Venture Capital is Unraveling (March 13, Resolution)
Resolution will be a weekly series at the intersection of economics, Web 3.0 and venture capital. Views do not reflect those of my employer. This week’s subject is on one of my favorite topics, market design, and how it shows that Silicon Valley is getting too smart for its own good.
In the book Who Gets What ― and Why: The New Economics of Matchmaking and Market Design, Alvin Roth identifies a trend in the 1980s where law firms were making offers to students upon acceptance to law school. Roth writes:
Those firms undoubtedly would have liked to see how their prospective hires actually did in law school — but they worried that if they waited, other firms would snap up the best talent before them. So they told themselves that if Yale Law School wanted a student, that student also had a strong chance of becoming a good lawyer
This was a suboptimal situation for all parties involved. The students were forced to make a career-defining decision earlier than they were ready for. The law firms were forced to extend job offers to students without seeing their performance in classes that would ostensibly prepare them for those careers. Roth calls this characteristic unraveling: when transactions in a marketplace occur inefficiently early.
Marketplaces still accomplish their purpose even as they unravel. After all, both parties choose to opt-in. Students want jobs and law firms want a chance at the best talent — and those desires were met.
In an irrational market, it is rational to make irrational decisions.
However, unraveling leads to market failure. The bubble pops. Law firms end up with poor employees and students end up in bad situations. Eventually, an external force must act upon the system to bring it back to balance (in this case, the National Association for Law Placement).
Enter venture capital à la Silicon Valley, where everyone wants to be contrarian and they do so by mimicking their favorite underground thought leader, which they found through the retweet of a prominent VC on Twitter.
The current ‘red pill’ of VC lies in the palm of Basecamp CEO Jason Fried, who has built a brand on the claim that venture capital is killing startups. The movement rallies against blitzscaling and pushes a viciously minimalist approach to business— sustainable growth at all costs. As the story goes, the industry is a vicious cycle of founders accepting checks that are too big and investors willing to write bigger checks.
Are the trends they identify a sign of the market unraveling? The signals are there, like when some of the biggest names in Web 3.0 venture capital raise a $133 million round for a team that later realizes they couldn’t actually achieve what they set out to do. In Web 3.0, the signals are even more alarming as investors have had to lower their focal point for minimum viable investment criteria — there simply aren’t enough examples of success in the space to inform their predictions. But while Jason Fried, Tim O’Reilly and others can provide a host of data points showing the inefficiency of venture capital, my observation sits at the level of worldview.
Meritocracy is firmly integrated in the realm of venture capital and startups. While others like Alex Danco have written brilliantly on the effects of SV meritocracy on diversity, my qualm is also on how it demands focus on micro-scale improvements when macro-scale ones may be needed. The resulting atmosphere is one where both venture capitalists and founders complain, but nothing changes.
Meritocracy emphasizes ownership. If a venture capital investment turns out to be a dud, we are quick to point out that success is never guaranteed and internalize lessons like how to improve the diligence process. It’s similar to the law firm in the 1980s that ends up with an associate lawyer who doesn’t actually know law. The law firm ‘goes back to the books’ and re-assesses the associate’s early background to avoid similar signals with new candidates — in the same broken system of extending offers to newly-admitted law students. To take personal ownership of the mistake does not address the issue underlying the market, and as long as the systemic issue exists we can expect behavior to continue similarly and even worsen.
When markets unravel, participants engage in a race to zero: engaging in earlier transactions on the assessment of even earlier signals. This frames the current VC focus on differentiation, where funds search for earlier opportunities to invest on signals that others aren’t seeing. When your feedback loop is ten years* it’s hard to remain grounded. There’s a reason that bubbles are predicated on derivatives — not specifically the financial instrument, but second-degree relationships — because at some point the valuation becomes uncoupled from fundamental value. As with bubbles, the system works until it doesn’t.
The behaviors of both law firms in the 1980s and today’s venture capital firms are the best strategy available to them. In an irrational market, it is rational to make irrational decisions. To opt out of these behaviors is even more destructive than participating in them. They’re the only way to play the game.
The environment encourages firms to focus on the optimization of unit results, not on system-level solutions. Accordingly, venture capital unravels**. Escaping this state of suboptimal equilibrium will require a large shift in mindshare and plenty of work to follow. It begins with an honest conversation.
*Ten years is the average investment horizon for venture firms.
**It’s hard to push against the inertia of unraveling. The allure of market failure is that it’s the only outcome where everyone else also fails(and most importantly, the responsibility of failure doesn’t reside with you and you alone).
