
Picking Winners: A Framework for Venture Capital Investment - blopeur
https://arxiv.org/abs/1706.04229
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chroem-
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.

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clavalle
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.

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soup10
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
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.

~~~
soup10
This isn't realistic. Many business need outside capital, they just need it
without the institutional baggage. For my own business i'm specifically
looking for investors that are aligned with the companies goals first. And its
proving difficult because so many investors have distorted ideas about the
very nature of business. Many believe the point of business is to make money.
Which is exactly the wrong mindset from my point of view and highly dangerous
to what we are trying to accomplish.

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startupdiscuss
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

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

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dzink
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.

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exogeny
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..

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pbiggar
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.

~~~
pge
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).

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bambax
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.

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coolswan
Despite it being so obvious, I really like their analogy,

    
    
      pharma::drug
      studio::movie
      vc::startup
    

"Just" need one to work out!

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tryitnow
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.

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samfisher83
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.

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rdlecler1
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.

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

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dokein
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.

