6 ms·

Picking Winners: A Framework for Venture Capital Investment

113 points by blopeur 9y ago

exogeny 9y ago
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..
- sjg007 9y ago
  Most VCs pass or miss on the big deals anyway.
  - pedalpete 9y ago
    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?
    - sjg007 9y ago
      There's a documentary about it on Netflix: "Something Ventured"
    - lpolovets 9y ago
      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.)
- pbiggar 9y ago
  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.
  - exogeny 9y ago
    This is my experience with them as well. Very positive.
  - pge 9y ago
    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).
- coolswan 9y ago
  Correlation usually insists on an existing lead as well.
deleted 9y ago
[deleted]
chroem- 9y ago
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.
- clavalle 9y ago
  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.
  - soup10 9y ago
    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.
    - pge 9y ago
      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.
hatmatrix 9y ago
I thought predicting winners in startups was searching for "Black Swan" events - the ones models often miss...
deleted 9y ago
[deleted]
coolswan 9y ago
Despite it being so obvious, I really like their analogy, pharma::drug studio::movie vc::startup "Just" need one to work out!
startupdiscuss 9y ago
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
- pge 9y ago
  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.
  - startupdiscuss 9y ago
    That is an excellent point (that many investors rely on increased deal flow from early success). It sort of pervades the other "styles"
dzink 9y ago
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.
samfisher83 9y ago
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.
bambax 9y ago
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.
rdlecler1 9y ago
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.
dokein 9y ago
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.
tryitnow 9y ago
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.

113 points by blopeur 9y ago

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..

sjg007 9y ago
Most VCs pass or miss on the big deals anyway.
- pedalpete 9y ago
  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?
  - sjg007 9y ago
    There's a documentary about it on Netflix: "Something Ventured"
  - lpolovets 9y ago
    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.)
pbiggar 9y ago
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.
- exogeny 9y ago
  This is my experience with them as well. Very positive.
- pge 9y ago
  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).
coolswan 9y ago
Correlation usually insists on an existing lead as well.

deleted 9y ago

[deleted]

chroem- 9y ago

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.

clavalle 9y ago
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.
- soup10 9y ago
  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.
  - pge 9y ago
    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.

hatmatrix 9y ago

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

deleted 9y ago

[deleted]

coolswan 9y ago

Despite it being so obvious, I really like their analogy, pharma::drug studio::movie vc::startup "Just" need one to work out!

startupdiscuss 9y ago

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

pge 9y ago
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.
- startupdiscuss 9y ago
  That is an excellent point (that many investors rely on increased deal flow from early success). It sort of pervades the other "styles"

dzink 9y ago

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.

samfisher83 9y ago

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.

bambax 9y ago

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.

rdlecler1 9y ago

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.

dokein 9y ago

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.

tryitnow 9y ago

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.