Are venture capital markets inefficient?

March 2018

Here are some facts about venture capital that might surprise you if you’ve learned some economics:

It’s hard to get actual hard data on fund returns, so these data points are by necessity somewhat speculative. But I think they’re enough to provide strong evidence that something weird is going on in the market for venture capital–that (a) if you were able to invest in any startup of your choice, at what seems like the market rate, you’d be able to get substantial free money; and (b) the market isn’t “clearing”–the supply of capital is much bigger than the demand for it.

This is confusing!

If you believe in the efficient market hypothesis, this probably sounds pretty weird. Your normal models would predict things like:

Why doesn’t that happen here?

Some explanations?

My guess at the explanation has two parts.

First, startups can be predictably undervalued because they care more about optimizing their chance of success than their valuation. That’s because startups are driven by power-law dynamics–the top couple “winners” in a space are likely to be as valuable as everyone else combined–so increasing your chance of being a winner is much more important than anything else.

Here’s an (incomplete) list of things that startups sacrifice their valuation for:

But even if we can explain why some startups are predictably undervalued, that’s not sufficient to explain why some VCs predictably earn excess returns. Why don’t the best venture capitalists expand their funds until their average return isn’t market-beating? Here’s one theory:

Y Combinator is the only organization to have plausibly solved the scaling problem. My guess is that they “solved” it by completely monopolizing their stage of the fundraising pipeline. If you’re raising a Series A there are lots of equally super-famous investors to pick from, so if one of them dilutes their brand you can go to someone else. Meanwhile, if you’re looking for an accelerator, your second best choice can’t tell “literally” from “literately”.4

Where’s my free money?

Normally, when an asset class is inefficiently priced, you can buy it and make free money. But in this case, you can’t. You can’t invest in the best startups because they’re already snapped up by the best VCs, and you can’t invest in the best VCs because they can’t increase their fund size without diluting their brand. In Yudkowskian terms (Yudkowsky 2017), even though the market is inefficient, it’s not exploitable (unless you’re a top-decile VC firm).5 Too bad for you!

Sources

Altman 2014: The New Deal

Altman 2015: YC Stats

Cochrane 2001: How High are VC Returns?

Wikipedia: Sequoia Capital

Footnotes


  1. Technically, for this to be true it requires some additional assumptions about the shape of the joint distribution of (past performance, current performance). 

  2. The brand is also its own asset, separate from whatever value-adds it’s based on, because the best-brand VCs have their pick of startups, and so if they invest it sends a strong signal that the startup is likely to succeed. See Mowshowitz 2015 for a more cynical take that this is most of the reason for the market inefficiency. 

  3. The brand theory also explains why so many actors and sports people become venture capitalists. It’s not that they have good business sense. Instead, merely by being famous, they become a Schelling point that the best companies and advisers coalesce around. 

  4. The source for the ranking is Forbes. They seem to be highly regarded by other sources as well. 

  5. Actually, startup equity is Yudkowsky’s first example of an inefficient-but-inexploitable market, although I’m demonstrating a different type of inefficiency (predictable price increases), and for different reasons (VCs not competing on price). 

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