Thursday, October 30, 2014

On VCs, Clairvoyants, and Magicians

The guy at the next table looks out at the amber sunset, puffs up with gravitas, and announces to his wide-eyed friend “soon all things will be connected seamlessly to the ubiquitous network." Time to change tables. I grab my drink and set off to find an area outside of Houdini’s vocal range. The bar at the Rosewood is cursed by its reputation as the place where VCs from Sand Hill Road meet, so it attracts posers playing the prophet like LA attracts actors.

Coincidentally, on my way over to the Rosewood, I saw along El Camino Real a hand-painted sign saying “clairvoyant conference” with an arrow pointing to a hotel. Imagine a conference for clairvoyants! You would not need to have sessions on “future trends,” since they would already know. But wait: Why the sign giving directions, for that matter?

Since time began, it seems people want to believe that some of us have a special knowledge of what is to come. So we’re vulnerable to those who claim such knowledge - albeit that different people fall for different images of the prophet. You might mock the trappings of the village shaman, the tarot reader, and the astrologist – but I bet you’d clear your calendar to hear the latest word from the valley’s richest VCs.

I’m not just waxing cynical. It turns out that venture capitalists typically are bad at telling the future. As an industry, VCs don’t perform that well financially. To find VCs who outperform the market, you have to selectively sample only the most successful ones - but that is true for slot machines, too. OK, a minority of VCs do tend to appear repeatedly on the winning side, so perhaps they are the real Houdinis. Maybe. Or maybe having been successful they end up getting preferential access to things that continue to make them successful. (I appreciate that advantage, working at Stanford.)

Whatever the reason, the fact that at least some VCs are repeatedly successful has created the mystique that there does exist, somewhere along Sand Hill Road, somebody who does know what’s next. Hence all the puffery at the Rosewood. How are we to know that he’s not really a visionary?

Professor Elizabeth Pontikes and I took a careful look at this question. We collected data on thousands of firms in the software business and looked at their fates over time – including both successes and failures in the data. We found that these firms herd into “hot” markets that have been blessed by the VCs. But we also found that the VCs herd into markets too, following each other in financing frenzies. The resulting hype cycles lead to bad outcomes for companies; firms getting funded in these waves are the least likely to ultimately succeed by going public. So much for Houdini.

Perhaps even more interesting, the VCs themselves seem to be aware of this problem. While VCs herd into hot markets, at the same time they try to avoid investing in firms that do so. The VCs prefer instead to invest in those who pioneered what is now a hot market (and survived). As a kid I had a precocious classmate who would jump to the front when he saw a trend, pointing resolutely forward in Napoleonic fashion, proclaiming “follow me!” I’ll have to check; perhaps he grew up to be a VC.

Remember, the most disruptive changes are not predicted by our experts. They are pioneered by those foolish enough to ignore the consensus. Be skeptical of those who claim to know what's next.

For the research behind this article, see my paper with Elizabeth Pontikes.

Wednesday, October 15, 2014

The Partnership Fallacy

Remember doing group projects in school? Typically your teacher would partner you up with students who had different skills. Maybe a good writer would be matched with someone who knew math, for instance. In theory, you would each teach the other; the group project would get done, and everyone would learn. But what really happened? Perhaps pushed for time, at some point everyone in the group realized that the job needed to get done. And if you wanted to do well, this meant dividing labor. You broke down the project into parts, as in the well-known "divide and conquer" algorithm pictured here, and each of you took on the part that you understood best. In the end, the project was a success – but the math person did even less writing, and the writer again avoided math. So goes the partnership fallacy:  We partner up hoping to improve our weaknesses, only to divide labor and so make our weaknesses even worse.

Business leaders often fall victim to the partnership fallacy. For example, it may be hard to believe today, but in the early 1990s Apple Computer (as it was then called) was widely known to be bad at making small devices. The company’s earliest attempts to make small computers had flopped. Meanwhile, Sony stood out as the worldwide leader in making cool, miniaturized electronics. So Apple’s leaders decided to form a partnership with Sony. The idea was for Apple to learn about miniaturization while producing a laptop computer. History says that the alliance succeeded, because it created the first “Powerbook” computers. But in terms of learning, the alliance was a failure. Case studies at the time reported that deadlines kicked in, and pushed the two companies to each stay focused on what they did best. In particular, Sony took care of miniaturization, with very little day-to-day contact between Sony and Apple engineers. In the end, they got the job done – but Apple emerged without learning Sony’s miniaturization magic.

What’s more, often partnerships fail even to accomplish their stated goal, never mind learning. If you have much experience, you can probably name an example or two of failed partnerships. Business leaders typically allow these arrangements to fizzle out without much fanfare. Combining firms through merger and acquisition suffers this problem, too. We talk a good story about “synergy” and “learning” and “1+1>2”, but the evidence shows that combining firms typically increases only the variance in performance (not the level of performance as promised by “synergies”).  

The lesson: Partnerships are not a substitute for learning by doing. Partnerships sound great during a planning session. After all, who can argue with the idea of bringing in somebody who already knows what you need to learn? But ask yourself, how did they come to know?  Odds are, they learned the old-fashioned way: by doing. Effective leaders understand how organizations learn, so they avoid the partnership fallacy. Partner if you must, but don’t fool yourself that this is a great way for your organization to learn.

For a thorough academic study highlighting the value of organic learning and growth, read my book on competition.