ILLUMINATION
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ILLUMINATION

Venture Capital: A Messed Up Keynesian Beauty Contest

[Disclaimer: The content below is not an original thought. Rather, an extension of Glenn C. Loury’s work in the Anatomy of Racial Inequality.]

Over the past 30–40 years, Venture Capital (VC) has played an important role in the growth and success of multiple early-stage startups. Especially in the Americas, Europe, and Asia.

Uber, Airbnb, Stripe, Coinbase, Palantir, and numerous other hyper-successful companies today were backed by VCs in their early stages.

To illustrate the magnitude of this industry’s growth, I would like to bring your attention to the 2 graphs below.

Graph 1 depicts the dollar value of VC investments in the US from 1995–2020 (in billion $). The near exponential growth from 1995–2000 could have been a result of the dot com bubble which peaked in March 2000. Despite COVID, 2020 was the year with the greatest value invested by VCs during this time span — $ 130 billion in total.

Source: statista.com

Graph 2 shows the increase in average value of a single deal over the years (even though the deal count has somewhat remained constant over the past 3–4 years).

Source: https://infogram.com/q3-2021-venture-monitor-vc-deal-activity-1h7g6k0ze0e5o2o

Despite the highly lucrative and important role VC plays for early-stage companies, if you’re even somewhat familiar with how the industry works, I would guess that you’ve come to realize how messed up the whole shenanigan is.

If you’ve never heard of a Keynesian beauty contest, let me rant about it for a while.

It was named after the renowned British economist - John Maynard Keynes. As Keynes was reading the newspaper one day, he noticed a section that depicted facial profiles of 6 different women. It was a beauty contest and the game was to pick the most beautiful face out of the 6. If the majority of the people reading the newspaper picked the same face, they would all get a prize.

Keynes immediately recognized that this game was pointless as individual preferences were subjective. Not to mention the fact that some of the readers, or at least the ones who understood the game, would try to pick the candidate that she expects everyone else to pick. This futile endeavor continues in an infinite loop where everyone tries to predict what everyone else will do. And everyone tries to predict what everyone else predicts everyone to do. Thus an infinite loop.

VC is not all that different from such a beauty contest.

Young startups that aim to raise money from VCs do so in stages. Usually, there’s a pre-seed round, seed round, series A, B, and C. And eventually, if the company decides to go public they can do so via an IPO, direct listing, etc.

An individual will invest in the series A of a startup, only if she expects to generate a positive return. Meaning that she expects her infant startup stonks from series A will be bought by someone else at a higher valuation during the series B round (or at a later point in time).

To bring this point home, imagine a world where all investors are rational (surprisingly, VC seems to be one of those exceptions where market participants do indeed act somewhat rationally). Let’s call this ‘Rational World’ (RW).

In RW, one invests in a startup only if the founder(s) has a unibrow.

A startup could have the most sophisticated product with a high demand for it. But if the founder doesn’t have a unibrow then no one invests in said startup.

But let’s assume that angel investors in the pre-seed stage don’t really care about unibrows at all. They’ll invest in any team that checks all their boxes (and having a unibrow is not a box that needs to be checked). But these angels happen to think that the ones who will invest in the subsequent seed stage do indeed care about unibrows. Therefore the angels — acting as profit-seeking rational individuals - will choose to throw their money at only unibrow founders.

Now let’s take this a step further. Perhaps the seed investors also couldn’t care less about unibrows. The expectation of pre-seed angels that seed investors care about unibrows was incorrect. But unfortunately, the seed investors strongly expect series A investors to have an affinity for them unibrows. And under the assumption that individuals are acting rationally (think profit-maximizing), this pattern plays out through all stages of fundraising. Ipso facto, VC turns into a socially inefficient mechanism for investing in companies.

In short, everyone ends up acting in a way that corresponds to their expectation of how others will act.

Fin.

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