Why Do Venture Capitalists Overpay

Why Do Venture Capitalists Overpay

In the ๐๐จ๐ญ-๐œ๐จ๐ฆ ๐›๐จ๐จ๐ฆ, ๐ญ๐ก๐ž ๐ฌ๐จ๐œ๐ข๐š๐ฅ ๐ฆ๐ž๐๐ข๐š ๐ž๐ซ๐š, ๐š๐ง๐ ๐ง๐จ๐ฐ ๐ญ๐ก๐ž ๐ฉ๐ฅ๐š๐ญ๐Ÿ๐จ๐ซ๐ฆ ๐ž๐ซ๐š, the similarity is that #vcs have pumped capital in startups, inflating startup pricing. When the correction happened, theย #valuationsย of these firms plummeted. We hear stories ofย #startupsย laying off employees as they no longer can rely on future funding, thus focusing on profitability.

Why do these cycles happen, and why do VCs overpay the startups?

When I analysed, I concluded that this is a classic instance of a #gametheoryย where each ๐•๐‚ ๐Ÿ๐ข๐ซ๐ฆ ๐ฅ๐จ๐จ๐ค๐ฌ ๐ญ๐จ ๐ฆ๐š๐ฑ๐ข๐ฆ๐ข๐ณ๐ž ๐ฌ๐ก๐š๐ซ๐ž๐ก๐จ๐ฅ๐๐ž๐ซ ๐ฏ๐š๐ฅ๐ฎ๐ž ๐›๐ฒ ๐š๐ง๐ญ๐ข๐œ๐ข๐ฉ๐š๐ญ๐ข๐ง๐  ๐œ๐จ๐ฆ๐ฉ๐ž๐ญ๐ข๐ญ๐จ๐ซ ๐ฆ๐จ๐ฏ๐ž๐ฌ.

Let me substantiate with an example:

In the low-interest rates where investing in bonds yields lower returns, VC firms raise capital from LPs, promising higher returns than ten-year bonds.

VC1 and VC2 want to invest in a fintech startup.

VC1 strategy is to maximise its returns, given the VC2 strategy
VC2 strategy is to maximise its returns, given the VC1 strategy

In the below matrix, when VC1 and VC2 invest, the return is 3.5%, and we call this the ๐๐š๐ฌ๐ก ๐ž๐ช๐ฎ๐ข๐ฅ๐ข๐›๐ซ๐ข๐ฎ๐ฆ. Simply put, Nash equilibrium is a dominant strategy where the expected behaviour converges with the actual behaviour.

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In the Non-Nash equilibrium scenarios, if VC1 invests and VC2 does not, VC1 has to invest in bonds, giving it a poorer return than VC2.

Suppose both VC1 and VC2 refrain from investing in startups, ๐ญ๐ก๐ž ๐ฏ๐š๐ฅ๐ฎ๐š๐ญ๐ข๐จ๐ง ๐๐ž๐ฆ๐š๐ง๐๐ž๐ ๐Ÿ๐ซ๐จ๐ฆ ๐ฌ๐ญ๐š๐ซ๐ญ๐ฎ๐ฉ๐ฌ ๐ฐ๐จ๐ฎ๐ฅ๐ ๐ซ๐ž๐๐ฎ๐œ๐ž, ๐ฆ๐š๐ฑ๐ข๐ฆ๐ข๐ณ๐ข๐ง๐  ๐ญ๐ก๐ž ๐š๐ ๐ ๐ซ๐ž๐ ๐š๐ญ๐ž ๐ซ๐ž๐ญ๐ฎ๐ซ๐ง๐ฌ ๐จ๐Ÿ ๐š๐ฅ๐ฅ ๐•๐‚๐ฌ. However, the rational pursuit of ๐ฌ๐ž๐ฅ๐Ÿ-๐ข๐ง๐ญ๐ž๐ซ๐ž๐ฌ๐ญ ๐จ๐Ÿ ๐•๐‚๐Ÿ ๐š๐ง๐ ๐•๐‚๐Ÿ ๐๐ซ๐ข๐ฏ๐ž๐ฌ ๐ญ๐ก๐ž๐ฆ ๐ญ๐จ ๐ญ๐š๐ค๐ž ๐š๐œ๐ญ๐ข๐จ๐ง ๐ญ๐ก๐š๐ญ ๐ข๐ฌ ๐ฎ๐ฅ๐ญ๐ข๐ฆ๐š๐ญ๐ž๐ฅ๐ฒ ๐๐ž๐ญ๐ซ๐ข๐ฆ๐ž๐ง๐ญ๐š๐ฅ ๐ญ๐จ ๐ญ๐ก๐ž ๐œ๐จ๐ฅ๐ฅ๐ž๐œ๐ญ๐ข๐ฏ๐ž ๐ข๐ง๐ญ๐ž๐ซ๐ž๐ฌ๐ญ of all investors.

We call this conflict between self-interest and collective interest a ๐ฉ๐ซ๐ข๐ฌ๐จ๐ง๐ž๐ซ’๐ฌ ๐๐ข๐ฅ๐ž๐ฆ๐ฆ๐š because in pursuing self-interest, each VC imposes a cost on other VCs, driving up other overall startup valuations.



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