Thursday, March 30, 2017

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.