Is Venture Capital An Efficient and Transparent Market?

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Is Venture Capital An Efficient and Transparent Market?

Kareem left this comment on my post about Andreessen's posts:

"When you've got an efficient and transparent market"

Can you dig into this a little more, Fred? In my (limited) experience, the VC market seems anything but efficient, and one website does hardly makes the industry transparent.

I suppose using the word efficient was a mistake because "efficient markets" describes a hypothesis about market behavior put forth by Eugene Fame in the early 1960s. To quote from Wikipedia in case you don't wan't to click on that link,

Efficient Market Theory asserts that financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. Professor Eugene Fama at the University of Chicago Graduate School of Business developed EMH as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school.

The efficient market hypothesis states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect stock prices that is unknowable in the present and thus appears randomly in the future.

I do think it's possible to outperform in the venture capital market using information the market already knows. It happens all the time. You can do it by having insights into that information that others don't make. You can do it by backing the better team. You can do it by having a brand (like Sequoia's) that allows you to win the best deals when everyone already knows they are the best deals.

So venture capital is not an efficient market in that sense. Venture capital is a private equity market and I believe that private equity markets will never be truly efficient in the way that Fama described because the shares of venture backed companies don't trade in the classic sense. You may want to be an investor in YouTube and you might be willing to pay twice the price that Sequoia paid, but if YouTube doesn't need the money,or if Sequoia's supplying it to YouTube on terms that YouTube is happy with, you aren't going to be able to be an investor in YouTube. Venture capital is not a true market.

But there are market forces at work. Entrepreneurs work hard to understand where "the market" is in terms of valuation. And they generally make an effort to get at least several firms interested in their financing so they can get enough "bids" to determine what the right valuation is. Anybody who has been paying attention to the web services segment of the venture capital market knows that valuations have been steadily on the rise in this sector for the past three years. When you see Geni.com or Mahalo.com raise money at $100mm pre money, you know that the market is frothy and it's a good time for entreprenuers to be raising money. It's also equally true that VCs look at those numbers and know its not exactly a great time for us to be investing in this sector.

But as Marc Andreessen points out in his third (and supposedly last for a while) post on VCs:

And that's why, from where I sit in Silicon Valley, there are probably 200 venture capital firms within 20 miles with likely over $20 billion of capital at their disposal chasing a very small number of good potential investments, despite terrible average returns for the asset class over the last seven years.

What is a venture capitalist who has capital to invest do when the valuations in their target sector rise to unsustainable levels? Keep investing, of course. That's what we are paid to do. At Union Square Ventures, we are working hard to manage this risk of elevated valuations. We've seen it before, felt the pain it inflicts, and don't want to feel that pain again.

But regardless of what any one firm is doing to mitigate risk, the market for venture capital in the segment that I know well, web services, is white hot. I believe that any good entrepreneur with a good business idea will get funded in this market and will get funded at a fair and reasonable valuation. If you can't raise money in this market, you really need to look at what you are doing and figure out why it's not working. The market is certainly not to blame.

That's what I was referring to when I used the work efficient. I meant that it's a very efficient time to be raising capital if you are an entrepreneur.

I also believe the market has become more transparent. There are many new ways that VCs can figure out where to invest, what to invest in, and who to invest with. Blogs like TechCrunch, Om Malik, Read Write Web, and many others are doing the VCs an incredible service by pointing out new web services to invest in every day. Blogs like this one, Marc Andreessen's, Brad Feld's, and many others also are providing ideas and transparency to VCs and entrepreneurs alike.

And there is already one "rate your VC" website and possibly others to come. I agree that one website doesn't make a market transparent, but I linked to it just to make a point. Never before has the entrepreneur had resources like what's available now to navigate and figure out the venture capital market.

Venture capital (and all of it's private equity brethren) will never be efficient in the academic sense of the words. Private markets lack several important forces that create true efficiency. But from where I sit (to use Marc's phrase), the venture capital market has never been more entrepreneur friendly than it is right now. Even in 2000 when $100bn+ was invested, the entrepreneurs knew a lot less about what was going on than they do know. And this trend toward more transparency and liquidity is not going to stop anytime soon. This is how we are going to operate going forward. If you are a VC, get used to it. If you are an entrepreneur, get going.

Comments (16) | Posted June 12, 2007 in Venture Capital and Technology

Comments

Fred,

Isn't the point here that the USD20bn available is chasing a very small pool of possible opportunities by restricting themselves to Silicon Valley (or New York for USV) while there is a larger pool of opportunities if the VCs are willing to explore beyond the standard geo locations?

I realise you prefer to be able to do a lot of (all?) board meetings in person, but that at the same time restricts you to only opportunities within NY area (assuming my geography is reasonable).

It seems to me that the biggest in-efficiency in the VC industry doesn't relate to the failure to pick winners but the failure to move VC capital to where (geographically) the best opportunities are.

For smaller VC firms it is going to be harder, but can be accomplished by creating a VC network of various VCs in different geographical locations. Now I can see two ways of doing this. One is to create something like the airline networks such as Star Alliance and OneWorld. The other is to create lots of small satellite offices that don't necessarily have a GP but do have people to act as your eyes and ears and even represent the firm on the board meetings.

Simon

Posted by: Simon | Jun 12, 2007 7:56:32 AM

Simon, I'm actually seeing a surprising number of companies that are being funded outside of the prime locations. Towns that I've seen recently off the top of my head are various locations in Colorado, Chicago, and even Baton Rouge.

On the other side of this, if I were a VC I'd have to see a really great product to want to fund a team who doesn't capitalize on the huge advantages of being in the valley networks.

If you were funding a movie studio, would you want to place your bets on the team who lives in Kansas City or the ones in Hollywood.

Either way, all that's a tangent. I'm very happy with the increasing level of transparency and hope more and more partners get blogs :)

Posted by: Rick | Jun 12, 2007 9:53:00 AM

Simon,

We're working with some outside the valley VC's right now and the big problem they see is lack of quality deal flow. When a good deal comes along they're all over it. We ended up having more interested parties than we did space in the round. If a hub of entrepreneurs appears somewhere, the VC's will follow.

There is more capital outside of the valley than you think there is, especially if you're doing a seed round.

As far as transparency... Raising a round is nothing like what you expect it to be like. It is a long haul. A term sheet is only the beginning.

Posted by: Erik Schwartz | Jun 12, 2007 10:14:34 AM

I just got schooled. Thanks for the education Fred!

Posted by: Eric | Jun 12, 2007 10:35:17 AM

Let's say there are two competing VCs to invest in some pool of new businesses and both of the VCs are of equal intelligence. If information is freely available and no-cost, both of the VCs should evaluate the information similarly, and both of the VCs should be able to identify which is the better team, hence both VCs should be competing to invest in the same firm: the highest payoff business, risk adjusted.

In the real world there is a transaction cost (wikipedia it) related to information. There is an "economic cost" for some people to interact with other people. They may not get along, in other words. They may live on opposite sides of the country, or speak a different language or any other barrier you can imagine to perfect information. Some firms are better able to lower this transaction cost than other firms, and firms who are better able to lower this cost are able to extract more of the quasi-rents (wikipedia it).

I think you will find some of the top VCs spend a lot of time developing relationships with their potential investees. Feld said he likes to bring them bowling. I know Fred here has mentioned developing a relationship on a number of occasions. I am certain that both of them have attempted to work with entrepreneurs who went on to be successful with other VCs where their personalities didn't match up.

When you see Geni.com or Mahalo.com raise money at $100mm pre money, you know that the market is frothy and it's a good time for entreprenuers to be raising money.

It depends on how you define efficacy of that capital. I am not sure that there is a linear representation of dollars invested -> future stream of incomes. It could be the hotter the market the worse it is for an entrepreneur to raise capital. An entrepreneur's goal is to maximize profits. Not all firms with big capital investments end up being profitable, although some do of course.

VC firms can, generally speaking, invest two things into a firm: time and capital. As the cost of capital rises (the risk increases) firms will substitute away from capital and start investing their time. I have read before that VCs tend to spend most of their time with their worst performing companies (their riskiest performers).

An interesting post Fred.

Posted by: Jamie | Jun 12, 2007 11:12:19 AM

fama was wrong!

the emh a hoax perpetrated by brilliant imbeciles in ivory towers who failed to incorporate humans into markets. duh...

efficient markets my fat black ass...

Posted by: phil | Jun 12, 2007 12:28:20 PM

Did you really mean, "When you see Geni.com or Mahalo.com raise money at $100mm pre money,..." is that a typo or did I miss something dramatic?

Posted by: Bob | Jun 12, 2007 1:02:30 PM

I think you need to approach the efficient and transparent questions individually. While the VC market is certainly not efficient in the F&F emh sense of the word, pretty much nothing is, so that's irrelevantly as far as I'm concerned. Not even the most devout F&F fans could make a case for the US equity market fitting the emh model. If that doesn't, not much will. However, I think the VC market is still mostly efficient (call it semi strong whatever you want). There's enough competition among firms, even when accounting for the brand preference someone like Sequioa gets, that it would be hard to get REALLY inefficient.

Now, I think the VC market is absolutely NOT transparent. Like you say, it is getting much more transparent. Blogs like this one, Ask the VC, Ask the Wizard, etc. all offer great insights into a world that was previously completely closed to outsiders. That being said, the new resources that seem to pop up (and get embraced) every day would suggest to me that there's still a market for a lot more information on the subject. If there's still a demand for that much more information, how could it possibly be transparent right now? It's certainly moving that way, but I can't see how it's there yet.

Posted by: Evan Solomon | Jun 12, 2007 2:22:18 PM

We chose Lancaster, PA, our hometown Last time we moved to Seattle, and sure there were resources there, but this is home. We're doing great.

So Fred (and whomever): I see about a 40% difference in valuations between East Coast and West Coast, and VC seem to confirm the bias.

True? Why should I shop my deal on the East Coast if this is the case?

Posted by: Charlie Crystle | Jun 12, 2007 2:29:44 PM

Fred,

First time commentator – great blog! Thanks for sharing your insights.

Thought provoking quote:
“The venture capital market has never been more entrepreneur friendly than it is right now. Even in 2000 when $100bn+ was invested, the entrepreneurs knew a lot less about what was going on than they do know. And this trend toward more transparency and liquidity is not going to stop anytime soon.”

What I find most interesting is that one can substitute the words “venture capital” in the quoted paragraph and re-insert just about any business or information-based concept and the observation would remain true. This is exactly a defining characteristic of the Net – unparalleled transparency of ideas and liquidity of information. The amazing power of current and future Web Services built on top of the Internet lies in their ability to provide market aggregating platforms through which to tap a collective intelligence and enable improved efficiencies like never before. What’s more, the Net’s ability to harness the long-tail even further improves each overall market.

Now none of this implies all of these services create truly “efficient” markets (in the academic sense) – wherever there is lack of information there is inefficiency – but, the Internet has completely changed the landscape for market-based productivity, just as you describe regarding this one, and important, instantiation in the case of Venture Capital.

Thanks for the post!

Posted by: Ben Siscovick | Jun 12, 2007 3:26:45 PM

Bob

You are reading right.

Geni valued at $100m
http://valleywag.com/tech/paypal/geni-valued-at-100m-242097.php

Is Mahalo worth $100m before it's even launched?
http://valleywag.com/tech/top/is-mahalo-worth-100m-before-its-even-launched-260330.php

Posted by: Rick | Jun 12, 2007 4:53:35 PM

At the risk of sounding like a suckup, I think it's fantastic that you openly promote a site like TheFunded. I think many VCs are either terrified of or unaware of the site.

Given the control the VCs have, I think any transparency is a good thing. TheFunded may have its issues, but based on my limited experience, comments on the VCs I've pitched have been mostly accurate...

Posted by: fewquid | Jun 12, 2007 5:52:24 PM

I'm not sure I understand all this, but hey, if you're looking for inefficient investments, give me a ring, I got a lot of ideas......

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Posted by: aizheng | Jun 16, 2007 5:27:43 AM

Rick & Erik,

I was actually thinking more globally than simply US based. There are a lot of decent potential and existing dealflow in places like London and the M25 circle.

The general reason that they are not necessarily receiving funding is the lower tolerance of risk in the UK (and Europe as well) than there is US.

I don't see that the Hollywood example really applies.

Posted by: Simon Cast | Jun 16, 2007 8:19:07 AM

VC is a grossly inefficient market. And Simon, the first commenter, hit one big aspect of that right on the nose: localization. Rick's comment following about "a surprising number funded outside of the prime locations" makes me laugh out loud. Statistically a blip.

VC, especially as relates to the funding of Internet startups, is essentially a phenonenon occuring in a handful of localities, and that won't change soon. The closest I've seen to an attempt to replicate it elsewhere, for a VC to essentially syndicate itself out to other geographies, was what Tim Draper tried to do with DFJ. (How successful that's been, I'm not sure, nor do I know how many of those franchisees have actually invested in a local Internet startup.)

And Erik's comment that "If a hub of entrepreneurs appears somewhere, the VC's will follow" -- more bunk. VCs plain and simple like it where they are; the vast majority will not invest in far-off startups, nor will they leave their digs to set up a satellite office somewhere to do so. The best VCs will do, with virtually all the fundable Internet startups I've seen in non-prime locations, is tell to them to move where they are. It happens every day.

Fred, I'm sure you like your view from NYC, as do the Valley guys from their perches. And you don't want to live on planes. So, VC is by and large a highly localized phenomenon -- despite all the lip service we're constantly fed that our world is going "virtual." As time goes on, the more I see that nothing changes.

Posted by: Graeme Thickins | Jun 17, 2007 10:32:51 AM

A VC

Musings of a VC in NYC