Herd Culture & Pitfalls in Venture Capital

Let’s all be contrarian together.

Not unlike public markets investing, the key to finding investment opportunities in venture capital — ones capable of such outlier returns that winners can more than account for the many losers — is to discover new companies the market has undervalued or ignored entirely. That’s because new companies that most people find exciting pose big two problems:

  1. if it’s obvious enough for most people to believe that it will be the next progression in the market then it’s obvious enough that incumbents have already thought of it and invested substantially to build and deploy it themselves;
  2. the level of interest from other investors and widespread confidence in a company’s high potential will value its shares appropriately for its true potential (or more likely overvalue them), inhibiting the capacity for a VC to realize dramatic upside even if it succeeds. (In later stages like Series B, C, etc., you can have companies that are by then widely seen as good investments but are undervalued still relative to the growth you foresee.)

[Caveat: In bull tech markets, it is possible to still make huge returns despite these two problems, provided the investor exits before the market corrects (i.e. buy when the company is slightly overvalued and sell when its extremely overvalued). That seems like a riskier bet to me than putting money into big ideas off the beaten path however.]

Venture capital then is about investing in brilliant ideas that look like bad ideas to most people. The reality is that the skeptics will be correct most of the time…most of those ventures are in fact just bad ideas. The game isn’t to be right all the time, or even to be wrong the least amount of the time, though. It’s to be the most right on a capital-weighted basis: to catch the outlier(s) that generate the biggest return, whether it’s from one company or three.

The top performing funds have a higher proportion of investments that go to zero than funds with returns that are merely good or average. If it’s a matter of hitting grand slams, to borrow Chris Dixon’s analogy, then an investor should only take massive, high-risk-high-reward swings.[1]

Like most platitudes, these concepts are well known but not followed well in practice. This is apparent both anecdotally and by reviewing historic industry financial returns. (VC is an industry where everyone acts like hot stuff even though the majority don’t beat the returns of an average mutual fund.)

I’m new to the game, but from my observations thus far are 4 factors that trip up investors (including, I’m sure, myself at times) and define the general behavior of most VCs:

The first is familiarity bias. Consciously or subconsciously, people look for winners behind other winners…they assume the The Next Big Thing will look similar to The Current Big Thing just a little different.

This is not an entirely false assumption; if the Current Big Thing is part of a broadly applicable technology shift then the initial company that defines the new trend could be the first of multiple that each apply the new technology to separate spheres. Or the Current Big Thing could be too early in the trend’s development and passed a couple years later by a better timed competitor taking a different approach.

But it seems like a lot of investors over-index on this assumption, especially given that the companies falling under this classification tend to have the problem of being ‘good ideas that look like good ideas’. Look at how much attention investors continued to pay to mobile social apps and on-demand delivery marketplaces…most of that attention came after the giant winners were well established.

If you’re hunting for category-creating enterprise that defines new markets and can go on to become a $10 billion+ enterprise — which is necessary for large VC funds to find — this approach doesn’t match historical patterns. Companies that get that big in just a few short years are each offering something more fundamentally new and defensible that few other companies have been paying attention to.

We tend to (subconsciously) forecast the future linearly, looking for the logical next step instead of hunting for wild cards that have a small but feasible chance of storming in out of nowhere. Historically that’s exactly where the most massive new tech companies come from though; they only look like a logical next step in retrospect.

The second problem is Sayre’s Law. In 1973, Columbia professor William Sayre was quoted stating “academic politics is so vicious precisely because the stakes are so low”; that catchphrase was later repeated by Henry Kissinger and others who have done battle in the halls of higher ed. It gave rise to the cheeky term “Sayre’s Law” — that there is an inverse correlation between the stakes at play and the amount (and fierceness) of competition.

Humans do not want to take unnecessary risk. They want to achieve success by the least risky path that can still potentially get them to their destination. But as a result, most people target the same few well-established paths; the popularity of those paths gives them reassurance that it’s the smart way to go. This is why restaurants are simultaneously the worst and most popular businesses to start…somehow people miss the paradox that the most popular fields are by definition the most intensely competitive.

In venture capital, the need for exponential growth within the time span of a ten year fund excludes many types of businesses from consideration. But within the broad bandwidth of what venture capital will still consider, investors often follow the same instinct. VCs want to achieve their venture scale returns in the safest way possible. So they follow what has been shown to work…they invest in the trends that seem hot based on recent big wins (as noted above) and based on popular consensus among their peers that it’s the smart place to look. They invest in fields that are easier to understand and in new companies that have the clearest path to a base level of success. Investors are still human, and they instinctually want to get their success without taking wild, all-or-nothing swings. Any startup is very risky, so it’s easy to write off any startup investment as fulfilling the need to take big risks mandated by VC portfolio theory.

What big opportunities there still are in hot fields become intensely competitive and usually overvalued (and yet new investors keep jumping on the bandwagon). Small markets where there is opportunity for a new company to transform and radically expand the market tend to get ignored. Fields that are more complex, capital intensive, or futuristic…the ones where the stakes are high and a win is more difficult but likely to mean a massive, world-changing breakthrough if accomplished…are less competitive.

“Type A” people are also drawn to competition. Prestige in society comes from achieving the highest status level in the most competitive, popular fields of play. Many VCs are the product of this; their upbringing understood success as acceptance to the most selective schools and companies. It’s a point of pride — I think often subconsciously — to compete to be the most notable investor in the most popular categories; avoiding competition isn’t what brought them prior success.

Third of all, the economics of venture capital discourage risk taking as much as they encourage it. The 2% annual management fee on AUM means a VC partner can earn a very comfortable salary — millions of dollars a year at larger funds — just by showing up to work. If (consciously or subconsciously) you value that high, stable income more than a high stakes gamble for substantially more through investment gains, then it makes sense to play more conservatively.

Firms with mediocre performance last much longer in VC than in almost any other industry. If you take lots of big, all-or-nothing bets in the 2–3 years of deploying a first fund and none of those work out massively over the following 5–8 years, then you probably won’t be able to raise another VC fund again; if you play it safe and get average returns, you likely can. Being contrarian only works if you end up actually being right in the end, so why take the risk when life is so good being average?

Fourth, there’s a social cost to contrarian investing in early stage venture capital, especially during bull markets. VCs become “cool”, seen as kingmakers in the broader hype around tech startups; being the ones with a checkbook, they get flooded with attention from the influx of entrepreneurs pitching startup ideas. The tech press also pays a disproportionate amount of attention on funding announcements and venture firm activities. This all gives VCs the taste of being sought after, popular, respected. In markets like the last few years, VCs have had the opportunity to become veritable business celebrities alongside big tech CEOs and CNBC hosts, not just within the niche tech press and conference circuit but across mainstream business and creative industries as well.

This 1) feels good, and 2) can benefit deal flow and ability to access competitive deals, at least relative to doing nothing. So naturally many investors desire it. Qualification for this attention comes from affiliation with the most hyped companies of the moment (regardless of check size or price paid), however, not current or future financial performance. In any industry, the desire to be seen as one of the cool kids weighs heavily on people’s behavior whether they acknowledge it or not. In venture, it incentivizes people to fight for allocation in the hottest deals rather than invest in a weird company no one is writing about, which isn’t always the best financial decision.