Color, Valuations, and the Winner’s Curse

April 27, 2011
by Scott Johnson

My friend Kevin Lewis is a professor at Duke Business school and he sends out a feed of interesting abstracts describing recent research that I sift through every day or so. Today I found this one:

The Bidder’s Curce

Ulrike Malmendier & Young Han Lee, American Economic Review, April 2011, Pages 749–787

Abstract: We employ a novel approach to identify overbidding in auctions. We compare online auction prices to fixed prices for the same item on the same webpage. In detailed data on auctions of a board game, 42 percent of auctions exceed the simultaneous fixed price.

There was another relevant and related study in the same feed:

The Impact of Mimicry on Sales — Evidence from Field and Lab Experiments Andreas Herrmann et al., Journal of Economic Psychology, forthcoming

Abstract: A buyer’s observation that one or more people are consuming a product can lead that buyer to consume the product as well. The evidence supporting unconscious and unintentional (automatic) mimicry of consumption suggest that it is a pervasive and robust phenomenon.

So, we can conclude that people tend to want what they observe others consuming, and when a bidding war starts they act irrationally and overpay. Sound like any expansion rounds or even seed rounds you have observed recently? Color is the most visible, but the list is actually pretty long. Why is this important?

Three reasons:

1. A company with artificially high post money value must inevitably spurn reasonable exit offers.
2. High valuation outliers make inside rounds impossible to price, and forces outside financings with pro-rata demands that make raises too big (and hence too dilutive) and done at prices that divide the board at exit.
3. The money gets spent, the company doesn’t grow into the valuation, and the next financing is a down round. A solid company with good prospects got ahead of itself and may never regain momentum.

This may all sound self serving, because we as VCs are thought of as purely buy-side partisans. In fact, once our first money is in, we are on the sell side through every subsequent round. We benefit greatly from write-ups in our portfolio. Big high-priced follow-on rounds are affirming and exciting for us. But in the end they can be very damaging, as strategic buyers are not nearly as aggressive on price right now as the expansion stage investors. So if you are fortunate enough to have multiple bidders in a capital raise, be cautious. Raise money from people you look forward to working with at a price that keeps your entire board in alignment as you make important strategic decisions.

Originally published April, 27, 2011 at navfund.com.