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Given the expected values in your example, I don't think anyone would fault a VC (or any actor with a non-pathological marginal utility curve) for taking option

Given the expected values in your example, I don't think anyone would fault a VC (or any actor with a non-pathological marginal utility curve) for taking option 2. Now, what about the two bets: 1) 80% 1x, 20% 5x (EV: 1.8x) 2) 99% 0x, 1% 100x (EV: 1.0x) How many VCs do you know who would take 1 over 2, even though it's the "obvious" money-winning bet? I'd love your thoughts on why this is. My semi-cynical thesis is that VCs need home-run logos on the Portfolio page of their website to keep their spot at the dealflow table. Let's break the VC world up into three types: A - Brand-name VCs that funded yesterday's massive unicorns, and are regarded as clairvoyant masters of the universe B - Unknown VCs with a half-decent return on their last fund, but didn't back anyone you've heard of C - VCs that swung for the fences a few too many times and imploded Founders want to work with "A" VCs (for both rational and irrational reasons), so the first names they call are the ones whose past big bets paid off. "B" VCs are much lower on the call list, and only get access to the deals that "A" VCs all passed on. "C" VCs are obviously not available to chat. It is arguably rational for a VC to seek to become an "A" and end up as a "C", rather than to muddle along as a "B" until she's getting pitched every week by hair salon and gym owners with A Great App Idea and her LPs wonder what she's doing with their money.

lpolovets 10y ago
Lots of great points in your comment. First, I don't think any rational VC would take #2 over #1 in your example, but the caveats are: a) people aren't good at estimating small probabilities, so they might think that #2 should be 97%/3% instead of 99%/1%, and then #2 is "better". And b) They overestimate how much of a "sure thing" something is, so maybe what seems like 80%/20% in scenario #1 is really 50% 0x, 30% 1x, and 20% 5x. I can't remember the origin of the quote, but I've repeatedly heard that "trying to build a $100m company is not that much riskier than trying to build a $10b company, so you may as well shoot for $10b." Also, generally VCs won't take bets where the EV is <3x or so. A good fund will have a net return of 3x+, and you can't get there by making a lot of 2x bets. Furthermore, 99% 0x vs. 1% 100x is very lopsided. Probably too lopsided for most investors with portfolios of 20-40 companies per fund. If someone made that bet for all 30 companies in their fund, the fund would be 0x almost 3/4 of the time. But if the bet was more like 95% 0x and 5% 100x, then that's kind of interesting. Making 30 investments like that would produce a terrible return 21% of the time (0 wins), a good return 34% of the time (1 win), and a terrific return the rest of the time (2+ wins). That said, prestige is (unfortunately) a factor. So I could imagine someone making an investment with an EV of 4x that is likely to be a unicorn over an investment with an EV of 5x that is unlikely to be a unicorn. The last thing I'll add is that A/B/C grades for investors are context-specific. An 'A' like Sequoia or Accel might be generally pretty great for everyone, and you won't go wrong taking money from those firms. But in certain areas, lesser-known funds might be very strong company-building partners. For example, there are specialty funds that are focused on SaaS companies or frontier tech, and if you operate in one of those spaces then those funds might be just as good as taking money from Sequoia. Finally, below is an interesting set of tweets from an LP who has been investing in VC funds for several decades. TLDR: it's basically impossible to build a great fund return on top of lots of small wins; you need a few huge wins instead. https://twitter.com/HorsleyBridge/status/657287940456886272 https://twitter.com/HorsleyBridge/status/657287940456886272 https://twitter.com/HorsleyBridge/status/657288063329013760 https://twitter.com/HorsleyBridge/status/657288063329013760 https://twitter.com/HorsleyBridge/status/657288245105917952 https://twitter.com/HorsleyBridge/status/657288245105917952 https://twitter.com/HorsleyBridge/status/657288489331855360 https://twitter.com/HorsleyBridge/status/657288489331855360
- akiselev 10y ago
  I wonder if this financial reality is really the way it has to be or if it's a natural consequence of competition in the VC industry getting out of control. When the intangible value-add a firm can provide is low, all they can really compete on is the financials and how favorable the terms are to the founders. This causes a spiral where the valuations go up (dragging up even the valuations of 'A' firm deals) but the dilution each round does not keep pace. Founders with unicorn ambitions benefit by growing faster and keeping more of the future fortune so they keep the inflation train going. Everyone else who wants to build a solid company or reward investors with a steadily growing stream of dividends and a good but not great ROI suffers from the pressure to grow faster than they or their business model are capable of handling. Of course there's a second pressure from the other direction as companies compete to acquire more nimble competitors in lieu of hiring slowly and risking internal R&D. Since M&A has become a more and more common exit strategy over the last few decades, there's more opportunity for those unicorn returns with less risk, further souring VCs' opinion of other deals. In other industries like biotech it's not that rare to see early rounds where founders give up 40-50% of the company so even though investments are bigger and riskier, the financials work out to returns as good or better than tech in general. The pharmaceutical industry has outsourced large amounts of R&D risk to biotech investors for a long time though, so the risk is usually scientific and not product-market fit or sales/distribution. If you're working on a drug for a certain disease or condition, it's pretty easy to calculate how much you can make or how much you'd be worth to a pharmaceutical giant at various stages of risk (seed, animal studies, efficacy studies, clinical trials, post approval, etc.).
fanzhang 10y ago
> My semi-cynical thesis is that VCs need home-run logos on the Portfolio page of their website to keep their spot at the dealflow table. The causality probably isn't: LPs want home runs -> LPs look for home runs on VC pages -> VCs deliver home runs. Rather, it's probably: In the VC space, home runs make up the majority of the EV -> This common fact supports LPs looking for home runs, and VCs looking for home runs. There are probably some synergistic effects where the two are more than additive, but I think the underlying cause must be that in VC space, home runs make up the bulk of the return. To see this, consider PE firms or mutual funds -- are these industries a lot less into home runs? I would argue yes -- that for these firms they are measured by LPs by their historical average returns, or fees, or whatnot. Because in these firms that's the closest proxy for skill. Whereas in the VC world, home runs are the proxy for returns.
taneq 10y ago
Shouldn't a rational VC be taking a couple of (2) in among a bunch of (1)? You want a mixed portfolio with an overall positive expected return, but you want to fold in a few moonshots on the off-chance that they pay off and make you mega-rich and famous.

lpolovets 10y ago

Lots of great points in your comment. First, I don't think any rational VC would take #2 over #1 in your example, but the caveats are: a) people aren't good at estimating small probabilities, so they might think that #2 should be 97%/3% instead of 99%/1%, and then #2 is "better". And b) They overestimate how much of a "sure thing" something is, so maybe what seems like 80%/20% in scenario #1 is really 50% 0x, 30% 1x, and 20% 5x. I can't remember the origin of the quote, but I've repeatedly heard that "trying to build a $100m company is not that much riskier than trying to build a $10b company, so you may as well shoot for $10b." Also, generally VCs won't take bets where the EV is <3x or so. A good fund will have a net return of 3x+, and you can't get there by making a lot of 2x bets. Furthermore, 99% 0x vs. 1% 100x is very lopsided. Probably too lopsided for most investors with portfolios of 20-40 companies per fund. If someone made that bet for all 30 companies in their fund, the fund would be 0x almost 3/4 of the time. But if the bet was more like 95% 0x and 5% 100x, then that's kind of interesting. Making 30 investments like that would produce a terrible return 21% of the time (0 wins), a good return 34% of the time (1 win), and a terrific return the rest of the time (2+ wins). That said, prestige is (unfortunately) a factor. So I could imagine someone making an investment with an EV of 4x that is likely to be a unicorn over an investment with an EV of 5x that is unlikely to be a unicorn. The last thing I'll add is that A/B/C grades for investors are context-specific. An 'A' like Sequoia or Accel might be generally pretty great for everyone, and you won't go wrong taking money from those firms. But in certain areas, lesser-known funds might be very strong company-building partners. For example, there are specialty funds that are focused on SaaS companies or frontier tech, and if you operate in one of those spaces then those funds might be just as good as taking money from Sequoia. Finally, below is an interesting set of tweets from an LP who has been investing in VC funds for several decades. TLDR: it's basically impossible to build a great fund return on top of lots of small wins; you need a few huge wins instead. https://twitter.com/HorsleyBridge/status/657287940456886272 https://twitter.com/HorsleyBridge/status/657287940456886272 https://twitter.com/HorsleyBridge/status/657288063329013760 https://twitter.com/HorsleyBridge/status/657288063329013760 https://twitter.com/HorsleyBridge/status/657288245105917952 https://twitter.com/HorsleyBridge/status/657288245105917952 https://twitter.com/HorsleyBridge/status/657288489331855360 https://twitter.com/HorsleyBridge/status/657288489331855360

akiselev 10y ago
I wonder if this financial reality is really the way it has to be or if it's a natural consequence of competition in the VC industry getting out of control. When the intangible value-add a firm can provide is low, all they can really compete on is the financials and how favorable the terms are to the founders. This causes a spiral where the valuations go up (dragging up even the valuations of 'A' firm deals) but the dilution each round does not keep pace. Founders with unicorn ambitions benefit by growing faster and keeping more of the future fortune so they keep the inflation train going. Everyone else who wants to build a solid company or reward investors with a steadily growing stream of dividends and a good but not great ROI suffers from the pressure to grow faster than they or their business model are capable of handling. Of course there's a second pressure from the other direction as companies compete to acquire more nimble competitors in lieu of hiring slowly and risking internal R&D. Since M&A has become a more and more common exit strategy over the last few decades, there's more opportunity for those unicorn returns with less risk, further souring VCs' opinion of other deals. In other industries like biotech it's not that rare to see early rounds where founders give up 40-50% of the company so even though investments are bigger and riskier, the financials work out to returns as good or better than tech in general. The pharmaceutical industry has outsourced large amounts of R&D risk to biotech investors for a long time though, so the risk is usually scientific and not product-market fit or sales/distribution. If you're working on a drug for a certain disease or condition, it's pretty easy to calculate how much you can make or how much you'd be worth to a pharmaceutical giant at various stages of risk (seed, animal studies, efficacy studies, clinical trials, post approval, etc.).

fanzhang 10y ago

> My semi-cynical thesis is that VCs need home-run logos on the Portfolio page of their website to keep their spot at the dealflow table. The causality probably isn't: LPs want home runs -> LPs look for home runs on VC pages -> VCs deliver home runs. Rather, it's probably: In the VC space, home runs make up the majority of the EV -> This common fact supports LPs looking for home runs, and VCs looking for home runs. There are probably some synergistic effects where the two are more than additive, but I think the underlying cause must be that in VC space, home runs make up the bulk of the return. To see this, consider PE firms or mutual funds -- are these industries a lot less into home runs? I would argue yes -- that for these firms they are measured by LPs by their historical average returns, or fees, or whatnot. Because in these firms that's the closest proxy for skill. Whereas in the VC world, home runs are the proxy for returns.

taneq 10y ago

Shouldn't a rational VC be taking a couple of (2) in among a bunch of (1)? You want a mixed portfolio with an overall positive expected return, but you want to fold in a few moonshots on the off-chance that they pay off and make you mega-rich and famous.