Picking Winners: A Framework for Venture Capital Investment | Hacker News Reader

Picking Winners: A Framework for Venture Capital Investment

arxiv.org

113 pointsblopeur35 comments

I feel like venture capital is a major choke point in our current implementation of capitalism, where "the market will decide" is really a euphemism for "a small handful of extremely wealthy investors will decide." We're paying a massive opportunity cost on all of those ideas that don't ever reach the market because VC's don't think they're easy money.

A good way to resolve this would be to reform the accredited investor laws into something more meritocratic. Instead of needing to own one million dollars in assets, there ought to be some sort of knowledge-based competency exam so that regular people can invest in ideas they think are worthwhile.

If you want to increase good ideas getting to market, fund basic science, not startups. VCs might not be picking exactly the right companies, but it is hard to argue there isn't enough private investment capital for high growth startups. The real missing link is support for new ideas long before they are startups.

VCs are a perfect implementation of "the market will decide" but I think you misunderstand in this case what the market is. It's not some idealized invisible hand, the market is the people who show up and participate, exactly like your local farmers market for vegetables.

And the VCs are the ones who show up and participate, so they are in large part the market for early stage startups.

Anyone else who wishes is naturally allowed into this market as well. Markets are no panacea, they've only ever worked as well as their participants, (being composed of nothing else) and they tend to do better when they're broader and deeper, which VCs most certainly are not, in comparison to other markets such as for stocks.

Minor point - you can also be an accredited investor if you "have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year." [1]

That feels somewhat more "meritocratic" to me.

1. https://en.wikipedia.org/wiki/Accredited_investor#United_Sta...

VC is really only applicable to a small subset of possible successful business. It is actually poisonous to businesses that will succeed financially but with rates of return less than 10x in a relatively short time scale.

So, for what VC is doing in the market I think it is fine for a handful of people that can absorb the necessary risk make those decisions and the bets.

But there is a huge gulf between those types of new business investments an d smaller risk(both in size of capital needed for the experiment and unknowns)/smaller reward investments.

That fat middle is where smaller investors or crowdfunding could really come into their own.

part of the problem is VC has developed a doctrine that is designed for investors, not companies. VCs should be focused on serving their companies, not their benefactors. But in todays world its just not the case. You hear founders talk about burning money and rocket ships and high-risk and danger because of this perverse set of incentives. A revolutionary change is needed to put power back in the hands of companies where it belongs. Companies that are changing the world need to be run by patient careful men, not unstable kids with a dangerous appetite for risk.

Putting "power back in the hands if companies where it belongs" requires no change at all. Just don't take VC money. It's that simple. Most companies are not best served by raising money from VC firms (and I say this as someone that has been an institutional VC for almost 20 years). But if your take on a business model that requires capital, the expectations of return of those investors are going to be commensurate with the risk. As soon as you raise outside capital whether from a VC or borrowed from your local bank, you have committed yourself to new obligations that will put constraints on how you run the business. Those constraints can be explicit ("pay us X interest every month") or implicit ("the risk associated with the startups we invest in is so great that we have to swing for the fences with every investment, so we are going to push you to a billion or bust strategy."). It is important to understand them before you take outside capital (topic for a longer post...). But if you want to stay in control, it's always best just not to take any outside capital at all.

This isn't realistic. Many business need outside capital, they just need it without the institutional baggage. For my own business i'm specifically looking for investors that are aligned with the companies goals first. And its proving difficult because so many investors have distorted ideas about the very nature of business. Many believe the point of business is to make money. Which is exactly the wrong mindset from my point of view and highly dangerous to what we are trying to accomplish.

This is where ICOs (Initial Coin Offering) Token Sale may help. It is doing two things: 1. democratization of who gets to be VC 2. democratization of access to capital.

ICOs show quite well how that "democratization" can have bad effects. Most of them are plain stupid (better and easier to realize without a blockchain or smart contracts). I assume they are for speculation/gambling only. There should be safeguards in place to prevent people from dumping all their money into it.

Now, I agree that crowdfunding startups should be possible. Why shouldn't I be able to participate funding with 10$? The valid argument is that the process is so costly that it makes no sense for this tiny amount of money. So, how can we make the process cheaper without (!) removing all the safeguards?

You can. Republic.co and a few others are allowing non - accredited investors access to startup investing at nominal levels, thanks to title iii of the jobs act. Adoption will grow with awareness that this is an option.

you are correct about this, but I think what you frame as a negative is really a positive. I think the VC model is one of the only examples funding I've seen where really innovative, experimental and risky projects can even get a tiny bit of traction (the other example is a government grant).

I think the public is most likely risk adverse, and will be burnt with 100 startups promising the moon and failing.

If you're smart enough to pass the competency test, why can't you just make a million dollars in ten years? Essentially, the minimum net worth requirement for accredited investors already serves as a de facto test.

It's crazy to me that you're conflating income with intelligence. There are a lot of stupid ways to get rich and a lot of really intelligence-demanding careers that don't pay well at all.

I think the point is a far more cynical one. If your goal is to make money, why are you not making money?

Either it's not your goal (and you shouldn't be an investor) or you're too dumb to be successful at it (and you shouldn't be an investor).

It's a litmus test not an intelligence test.

This analysis is a little too "content free" for my tastes. (Edit: I don't mean there is nothing to it, I mean the analysis is largely formal as opposed to the content of the decision)

But this problem hasn't gone unnoticed and there are some ideas around how to solve the "pick the rare winners" problem:

1. Andreessen: Don't pick winners. Invest in the startup after it has already demonstrated itself to be a winner but before it goes public. This is the safe growing area.

2. McClure: Invest small amounts, early so that you can afford to spread the investment over many companies.

3. Thiel, Gurley: Be right

4. Graham: combination of #2 and #3

5. Doerr: Network like crazy to have a shot of being in the few good ones (this assumes you will recognize them)

#3 is not necessarily something we can reproduce

5 is the often overlooked one. The quality of the opportunities that at one sees is a huge driver of ultimate returns. Two equally skilled VCs with differing quality deal flow are going to have different returns. So brand and networking are material drivers of return.

I would argue that that applies to more of the names you reference than just Doerr. For example, the early success of YC with dropbox helped drive better deal flow for future deals.

That is an excellent point (that many investors rely on increased deal flow from early success). It sort of pervades the other "styles"

The model seems to correlate what worked previously to what will work next. However, in a field that is supposed to lead to new product funding - past industries may steer funding in the wrong direction from what will work next. Two issues:

1. The purple cow effect - the opportunities for highest growth may be in underserved segments which are best addressed by founders less represented in Silicon Valley. (the next big thing may be a farming startup in India, but the founder won't fit the well connected or well advised by people with startup exits model this framework uses, and thus will be missed by SV investors, which leads to problem 2. )

2. The money trumps product problem - whatever you can't beat with a solid product, you could always hammer with more money in the bank. Instead of hearing about a farming innovation in India, American farmers could be getting FarmVille ads on TV instead and tuning out. Since VCs invest locally, even if a startup starts picking up steam in Chicago, SF investors who don't have a toe in that pond, pick the local fish that eats the same algae and fund it far better than the Chicago company, which might have a better product. In a land-grab industry that money may be enough to gain adoption to the SF pond-dweller, but returns for the entire market will be lower, due to lower product quality and tendency of big firms here to pick only one company per industry.

So the framework, biased by past data, may skew future data away from results that would be optimal without a framework.

There's a few VC firms (Correlation Ventures leaps to mind, as noted in the article) that invest solely on the basis of a quantitative model that looks at the various features of the business (market, founders, etc.) and then doing some kind of neural network/similarity scoring analysis on it. Of course, a big feature that I presume their models have which this paper does not is the understanding that an IPO is worth tens of small wins, if not more.

The real optimal setup here would be to pair that kind of mathematical rigor with the dealflow of an a16z or KP. I would suspect that both of those two would say that a similar model exists in the heads of their partners so far as pattern recognition, but..

I just spoke to Correlation Ventures this week. Great model, and a refreshing change for fundraising. They came in cold after hearing about us from another VC, then we had one phone call which was mostly a friendly chat, and then 3 emails with pretty simple docs and clarifications. They got back to me with a decision in 2 days. After that, they just want a short conversation with a VC co-investor, and another short call with me. Super simple.

I agree that correlation has a great model that makes them easy to work with as a vc or entrepreneur. That said, they cannot exist without other traditional firms leading investments (just as in the public markets, an index fund cannot exist without active fund managers doing the work they have always done).

This is my experience with them as well. Very positive.

Most VCs pass or miss on the big deals anyway.

If this were true, 'most VCs' would be bankrupt, and many probably are.

However, nobody should care about 'most VCs'. You only need one. The good ones do not miss the big deals. There may be evidence that they take a long time on the big deals, but miss them? What evidence do you have?

They absolutely miss many big deals. Think of it this way, there are several dozen well-known Series A firms like Sequoia, Kleiner Perkins, Google Ventures, etc. But for any single company like Airbnb or Uber, only one or two or maybe three of those dozens of firms gets to invest. That means for any given unicorn, 90% of the good firms missed it, and probably 99% of all legitimate Series A firms. Sometimes that's because rounds are competitive and a company might have 5 term sheets but can only take one, but that is the exception and not the rule.

VC is an interesting business model because you don't have to get all of the good investments, you just need one or two per fund.

(Source: I'm a VC.)

There's a documentary about it on Netflix: "Something Ventured"

Correlation usually insists on an existing lead as well.

With zero information, "picking winners" is like buying lottery tickets.

It's obvious that you can win at lottery if the cost of buying all the tickets is less than the total payout. It's usually not.

In the case of startups, it may still be the case. For this study they examined 24,000 companies over 16 years (1500 companies per year). 24k companies x $10k = "only" $240 millions (or, over 16 years, $15 millions / year on average).

So, if one invested $10k in each of these companies, as early as possible (to get the maximum equity in exchange for these $10k) then they would probably have come out ahead (hard to verify as I couldn't find the total exits in $$ in the study).

I think this is fundamentally, and ultimately, YC's business model: root out the obvious hacks and cracks, and accept everyone else.

Despite it being so obvious, I really like their analogy,

  pharma::drug
  studio::movie
  vc::startup

"Just" need one to work out!

So I briefly scanned this paper.

"The results show that our modeling and portfolio construction method are effective and they provide a quantitative methodology for venture capital investment."

I really can't find evidence for this statement anywhere in the paper.

This paper seems to conflate a prescriptive model with a descriptive model. A prescriptive model would be more focused on the data and less on the formal mathematical model. It would also be actually useful. It looks like they came up with an interesting way to model the portfolio selection problem, but it will simply not provide a "quantitative methodology" for VC investment as they claim. It's perplexing why that sentence was allowed in this paper.

If you are a VC could you extract anything that is useful and non-trivial from this paper? I doubt it.

If you look at figure 4 on page 24, it basically says that the VCs picking ability is about good as random chance. They have some really smart people working for them and its still hard to pick winners.

Recapping: top drivers roughly in rank order were: Great market, previous founder, founder worked at a company that IPOed or acquired, founder came from a top school, the quality of current investors (do they have exits). Seems like the standard things most investors look for, so the question is does it come down to deal flow.

I thought predicting winners in startups was searching for "Black Swan" events - the ones models often miss...

One of the challenges here is that "sector" is strongly predictive, but the data analyzed are historical. It's easy to know which sector one should have invested in historically -- and hard to know which sector to invest in going forward.

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