Wisdom of the Crowd and that of the VCs

question-1-startup-quizIn my last article I presented the results of the startup investment decision quiz. When you look at the final score it would appear very few, about 4.7%, got it 100% right. That is their investment decisions are exactly same as that of the VCs’. Let us look at it another way, say instead of you making the decision in isolation what if you are able to change your decision after seeing how the majority decided.

That is make a choice, so will many others without seeing or discussing with each other. Then you get to keep or change your choice based on the wisdom of the crowd. Since the crowd here is diverse enough with different background and experience it is reasonable to assume the crowd does not suffer from groupthink. Let us assume simple majority rule, >50% wins.

Now how does the wisdom of the crowd (of 234) compare to that of one VC firm? Here is the summary of the results with the table showing percentage of YES and NO decisions by the crowd and the VC’s decision for comparison.

startup-results

Not all that bad now, comparing the wisdom of the crowd with that of the VCs. The two startups that  got the termsheet from the VCs got one from the crowd as well. The crowd made the same positive decisions. And on the rest of startups the crowd decided to give termsheet to two additional startups the VCs passed on.

While the crowd did not miss on opportunities it was little more lenient in saying yes. If these two startups really are duds (so to speak) the crowd’s decisions will be called  “false positives”. If these results scale over large number  that is twice as many startups that will get funding when they shouldn’t.

Look at it this way, when there is unlimited funding to go around (with many VC firms, angels and others with unlimited money that fancy themselves as one) and unlimited number of startups pitching their venture (everyone is a founder), there are bound to be many false positives.

And that is not all good. It is just frothy.

Please don’t embarrass us by having a business model for your startup – VCs

When I wrote the valuation model for Pinterest, many people wrote to me to point out that Pinterest stopped using SkimLinks and hence stopped making any revenue. Making revenue it turns out is not good for your startup (don’t quote this line out of context).

How do you value an investment? Any investment, be it a farm , shares of an established enterprise or a tech startup?

Simple answer is, you look for profits they generate now and how it is expected to grow.

But that level of transparency and simplicity is a problem for venture capitalists investing in Silicon Valley’s startups. The New York Times Bits blog says why VCs don’t want the startups to show any viable business model let alone profits,

“It serves the interest of the investors who can come up with whatever valuation they want when there are no revenues,” explained Paul Kedrosky, a venture investor and entrepreneur. “Once there is no revenue, there is no science, and it all just becomes finger in the wind valuations.”

With any hint about business model one can come up reasonable valuation models for any business. Granted one has to make assumptions to get there but we can quantify the uncertainties in the assumptions and state our valuation in terms of probabilities which can be used to place bets (I mean investment).

That is not good because

they’re interested in pumping up enough hype and valuation to find a quick exit through an acquisition at an eye-popping premium.

How else can you justify $200 million valuation for Pinterest when its chances of making revenue that justifies such a valuation is less than 0.25 percent?

This seems to explain why VCs advice startups to give their product away for free and why VCs don’t advice startups about customer segments and filling an urgent need. As Stanford’s Pfeffer says,

These companies are simply being founded to be bought.

Not to fill an urgent need and to take their fair share of value created.