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VCs and Randomness

A few weeks ago I wrote about Black Swans and Venture Capital – an article that was promoted by reading "The Black Swan" by Nassim Taleb. I'm still re-reading parts of the book as I think about the effects of Black Swans (an improbable event with massive impact and post-facto rationalization) and how prevalent they are in venture capital.

At the risk of sounding like an infomercial for Mr. Taleb's books, I've just finished reading his first book – "Fooled by Randomness" which looks at the role that chance (luck, fate, call it what you will) plays in life and business. Like "The Black Swan", this book is also well worth a read and consideration by anyone involved in startup companies.

Here's some of my thoughts about Venture Capital and the effects of Randomness…

"The risk of a negative Black Swan is discounted."

Much like investment managers in other areas (stocks, hedge funds etc.), a lot of VCs rely on past performance and past company successes as a proxy for what might happen in the future - especially when looking at potential new investments. Black Swan events such as the collapse of the Dot.Com bubble in 2000 or the drastic pullback in Telecom Capital Equipment spending in late 2001 tend to be discounted and inevitably wreck havoc when they occur.

"A rising tide raises all ships."

This tendency to look at past success also leads to price inflation in later round valuations for companies in a "hot" area – a positive Black Swan such as YouTube or MySpace for example, drives up valuations in similar companies after a successful high profile liquidity event. Other companies in the same sector often benefit from improved valuations as everyone bids the price up hoping to get a piece of the next "big one".

"Success breeds complacency"

This behavior in turn tends to drive over investment in a particular sector as everyone wants to get on the band wagon. Inevitably this leads to a concentration of risk (too many companies in the same sector won't all reach a happy exit) and lower returns. This affects entrepreneurs and VCs alike but with a hidden cost to the entrepreneur – a few years of your life you don't get to have again (even if you can raise more money for your next gig).

"Spread the joy!"

It's better for a VC to widen their investment exposure and make aggressive investments in new, less "hot" areas or consciously acknowledge that investments in a "hot" area concentrates risk and requires a well defined point (and strong constitution) to know when to say "enough" and stop the losses.

If you are looking at a VC as a potential investor, try and understand what their current deal flow looks like and the philosophy behind the new investments they make rather than extrapolating on their past successes. Avoid the "herd" effect unless you are the alpha!

Remember, "Chance favors the prepared mind" – are you open to the effects of randomness?







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Intense Brit, lived in Silicon Valley since 1984. Avid pilot, like digital photography, ham radio and a bunch of other stuff. Official Geek.

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