VC Incentives: Logo-Hunting and Optionality
The Diff, 2020-05-08
Misplaced Incentives are the Root of Evil
Capital markets: disbalance of upside of high-risk trades (huge bonus) and the downside (zero bonus) for traders. Leads to perverse incentives of taking a lot of risks. It’s like selling an underpriced option (which eventually will blow in your face).
VC: associates want to become partners (usually – via lateral moves), and are incentivized by chasing hot deals, not necessarily profitable. Hard to know one’s performance from the outside —> media coverage beats fund returns for individuals.
VCs are chasing companies with momentum as (looking backwards) many successful companies showed momentum before IPO/exit, often justifying high valuations. At the same time, ROI on momentum is not as high as when not chasing hot deals.
High valuations mean competitors get a benchmark for funding, too; high round amounts suck capital out of the market for competitors.
Revenue-focused business can afford not to look at the bottom line too closely. Doesn’t work for smaller companies, which have to make a practice of avoiding costly mistakes regardless of the shiny upside.
And the Last Will be First
Associates don’t have decision power, but they have the power to emphasize certain data points and forget the other.
Selling a hot company to partners is way easier than an obscure company [with maybe better financials but less VC market validation]. Just make the partner think less about the deal.
Don’t Make Me Think (and Betray You)
A huge amount of time is wasted on research that doesn’t result in a deal. The return on time spent is diminishing.
Isn’t it better to spend less time researching and just chasing hot deals where other people have done the thinking for you? It’s like buying an overpriced option (i.e. bleeding money). The winner is the investee company.
Within a portfolio the best time spent ($ and impact-wise) is on the underperforming companies.
And often a hard decision is needed: replacing the CEO of an underperforming company.