Why the Most Successful VC Firms Keep Winning
In an industry built around investing large sums in uncertain ventures, the best companies seek out the best investors, and gains accumulate at the top. Part 3 in a series.
Originally Published on NewCo Shift.
Investing in software companies is inherently an uncertain activity. It’s called high risk, but highly uncertain is a better label. Yes, you’re taking a risk with money, but the real problem is the widely variant potential outcomes. If you invest in a restaurant, you are taking a risk but you will pretty much end up with a profitable restaurant, or lose your money. If you invest in a software company, you can go bankrupt, have a small but profitable company, sell for five times the money in, or end up with a world-spanning multi-billion dollar behemoth that turns everyone it touches into a millionaire. That dramatic range is why you can get a bank loan to start a restaurant but not a software company. It’s exactly why people invest in software, but also why it’s so difficult to do well.
There’s no proven method for managing that uncertainty. The most successful investors frequently get it massively wrong, and a playbook that worked perfectly in one circumstance falls flat on its face in so many others. Yet, even when they frequently make monumentally bad investments, the best investors keep delivering the best outcomes. If no one knows what separates the best from the rest, how can some firms or individuals keep winning?
Of course, many would disagree with my claim, they would say the best keep winning because they can tell a great company from a bad one, but if you look at the trends in venture capital you can see the industry as a whole has given up on a clear system, even if individuals still cling to deserving their greatness. Fantastically successful investor Paul Graham once said that he can be tricked by anyone who looks like Mark Zuckerberg. He’s since claimed that was a joke, but he built his empire by making more bets than anyone else, which is a strategy explicitly designed around the fact that he doesn’t actually know why some things succeed and others don’t. Disgraced investor Dave McClure started 500 Startups with the similar goal of just making lots of bets, rather than making any attempt at making “good” bets.
Even those who invest in venture capital firms have given up on knowing who’s best. Given a pot of money allocated to VC, limited partners will distribute it across many firms, knowing that they have to play many hands to get a winner. After all, the industry average return for venture funds is, ah, absolutely nothing. The winners win big, and the rest balance that out, so LPs need to put money in enough places to be confident they end up with the winners.
If no one knows the difference between the best and the worst, why do the winners usually keep winning?
Access.
Venture capital is all about access: Founders having access to capital, and investors having access to the best deals. If you’re a founder today and you have a choice between taking money from a top-tier firm that keeps delivering hits, or another firm you don’t know and who hasn’t done well, which do you take? Of course you take the best firm with the biggest network and most well-known brand name.
Similarly, if you’re an investor who’s helped take lots of companies public, how does your deal flow compare to those who are just starting out and who don’t have a reputation for building big companies? Of course the best companies come to you.
In other words, there’s an implicit matching algorithm, where companies that are obviously doing really well are able to work with what look like the best firms, and as a result they are able to reinforce each other’s success. The best firms look better because the best companies seek them out, and the best companies do better because they’re getting the chance to work with the best brands. (For all that I am skeptical of repeatable investment skill, I am a deep believer in the value of brands.)
Venture capital is defined by the asymmetric stresses pressed on investors and founders by the need for access; every entrepreneur stresses over how they’ll get access to capital, and every investor’s business model is built around managing deal flow. Entrepreneurs who already had a great outcome magically have no trouble raising huge amounts of money, and yesterday’s great investors have no trouble convincing today’s great companies to work with them.
This focus on access also helps to explain some of the churn the system experiences. If no one knows what makes a great company, how can the best investors always get access? They can’t. There are plenty of great companies that fail to get first-tier support early on. If they do raise money, then those who backed them end up looking like tomorrow’s geniuses, and the cycle starts over with them closer to the top.
This access-based sorting also helps to explain how the VC industry is so discriminatory. Less than 5% of investments go to women-led companies, and just having a woman founder ruins a team’s chance of getting funding , and the numbers are as bad for firms led by African Americans, for example. If we believed investors actually knew what they were doing, then we could only conclude that they were correct to exclude women and minorities from investments, that these founders just couldn’t build great companies.
Of course, the data clearly says otherwise: Founding teams with women on them significantly outperform male-only teams. Because investors don’t know how to pick a good company from a bad one, they are relying on access and reputation, and because they’ve never let women or minorities in before, they can’t now. Their “pattern matching” doesn’t hit here.
This matching algorithm that runs our industry is reliant on privilege and luck. Venture firms and founders are almost exclusively white men from expensive schools (with a huge proportion from just Stanford and Harvard), and if you were lucky enough to be an early employee at Facebook or Google (who have historically used the same sourcing requirements), then that’s a big leg up, too.
To be clear, I think some investors are much better than others, and entrepreneurs haven’t built huge, successful businesses out of sheer coincidence. It’s not that there’s no skill involved, or that the people who get so rich instead deserve nothing. It’s that skill is an over appreciated (and often small) part of what determined their success.
You will rarely find communities admitting that privilege and luck are what determine outcomes. Human nature itself has a deep aversion to accepting this. Instead, we do what humans have done forever: We develop myths.
Humans deeply believe that people get what they deserve, and deserve what they get, despite the evidence to the contrary. So many of our cultural biases are a story created to justify a reality we would like to perpetuate. For millennia we’ve been told that royalty was special, and that’s why they were in charge, when it was patently obvious that their ancestors were just the best and most ruthless at organizing enough troops to control a chunk of land. Genghis Khan was history’s greatest murderer, which enabled him to spawn kings and kingdoms that lasted for seven centuries, but you can bet his descendants didn’t use his skills at genocide as justification for their lofty positions.
Similarly, myths have grown around venture capital exist to explain the winners and losers. Somewhat like royalty, these myths help convince us that VC is more than privileged people using their positions to make lots of money. They must be winning because they deserve to win. Equivalently, people lose because they didn’t deserve to win. You could waste your life reading about how this founder got rich because they were smart and worked hard, or that investor succeeded because of their investment strategy, but you couldn’t consume a whole morning with the stories of equally smart founders who worked just as hard but went broke, or investors who applied that same strategy but somehow didn’t make it on the Midas list.
Thankfully, we’ve seen some really interesting experiments focused on eliminating access as a criteria for investing. Social Capital recently launched a programmatic investment algorithm, and Village Capital uses peer decision making between entrepreneurs. Backstage Capital was founded explicitly to invest in those who can’t get capital from the system as it exists today.
With these and related efforts, I’m optimistic that we can begin to peel back the myths about what makes a great investor, entrepreneur, or company, and instead begin building a more open market around investment and company creation. Only then can we hope to see venture capital include, enrich, and benefit all parts of the economy.
