you are investing your own money, it’s not crucial that your valuation framework be seen as objective or fair. Many investors look at valuation primarily in terms of market context and what other investors are doing. Others use simple heuristics like national averages adjusted with a few qualitative measures, even if that screens out some deals. Whatever approach you use, if it allows you to reach your desired level of returns then it is clearly working. 

    When being objective is important 

    Imagine it’s January 2023, and a friend is looking to place a bet on the upcoming NBA championship, and you – being wise and well informed – recommend putting money on the Denver Nuggets. This is a team which hasn’t won a championship in its 47 year history, and a year ago they lost in the first round, so the odds are great (in terms of MOIC) but your friend will take some convincing. 

    It’s in explaining this opportunity to another person that objectivity becomes important; your rationale must survive without the support of your own biases and perceptions. What are the data points which conclude that the Denver Nuggets have been overlooked or undervalued by the market? What is it about their 2023 roster and the wider competitive environment which indicates for success? How do you piece that into a compelling story for your friend? 

    This is, again, mirrored in the world of early stage investment. If you are looking for input on the potential of a startup – which has not yet been rubber-stamped in a market transaction – you will want to see it in a transparent, objective format which covers all of the key indicators. This is applicable in a range of cases, whether that is determining a valuation for the first round of a company, proposing a valuation to a group of angel investors, or reporting updated valuations to your LPs.

    This is where we finally arrive closer to assigning a ‘fair valuation’ to a startup, rather than the individual perspectives on valuation. Not a number determined by the combination of gut-feel and Excel-gymnastics designed to pattern-match past success, but something scrutable, explainable and repeatable. 

    Crucially, valuation can be incredibly useful even when it’s not associated with a market transaction. In fact, the single perspective of a lead investor on the value of a company is potentially less valid, and less reliable, than a more objective framework.1

    Backing outliers is the whole ballgame

    Early stage investment pivots around uncertainty and valuation is always a tricky exercise in assessing the tangible and the intangible. Reaching 100% efficiency in the risk/reward is never going to happen. 

    Similarly, your friend doesn’t have to buy every data point in your recommendation, they just have to understand what you are looking at, the conclusions drawn, and appreciate that it was a rational process with an outcome they can challenge or disregard as they wish. 

    Had they made their bet based on the odds at the start of the season, following the favourite as indicated by the market, they’d have lost their money. Had they waited a few months to see how each team performed in order to inform their judgement, they would have increased their chance to pick the right team, but with much lower potential returns.

    And that’s the argument in a nutshell. In order to understand an opportunity while the terms are most favourable, or to explain that opportunity to others, you need to think about practical and objective measures of future potential. Early stage investing is all about identifying outliers, like the Nuggets, which is precisely why we approach valuation from this perspective. 

    1. Especially given the extreme proclivity of investors to pass the buck, and base their pricing on other market transactions. [↩]
  • Startups are the clients of Venture Capital

    Startups are the clients of Venture Capital

    As a founder learning the ropes of venture capital, you might see VCs as asset managers, with LPs as their customers and your equity as the asset being managed.

    This is heavily implied by the chain of responsibility: you are required to report your progress to your VC investors who want to see milestones crossed and targets met. Similarly, VCs then have to report on the fund’s investments to their LPs. 

    It would be an odd relationship if customers were accountable to service providers, right? 

    Understanding the relationships

    When an LP commits to investing in a VC fund, they are typically locking themselves in for a ten year relationship. That’s three to four years over which they expect their capital to be invested, and six to seven years in which they hope they’ll start to realize those returns. This mirrors the kind of relationship you will have with a VC, which lasts a similar period of time from investment to exit. 

    In this context you might understand that LPs don’t really resemble a customer, and neither do VCs. Instead, they are the shareholders and operators of a specialized financing instrument for early stage companies. The relationship matters, updates are intended to prompt feedback, and success is shared. Crucially, both parties rely on the firm building a reputation for offering a good service, fair terms, and accelerating success stories. 

    Fred Wilson of Union Square Ventures shared more of the VC perspective on this in his 2005 blog post:

    The entrepreneur creates the value, they are the ‘raw material’ in the venture capital business.  If there were no entrepreneurs, there would be no venture capital business.

    Fred Wilson of Union Square Ventures, in “The VC’s Customer“

    How this shapes fundraising

    It can be difficult to view this from the perspective of a founder, as it assumes you are in a position of control – an odd fit with the usual perception of the venture capital process. Isn’t fundraising all about struggling with an endless string of rejections? Again, the bigger picture allows us to see how the relationships really function.

    Healthy markets rely on consumers having freedom of choice, and this is where venture capital suffers from an image problem: When you’re hammered with messaging about how slim the odds are for success, it can seem like raising money from a top-tier firm is the most important signal for success. The moth-like attraction to the top of the market means those firms are swamped with pitches and thus issue even more rejections.1

    However, if you look at venture capital as a marketplace of firms looking to service startups, you might be more inclined to think in terms of practical comparison. Ignoring the logos, who can best serve your particular needs? Where are the hidden gems and less obvious bargains?

    Consider consumer brands, where bigger companies tend to be worse at serving more specific (more technical, higher performance) consumer needs. A larger target market implies more mainstream use cases, and your brand often becomes more important than the performance of your products. At that point, there are likely to be smaller brands that outperform in a particular niche where their expertise makes a difference.

    This is a reasonable metaphor for venture capital, illustrating the benefit of approaching fundraising as a customer looking for a solution rather than an entrepreneur with their hat in their hand. As with any transaction, you are looking for the best bang for your buck, and smaller specialist funds are likely to deliver exactly that – for all sides of the transaction. 

    Highly specialist portfolios from young firms have a top-quartile hit rate of 61%, representing a 2x increase from the most generalist portfolios.

    Liam Shalon of Level Ventures in “Outperformance in Early-Stage Specialist Firms: A Data-driven Analysis“
    Photo by Victoriano Izquierdo on Unsplash

    1. And often lose focus on the fundamental role of VCs: financing innovation, not shaping the future. [↩]
  • LPs should encourage VC evolution

    LPs should encourage VC evolution

    In a previous article I wrote about the threat of consensus in venture capital.

    A few days later, Eric Tarczynski shared a fascinating thread about the journey with Contrary, his VC firm. He addressed this point about consensus with admirable candour, summarised here in two points:

    1. Raising from LPs is easier if you have recognisable logos attached to your previous funds. Success is measured by which big names in VC co-invested with you.
    2. Raising from LPs is easier if they get good references from their existing VCs. So you send deals to them, network with them, and co-invest with them. Success is measured by relationships.

    It’s unusual to get such an unvarnished look at the inside workings of venture capital, and the thread elicited a number of reactions. Most agreed it was a tough pill to swallow:

    Eric’s awesome but boy is that thread a pretty damning look into the inside-baseball-nepotism that starts from the top (LPs) and infects the whole VC ecosystem.

    Luke Thomspon [source]

    ‘We thought that being good investors with a unique thesis that actually makes money would be the best strategy, turns out, following the herd, piling onto garbage, and being unquestioning vassals to incumbent investor power gets you a larger fund’ – My interpretation

    Del Johnson [source]

    There’s an elephant in the room in all of this. Or perhaps it’s a bull in a china shop. Either way, everyone seems to be ignoring it and it’s doing a lot of damage.

    Weak signals

    From pre-seed to IPO, there is no consistent, transparent measure of success. That’s a long time for a GP to deploy capital without any concrete metrics for success. How does an LP ascertain if their money is being put to good use?

    Samir Kaji of Allocate (and former SVB MD) shared his take on the problem that LPs face:

    LPs are programmed to use past track record as the primary driver in making a decision on whether to invest in a new fund (A recent study showed historical persistence of VC is that 70% chance a fund performs above median if prior fund is 1st Q). However, more than ever, track record can be a very weak indicator if the fund is within <5-7 years.

    • Spread of how VCs are valuing the same companies is large.
    • Current TVPI to final DPI delta will be large for many funds, and some funds have resilient companies; others are filled w/companies that were pure momentum (but still marked up).
    Samir Kaji, Allocate

    There is an obvious desire from both sides to find something to show. As Luke put it, “we can pretend it’s all about independent thinking, non consensus and right, etc, but when you’re going out for Fund 2 and on a stack of unrealized, LPs want other signals.”

    This is why we end up focusing on ‘logo hunting’ and co-investment culture. If we’re all a gang, and we back each other up, then we’ll maintain the confidence of LPs. Meanwhile, the LPs are probably feeling a degree of comfort from investing in a few different funds, without realizing how intermingled and codependent they are.

    As Chamath Palihapitiya wrote in Advice to Startup Founders and Employees: Strength Doesn’t Always Come in Numbers:

    As it turns out, what VCs of the past decade assumed to be market alpha may have actually been market beta (i.e. fellow venture funds bidding up the same cohort of companies over several funding rounds).

    Chamath Palihapitiya, Social Capital

    This is clearly an undesirable outcome for LPs: The data for measuring venture capital fund performance is flimsy and creates a huge perverse incentives for GPs. This is clearly not good enough when so much capital is at stake. Especially when it involves pensions funds and university endowments. It’s a bad look for everyone.

    The final nail in the coffin here is how current practices can create a reality-distortion field around actual performance: in effect, a company’s ‘public’ valuation only changes when they want it to. This was outlined at length in a thread from Anand Sanwal of CBInsights, which included this slide from SVB:

    This is on the mind of every LP at the moment. What do their ‘paper’ returns from 2021/22 actually mean anymore? What will happen when the companies they are invested in via VC are forced to come to terms with reality?

    Meaningful benchmarks

    When you start talking about standardising anything in venture capital, there’s a reliably cold response. Everybody likes to believe they have their secret sauce, their intuition, their process, their edge over others… despite all signs pointing towards none of that changing the outcome.

    When you talk about measuring the performance of early stage companies, that’s when the real pushback begins. There’s too much uncertainty. It’s too unreliable. Projections are always a pipe-dream.

    There’s one simple response to these concerns: “Perfect is the enemy of good“.

    If you open yourself to new ways of looking at valuation (it’s not just about “market passing”), and new ways of performing valuation, you will find that there are practical, systematic frameworks to measure and report the development of private companies.

    Don’t get twisted up about producing an “accurate” result for an early stage company, it is foolishness – and not the point. The goal is to provide solid, useful benchmarks which can be calibrated against the market in a transparent manner.

    For an example of how this might be achieved, I will always recommend a read through Equidam’s methodology. It combines perspectives on verifiable characteristics via the qualitative methods, the exit potential via the VC method, and the vision for growth via the DCF methods. All packaged up into a nice, comprehensive report.

    What standardized reporting does for the LP/VC relationship

    If you can imagine a world where VCs produce quarterly reports on fund performance using a standardised framework, there are a number of profound benefits:

    1. LPs could better assess the performance of their existing VCs, creating more of a meritocracy.
    2. VCs would have an easier time raising, in addition to shortening their own internal feedback-loops to improve decision making.
    3. Moving away from current lazy valuation practices (ARR multiples) would help avoid extreme fluctuations in valuation, as we’ve experienced since 2021.
    4. It will (slowly) kill the dinosaurs, the giant firms which played a part in the development of this ecosystem and all of its flaws.
    5. A move towards transparency – especially around valuation – would be timely, as the SEC’s gaze falls on venture capital.
    6. There are also interesting considerations for liquidity in secondary markets serving private company equity, but that’s a whole post of its own.

    Conclusion

    It seems clear to me that this change will not come easily to venture capitalists, who are either comfortable with the status-quo or simply find it convenient. However, it might be possible for LPs to set new terms as market dynamics have shifted power in their direction.

    Still, this is a difficult argument to make. I’m suggesting no less than upending how much of venture capital operates, and I’m doing so from the position of a relative outsider.

    But I guess that’s the point? Venture capital has been a closed ecosystem for too long, full of esoteric practices shaped by a relatively tiny group of individuals. There is plenty of room for improvement, especially if we stop getting hung up on the need for ‘perfect’, when the current status is ‘poor’.

    Finally, a bigger point than any of the six I mentioned previously: if this makes us better at allocating capital to innovative ideas, and innovative people, then it’s got to be worthwhile.

  • Generative AI and the Games Industry

    Generative AI and the Games Industry

    This post looks at applications of generative AI in the context of the games industry, but much of the same logic can be applied elsewhere.

    Adapting to technological evolution

    With every new technology revolution – web3 most recently, and now AI – there follows a large herd of true believers. It can do all things, solve all ills, and life will never again be the same again. Enamoured by possibility, they follow with a true sense of opportunity.

    Loudest amongst this herd (and most critical of nay-sayers) are the wolves in sheeps’ clothing. The rent-seeking charlatans.

    This was explicit in the get-rich-quick era of web3, and much of the same problem has transferred over the AI as techno-pilgrims flee one sinking ship to pile into another.

    Secondly, on the other side of the coin, are the cynics. People who were raised on 56k modems and bulletin boards, who feel a deep discomfort as technology moves beyond their grasp. They felt like the rational resistance to web3, and so have little hesitation about weighing in on AI.

    We have to be conscious of both groups, and our own place on that spectrum.

    Why the games industry?

    There are three main reasons I’m keen to address the games industry as the case-study for this post:

    1. As with web3, AI is being shoved down people’s throats without due concern for why.
    2. It is largely focused on a young audience who are absent from these conversations.
    3. It connects with my personal experience in the games industry.

    If you want to read about the potential use cases for AI in banking, you’ll find a thousand thought-leader think-pieces. It was well-covered ground without much original thought even before ChatGPT came along.

    If you want to talk about the potential use cases of AI in the games industry, you’ll find some ex-crypto VCs and technologists trying desperately to pivot their brief experience. Insubstantial waffle.

    Perfection is the enemy of good

    Dealing with the more exciteable technophiles, you’ll probably notice they don’t show a lot of interest in the complex applications. Their interest is in the most extreme examples of movies, games or books being entirely generated by AI (or entirely decentralized, yada yada).

    Their point is simple: if AI can do these things crudely today, then tomorrow it will be able to do them well – and at that point we’ll be forced to embrace the bold new future. Right?

    This fallacy can be observed in every parent watching their child smear paint on paper for the first time: something inside them says ‘they could be a great artist’. It’s true: the ability to manifest art can be that simple, and the child has huge potential for improvement… Yet it’s still not going to happen for all but a miniscule few.

    In both cases, the AI model and the child, there cannot merely be push, there must also be pull. There must be a need being met. An appetite being satisfied. And 99% of the time, there isn’t. Once the novelty has worn off, nobody has any interest in watching an AI-generated movie, reading an AI-generated novel, playing an AI-generated game, or looking at your child’s paintings. There just isn’t a call for it.

    Instead of putting AI on the pedestal of a godlike creator, we should look at where it can be a tool to solve a problem.

    Merchants of fun

    You can get side-tracked in talking about experiences, socailising, adventuring, exploration, curiosity, challenge, status… Ultimately, games are vehicles for fun. That’s bedrock.

    Is an AI-generated game likely to be more fun than the alternative? No, of course not, and if you suspect otherwise then you’ve not spent enough time with the wonderful and wacky people who make games. They are true creatives.1

    Any application of generative AI to the games industry must have either enhance fun, or enhance the developers ability to deliver it.

    Exploration

    If you look at games like Minecraft or 7 Days to Die where you can explore a proceedurally generated world, it’s easy to see how generative AI might be able to supercharge that environment building.

    It’s worth considering, though, that this is a specific approach for a specific type of game. As good as these engines have gotten, most of the time games will require a more ‘designed’ world, with geography or features which play into gameplay mechanics, story elements or IP. Generative AI may offer tools to make this more efficient (as many proceedural tools already do), but is unlikely to replace it entirely.

    Socialization

    Imagine walking around a Skyrim or Cyberpunk style sandbox-world, full of NPC characters with their own unique look, voice, and personality. Each able to hold a conversation with you, flavoured with their own specific personality and knowledge. Not merely giving canned responses to pre-defined prompts, but able to interact fluidly with you and amongst themselves.

    Again, this is unlikely to ever be all a game needs. Stories still require specifcally designed characters with particular roles which need to be shaped by the intention of writers and a design team, but it is still a tremendous opportunity to solve the social component of virtual worlds.

    These are two quickly-sketched examples of how generative AI could enable a leap forward in the experience provided by games devleopers – and I am sure there are many more to be found.2

    Tapping into the market

    I wanted to do this in a more subtle manner, but it’s just more practical to break down Andrew Chen’s Twitter thread:

    Games can take 3+ years to build, and technology adoption happens at specific windows of time

    If your generative AI tool is a plugin (for the Unreal Engine, for example) then a studio can pick it up at any time and add it to their development stack.3

    You shouldn’t be limited to thinking in terms of ideas that are ‘disruptive’ to how games are made, and indeed most of the opportunity may be in ideas which are complimentary.

    indie games make little $. There’s only a few scaled players, who will always push on pricing

    If you were going to target indie developers it would have to be with a very specific value proposition and business model (e.g. Unity in 2004). There’s no reason to worry about this otherwise; there are enough larger studios.

    the games ecosystem is insular, with its own conferences, luminaries, and networks / networking” in the games industry often involves, well, gaming. Are you good at Valorant? 🙂

    Can you tell me an industry which doesn’t have its own conferences, luminaries and networks?

    The games industry is not insular, and it is comical to characterize it as a bunch of nerds playing games together. It’s a wonderfully open, social and diverse community.4

    a large % of game cos have artists and creative people. Many are threatened by, and oppose, AI tech

    I don’t know of anyone in the games industry, artist or designer, who isn’t starry-eyed at the possibilities of what AI can enable.

    They are also familiar enough with how games work to recognise that human input is always going to be required to shape and polish the human experience which emerges on the other side.

    you need to generate editable, riggable, high-quality art assets. Right now assets are idiosyncratic and hard to edit

    Generative AI has not yet proven that it can generate useable assets, never mind well-optimised thematic assets. That problem can probably be solved, but to what end?

    Will a world created by a generative AI ever truly feel interesting, coherent, beautiful? Maybe there are better things for it to do?

    large publishers often provide tech to their internal studios. They’ll partner to learn about AI, but will try to build in-house. Is your tech defensible?

    That might have been the case 15 years ago, but the vast improvement in game engines and tools has meant that developers are much more likely to build on existing platforms.

    If a publisher believes that a tool would make development cheaper and faster then they’ll support it without blinking.

    large gaming cos care a lot about their models and data not being shared across the industry. How do you guarantee that? / they also care that their models are trained on data that’s safe from a copyright perspective. There’s lots of hoops to jump through

    Stretching a bit here, but: You train your tools on an open set of data to the point where they are useable, and allow developers to provide additional training based on data from their own IP. In that scenario there is no reason for crossover between studios.

    It’s unlikely that training from one game would ever be useful to the application of the AI in another. It is probably more likely to produce undesirable results.

    Conclusion

    Some years ago an associate of mine went to interview for a job at a games company in Seattle. The interviewer had previously been the lead designer on Starcraft, and naturally expected the candidate to play a match against him while fielding questions about the role.

    The games industry is full of these amusing anecdotes of quirky behavior, and there is a pronounced culture associated with that. However, it is condescending to think that culture stands in the way of progress, or that games studios can’t engage with business and technology partners in a perfectly competent manner.

    If you make a useful tool which solves a problem for the games industry, you will be able to access the right people to make a sale. I’d go so far as to say it’s probably easier and faster moving than many other industries.

    If that is your aim, make sure you are spending enough time talking to games developers, learning about how games are made, understanding the player mentality, and the problems that you might be able to address. As always, finding product:market fit can require a lot of learning and iteration.

    Most of all, ignore the false prophets who were reading from the web3 gospel just a few months ago. They will just ride this trend until something else comes along.

    1. Yes, throughout this article I am drawing a deliberate and passive-aggresive distinction between ‘creating’ and ‘generating’. [↩]
    2. It bothers me that I covered Explorers and Socializers, but didn’t have the time to identify anything for Achievers and Killers. [↩]
    3. And in most mid-large studios there are usually multiple teams running in parallel focused on different projects at different stages of development. [↩]
    4. The irony of a venture capitalist calling the games industry ‘insular’ is not lost on me. [↩]
  • Why venture capital should be consensus-averse

    Why venture capital should be consensus-averse

    In The General Theory of Employment, Interest and Money, Keynes wrote about investment through the metaphor of a newspaper contest to select the six best looking people from a group of photos, with the prize being awarded to the contestant whose choice most closely corresponded to the average of all contestants.

    Keynes’ point was that, despite the clear and simple instruction, contestants are actually not inclined to consider which of the photographed people are the best looking. Rather, they now consider a third-degree perspective of ‘what would the average person imagine that the average opinion is?’

    We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

    John Maynard Keynes, Economist

    In A Simple Model of Herd Behavior, Abhijit V. Banerjee examined the inefficiencies created when decision making becomes reliant on signals from others. We become inclined to abandon our own data, in favor of prioritizing signals which themselves may also be based on nothing more than another prior signal. 

    If decreasing returns (average payoffs decline as the number of people who choose it increases) tends to reduce herding, one would expect increasing returns, which rewards doing what a lot of others are doing, to increase the tendency to herd. This is indeed what we find.

    Abhijit V. Banerjee, Ford Foundation International Professor of Economics at Massachusetts Institute of Technology

    There are a number of social psychological drivers of this behavior, but the most obvious are our desire to associate with popular choices, and the greater dispersion of responsibility if that choice proves wrong. 

    Consensus threatens innovation

    Generally, herd behavior is problematic in how it undermines sound judgment and rational choice, though by nature it tends to be low-stakes and risk-controlled. For venture capital, this innately human behavior should be viewed as an existential threat, running contrary to the needs of effectively identifying and funding innovation. 

    If no great book or symphony was ever written by committee, no great portfolio has ever been selected by one, either.

    Peter Lynch, former manager of the Magellan Fund at Fidelity Investments

    The root of the name venture capital, as Evan Armstrong reminds us in Venture Capital is Ripe for Disruption, is adventure capital. It’s only really an adventure if you’re not sure of the destination, and backing innovation is exactly that: you are straying into the unknown; high risk, large potential reward. 

    The classic archetype of a venture capitalist, fitting with this concept, is a highly perceptive and analytical individual who can evaluate all kinds of oddball, out-of-the-box startups and identify the ones with potential. Someone who sees opportunities where others do not, who does not care about (or actively avoids) pattern-matching with past successes, and who ignores the noise of signals from their peers.  

    There is an old saying in enterprise software, “No one is fired for buying IBM”—people mitigate risk for their decisions by choosing the consensus option.

    This occurs even in the supposedly risky world of venture capital.

    Evan Armstrong, ‘Reformed’ Venture Capitalist

    Hunger drives herd behavior

    In recent years, as the appetite for cheap capital grew to unsustainable heights, venture capitalists became preoccupied with following external signals to ascertain whether the market would agree to provide capital to their portfolio. Would their peers validate their investment choices? Would prospective LPs recognise the value of earlier investments if they weren’t shared with other respected names? Herd behavior crept in with pernicious effect; the seductive comfort of piling into seemingly safe deals with other investors. Manufacturing winners. 

    As long as downstream investors continued participating in the game of artificial value growth (and why wouldn’t they) it was still a good model, right?

    As long as the (paper) returns were good, it was still venture capital, right?

    We know how that ended. We also broadly know why it ended (crude valuation practices, interest rates making capital more expensive, exit markets rejecting inflated prices
 etc). The question we should ask now is what can be done to stop it happening again? 

    Learning from mistakes

    Anyone involved in investment of any kind should be aware of the way signals should be handled (with oven gloves). It is valuable input that can shape an investment decision but shouldn’t drive it. For venture capital, that might mean reevaluating everything from deal flow management to valuation practices. 

    • Are the majority of your deals sourced through referrals from other investors?
    • When evaluating potential investments, how dependent is your conviction on recent similar deals? 
    • How much analytical rigor are you applying to the individual nature of each opportunity?
    • When setting valuation, how much do you rely on crude ARR multiples?
    • How much does the VC Twitter echo-chamber shape your approach to early stage investment, generally? 

    These might seem like basic questions, but there is clear cause to begin a first-principles reevaluation of how capital is allocated to ideas and founders. The responsibility is to effectively fund technological progress, not to exploit an uncertain market for short-term gains.

    A new approach, with a more analytical focus on individual businesses, may seem unrealistic: too much time involved, too much uncertainty. To that, I’ll close on three points:

    • Startups in 2023 are running leaner. The great hunger for capital is over, for now. That opens the opportunity to strike out and make fund returning deals without needing to drag other investors along with you. Your ability to identify winners (not simply agree on them) matters more than ever.
    • There are tools and frameworks which make analysing startups in detail much more practical (Equidam is an obvious example). Build a process which lets you collect data about opportunities and decisions, allowing you to develop and codify your experience.
    • Reconsider industry dogma about practices and perceptions (for example: about financial projections at early stage). More data = better decisions, you just need to pick the right lens to derive the right value.

    As many have said, the 2023 vintage has great promise. Particularly for investors who best adapt to the new conditions.

    [EDIT 26/03/2023: Adding a link to Chamath Palihapitiya’s article about herd behavior in venture funds and the risks involved. It’s a much more analytical perspective, which you can read here.]

    [EDIT 22/06/2025: Adding an overdue link to Geri Kirilova’s article about enmeshment in venture capital, providing another perspective on this problem, which you can read here.]