Read any of the many “best of” lists on venture capital and a handful of names will pop up again and again (and year after year): Sequoia, Kleiner Perkins, Benchmark Capital, Accel Partners, Tiger Capital. These are the firms that lead funding rounds for Silicon Valley unicorns, where partners become legends for inking deals with Facebook, Google, or Uber before most people had ever heard of them. When startup founders begin looking around for investors, they dream of landing one of these firms.
In recent years, big VC firms have been getting even bigger. Top firms gobble up more and more of available capital, leading to lean times for the “middle market.” Why? In a new study, Olav Sorenson, Frederick Frank ‘54 and Mary C. Tanner Professor of Management at Yale SOM, Ramana Nanda of Harvard University, and Sampsa Samil of the University of Navarra, find that the success rates of top firms flow from access to the best startups that is not available to newer or less prestigious firms. “There are a certain number of deals out there where you can just sort of see it —this is something that’s likely to succeed,” Sorensen says. “The problem is that everyone can see that. Everybody wants to invest in those deals. The ones that are able to make that investment are those that have a strong enough reputation that the entrepreneurs actually want them involved.”
If access is the key to a string of successes, what does a firm need to do to get to that point? Often one big deal is enough to establish a reputation as savvy investors. And how does a VC firm find such a startup? According to Sorenson, you need good luck. “That first fund ends up being almost a roll of the dice,” he says. “You take some chances on some really high-risk ventures. You hope that a couple of them pay off. If they do, then you start to develop this reputation. Then you’re able to get into the more attractive deals.”
In an interview with Yale Insights, Sorenson described what the findings mean for up-and-coming investors, fledgling entrepreneurs, and the industry as a whole.
How much of a crapshoot is venture capital investing?
There’s lots of uncertainty around startups. There’s uncertainty on multiple levels. Will the product or technology work out? Will consumers want to buy it? Are they going to want to buy it for a price that you can make money at? Then there’s even a bunch of uncertainty about the team and whether or not they can successfully build an organization. For a venture capitalist, how do you pick the right investments? Statistically, they don’t do that great—only one or two out of every 10 investments. But some of those investments are successful enough that across a portfolio of companies, a venture capital firm can still make money.
Do venture capital investors who make one successful investment tend to continue to succeed?
If we were looking at mutual fund managers, there’s a general mantra that past performance does not guarantee future returns. Statistically that’s true. If you look at people that have been high performers in the past, they have almost no better chance than just random selection of doing well in the next period. But venture capital is different. In venture capital, if you look at the firms that were the top performers in the last say, five years, they’re highly likely to be the top performers in the next five years.
What’s the conventional wisdom about why this is the case?
People have debates about it. I would say the overwhelming interpretation has been that these guys understand how to select either the right people, the right entrepreneurs, or the right technologies. They’re making better bets than everyone else. One of the things that we were looking at in this recent paper is what exactly explains this sort of persistence and performance.
What did you learn about why?
First we documented that this is true, that firms that did well in one period are likely to do well the next period. Then we asked what might account for this persistence. Is it because they’re able to pick the right companies? Our answer is no. Is it because they’re able to pick the right industries? The answer is yes initially, but nobody seems to be able to pick the right industry twice in a row. Is it because they’re able to advise the company better? It looks like the answer is no. Then we go through and say, “Well, what does predict it?” What we find is that the big VCs are more likely to invest in syndicated investments, and later-stage investments, and in larger investments. Those are all situations in which there’s typically less risk and less uncertainty. But those are also deals that are hard to get into because everybody understands that there’s less risk and less uncertainty. The basic message is that the persistence comes from the ability to get access to deal flow.
Our explanation is that this has to do essentially with the status of the venture capitalist. Venture capitalists that have a good reputation are able to invest in the attractive deals that everyone would like to invest in. There are a certain number of deals out there where you can just sort of see it. This is something that’s likely to succeed. The problem is that everyone can see that. Everybody wants to invest in those deals. The ones that are able to make that investment are those that have a strong enough reputation that the entrepreneurs actually want them involved.
Where does that status come from?
To get started you need to get some successful investments so that you can develop a reputation, so that you’re able to get into these deals that everyone would like to get into. What that means is that the first fund ends up being almost a roll of the dice. You take some chances on some really high-risk ventures. You hope that you get lucky and a couple of them pay off. If they do, then you start to develop this reputation. Then you’re able to get into the more attractive deals.
How do the investors themselves see this?
There’s certainly a number of VCs that think, “Some of us are really smart. The reason why we’re successful is that we’re smarter than the other VCs.” That’s certainly a sizable set. When we go out and talk with VCs about this, they often aren’t surprised by our explanation, because there’s a number who recognize that one of the most important things is what they would call getting access to deal flow. To a large extent, I think the practicing VCs would agree that this is a crucial aspect of performance, even if they also think that they’re smart people, and they probably are, and that that contributes to their success.
If the first win is dumb luck and subsequent successes flow from that one, does that change the approach that VC investors should take?
It does suggest that what a new VC might want to do is really kind of swing for the fences. If you’re trying to take sure bets, or at least relatively low-risk investments, then you might have some success in terms of your overall average return, but you won’t have these kind of really well publicized, highly visible successes that seem to be what are responsible for establishing the reputations that get other entrepreneurs to want you as investor. It does suggest an approach where, well, I’m going to try taking some really big bets. If they go well, I could potentially be set up for my next fund. But if not, I probably don’t have a future in the industry.
Should it say something to entrepreneurs about how they should approach getting the venture capital?
We know that entrepreneurs tend to go with the VC with the better reputation. That may be the right thing for them to do because there’s an aspect in which it acts as a signal that creates a type of coordinating equilibrium. It makes it easier to attract other investors.
Another thing that entrepreneurs care about is getting the right employees. If you see a highly reputable venture capitalist investing in a company, that then makes it easier for you to attract the best talent. So there’s this sense in which there can always be a self-confirming aspect to getting these investments from VCs that have a strong reputation. I think there are limits to how much you should be willing to pay for that.
One of the other things that we know is that the high-status VCs tend to offer less attractive terms. In exchange for the same amount of money, they’re going to expect a larger proportion of ownership in the company. So entrepreneurs really need to think about it. If they’re going to have to pay a big price for that status, they might be better off working with the less well-known investor.
So are there times when it makes sense to go with a newer VC fund with less of a track record?
We know from researchers at Cal Tech that reputations in venture capital are often not firm level. They’re at the level of an individual partner. It’s not enough to get money from Kleiner Perkins. Who is the lead partner within Kleiner Perkins that would sit on your board and be most involved with the company? If it’s John Doerr, that’s fantastic. It’s a strong signal. But if it’s some junior partner who just got promoted, you might be better off moving with a younger, less reputable firm.
How has venture capital changed in the last decade or two?
The venture capital industry as a whole in the U.S. just hit a new record. In fact the 2018 investments exceeded the 2000 investments for the first time. For the first time since the end of the internet boom, we’re seeing a new surge in venture capital. The distribution of that looks quite different. What we’re seeing increasingly is very large investments in later stage companies, companies that already have high valuations, are already quite successful. Think Uber or Lyft, these large companies that have billions of dollars already in revenue.
We’ve actually seen a decline over the last four to five years in the number of early-stage companies. There’s also been a decline in the number of new VC funds that are focused on the early stage. I think what’s happening is that these dynamics are making it more and more attractive for investors to focus on the later stage, at least in the short run. But the problem is that later stage depends on a pipeline that’s coming from these investments in the very earliest, youngest companies. It will take a few years before that starts to affect the industry as a whole. I think that this paucity of early stage investment, and the entry barrier associated with not having a reputation, mean that we may see a decline in the companies that are available for later-stage venture capital in another three, four, or five years.