Pattern recognition

VC’s love to talk about their pattern mapping abilities. “We add more value because we’ve seen so many companies go through all sorts of situations before and we can quickly map whatever’s happening at your business to what we’ve seen in the past and leverage this experience.” Or so the logic goes. But what’s going on right now with early stage company valuations suggests that VCs may be poor judges of at least some of these patterns. Or at least that they’re incredibly human when it comes to estimating the likelihood of certain events actually happening.

In 2002 a series of random shootings rocked the Washington DC area. For a period of about two weeks, an unknown assailant killed 10 people in a sniper like fashion. Many people in the area were panicked at the possibility of being subject to such a random act of violence and drastically altered their behavior to avoid putting themselves in situations that they perceived to be potentially dangerous. In reality, DC is a city of over 600,000 people. And while the events of those two weeks were certainly shocking, the average citizen was significantly more likely to be killed in an automobile accident than by the DC sniper. But that certainly wasn’t how serious most people perceived the risk to be. Because fundamentally humans are extremely poor judges at predicting the likelihood of outlier events.

Fast forward to today’s funding environment and I believe a similar mindset is taking place. Companies like Facebook, Twitter, Zynga and Groupon are attracting so much press that investors are misjudging the likelihood that their next investment will turn into something similar (or even into something in the next tier or two down in terms of outcome). In reality, since Facebook’s first venture round in 2005 over 10,000 different businesses have received venture funding. And history suggests that the vast majority of these companies will see outcomes of less than $1BN. Actually of less than even a few hundred million. And that’s the very best of this group. The majority will either fail completely or barely return capital.

Market deviations are driven by a fundamental imbalance between two sides of a marketplace. And we’re seeing a classic case of that now in the venture capital market. Unfortunately these market deviations tend to feed themselves – at least for a while. Company X raises money at a high valuation and the markets shift their perception of the clearing price for deals of that type. Perhaps the company raises another round at an even higher valuation, validating (at least temporarily) the first investment decision. Maybe there are a handful of high profile exits that, at least in those cases, justify the high valuations paid by their investors.

Eventually, however, the markets face their moment of truth. And there will be one (as there always has been) for the current venture climate. And while I’m sure that there will be some great businesses created in this market I think we’ll look back on this time period and again be reminded that the more things change in venture, the more they stay the same.