Most VC funding is about winning the lottery. But where an actual lottery is a zero-sum game (less than, actually), in the VC lottery many investors can be winners, all it takes is being sufficiently diversified into enough different startups with strong potential.
Not everyone is going to win the facebook lottery (Accel Partners, for example, achieved a ~40,000% RoI), but there are lots of lotteries in play. And the VCs that win those lotteries then end up with the most money. So the most money in play in VC-land tends to be from people who have played the lottery game and like it, so they want to continue to play the lottery game.
It's a lottery, you only need one. One facebook, one google, etc. Those successes bring in RoI not just of double digit percentages (the sort you'd expect from high-risk investments) but in multiples, orders of magnitude even. 10x, 100x returns sometimes. And when you hit those jackpots all of your other investments are now meaningless. The result is that VC becomes a game of searching for jackpots. Everyone wants a little bit of everything, and everyone wants to have their fingers in the things that look most interesting, that seem to have the chance to blow up. VCs also push the companies they invest in to grow fast and hit the point of finding out whether or not they're a "jackpot" idea or not.
At the same time, investors have figured out innumerable ways to get paid out of companies that are obviously not going to make it and won't ever hit a traditional liquidity event. They've gamed the system to an enormous degree but they also pump so much money into it that it's hard to stand up to them.
The VC game in Silicon Valley isn't about investment, it's about playing the lotto. You dump money into as many companies that have even a small degree of promise, you blow them up to the point where you can find out whether or not they have market traction, and then you collect your winnings from the tiny fraction that hit it big. Not only is it vastly disadvantageous to not have your fingers in as many pies as possible but the VCs with the most money are precisely the ones who have been playing this game already and hit it big with google, facebook, instagram, etc.
Investing in 9 sham companies that fold and 1 unicorn that pays out at 10:1 or 100:1 is more lucrative than investing in 10 companies with modest, but reliable RoI's. Peter Thiel's Facebook investment paid off at 2000:1, Accel's facebook investment paid off at 800:1, Andy Bechtolsheim's google investment paid off at 17000:1, Andreessen Horowitz made 300:1 off of instagram. If you've got a good enough pitch you can get as much money as you want.
People lose money in lottery tickets, casinos, equity investments, etc all the time. If a VC is successful over a period of time with a history of investing in winners, then there is something more than simply randomness.
The lottery is not a very good analogy. Let’s look at worst cases. In the lottery you put in cash and usually get nothing back. You literally learn nothing because every draw is random. At a VC-backed startup someone else gives you money. With that money you’re expected to pay yourself a salary. You get to learn at an incredibly fast rate on someone else’s dime. And you get that salary and learning even if your investors are awful and push you to do terrible things and you agree to do those terrible things and they tank the company. In the worst case, it’s a free education with room and board included. And, if it works, there’s a helluva upside.
So, lottery expected worst case: you lose all your money. VC-backed startup expected worst case: you learn a ton and end up no worse financially than you started.
As an aside, whether venture-backed or bootstrapped, having gotten to know a lot of successful founders the characteristic that seems to set them apart is their rate of learning. The best are relentlessly curious, always assume there’s something they don’t know, and seek to learn from as many people as possible.
The odds of succeeding with VC is even tinier. It’s just that the media hype up the lottery winners so VC continues to have companies wanting their money.
Someone should do a study to see if the lottery effect--where winning the lottery leaves you worse off because you don't know how to handle that much money--is at work with VC funding.
A VC fund will only get money if the risk-adjusted rate of return is greater than the rate of interest; otherwise backers of the VC fund invest their money elsewhere.
This means that VC have to become more selective with respect to the startups that they invest in, as I described.
Yeah. There’s a lot of startups, but only a few that are actually promising from a risk reward perspective. VC investing is about home runs. So they all fight over investing in a few companies
The real question, I think, is when investors are figuring out whether to go into the startup scene, what are the dominant influences on their decision?
If there's a long tail of Airbnbs that drives most of the expected profits generated by an investment strategy, then the status quo understanding of things--buy a bunch of lotto tickets, and make a bundle when one hits the jackpot--is probably an accurate representation of the market strategy.
If the median investor isn't going to make any money from getting a big hit, though, it's a different story. Most value is going to come from talent acquisitions. In which case, the article is right, and the incredible sea of funding available today is effectively a pooled set of resources by big corporations that are funneled to VCs in exchange for recruitment and building of effective teams. Which would make VCs the best-compensated HR managers in history.
There's also no reason both can't be true. Maybe the majority of profits are generated by Dropboxes, but the typical VC understands that those are lotto tickets and is relying mostly on the latter scenario.
It's impossible to know as getting VC investment increases the odds of success or at least surviving to the point where you can even attempt to have a go. Clearly some are better than others at choosing winners. Part of me thinks that this could be driven by network more than competence though.
Keep in mind this unicorn outcome percentage (less than 5%) is from investors who have more knowledge than you, make their living picking startups to bet on, and typically get to make about 20 different startup investments every 2-3 years. You, on the other hand, only get one shot at a time. So if you want to pick a winner, you’d better be a damn good picker. Much better than your average VC.
That's such a weird thing to see coming up over and over again.
Finding an investor is like being in the casino and having a high roller give you money to bet in return for a share in the stakes because they believe you have better luck than they do themselves.
Success is when both you and the investor cash out with significantly more money than you put in or when you make the business so profitable that your accumulated dividends exceed the initial outlay.
To see VC money as 'success' is simply wrong, it may increase your chances of success, and it may cushion your losses a bit (because not all expenses come out of your pocket).
But lottery returns might be better than startup returns. In both cases, investor sentiment is hyper-focused on the very, very low probability event of a high return, but unlike startups, the lottery's returns are deliberately smoothed to keep people playing.
That doesn't make lotto better than startups; the lotto is obviously objectively much worse. But the financial outcome of an unsophisticated investment in startups is likely to be worse than a lottery ticket; if you buy a bunch of lottery tickets, you'll get something back. If you don't know the industry, investing in startups is like throwing your money away.
I think something people don't consider in these discussions is that the current startup ecosystem --- the one in which the majority of companies return zero to their investors! --- is the product of relatively sophisticated investment. It's not impossible for a huckster to get funded, but it's troublesome enough that truly fraudulent companies are the exception.
All that changes once you set up a structure that allows people to "fund" companies "retail".
I've always assumed VCs take gambles like this because they know it just takes a single success to cover their lost bets.
So being first to bet on a possible winner is probably statistically better than taking the time to sift through the actual details of these startup ideas.
Doesn't this depend upon how your stratify the data?
That technicality aside, two points worth making: (1) VC funds are like startups. All of the money (that is made) investing in the winners, not the losers; and (2) The other side of the coin: VC is also like investing in hollywood Films and pro-sports franchises. People have an irrational desire 'to be in the game', and much value can be extracted through (what is best thought of as) dark externalities.
I think that the data in the article shows it's not just "all lottery tickets" - there's a meaningful difference between the odds depending on stage and "top tier" VC's do make a difference - just because your anecdotal experience doesn't align with the data doesn't mean the trend isn't there. Looks like the authors run a site where they highlight the best startups to join, and include other factors like headcount growth and traction so you're not just relying on VC pedigree.
Naw man, that's just how it goes in VC world. You have to play it like that. It's like a roulette table -- hard to hit a number but pays out 33x. Well, similarly, a very successful start-up can pay out 100-1000x and easily carry the other losers.
“People keep saying that lotteries are ‘a tax on people who can’t do math’, but if you pay attention there are lottery winners every day. There’s no better time to play the lottery!”
Look at venture capital, since they’re the ones that invest in every one of these VC-backed funds. Most funds don’t make money and of those that do, exceedingly few beat the S&P 500.
The examples you’re giving are a tiny sliver of startups and at this point are not startups.
In fairness to the lottery, few people consider it to be a sensible place to stick 50% of their net worth. Bearing in mind that top startups - which generate nearly all the return to VCs - have a marked preference for "smart money" and the majority of startups ventures fail hard, most lotteries probably have a higher expected value than retail investors are likely to see from the average crowdfunding portfolio.
Not everyone is going to win the facebook lottery (Accel Partners, for example, achieved a ~40,000% RoI), but there are lots of lotteries in play. And the VCs that win those lotteries then end up with the most money. So the most money in play in VC-land tends to be from people who have played the lottery game and like it, so they want to continue to play the lottery game.
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