- July 28, 2022
- Posted by: Ramkumar
- Category: Posts
Why Do Venture Capitalists Overpay
In the 𝐝𝐨𝐭-𝐜𝐨𝐦 𝐛𝐨𝐨𝐦, 𝐭𝐡𝐞 𝐬𝐨𝐜𝐢𝐚𝐥 𝐦𝐞𝐝𝐢𝐚 𝐞𝐫𝐚, 𝐚𝐧𝐝 𝐧𝐨𝐰 𝐭𝐡𝐞 𝐩𝐥𝐚𝐭𝐟𝐨𝐫𝐦 𝐞𝐫𝐚, the similarity is that #vcs have pumped capital in startups, inflating startup pricing. When the correction happened, the #valuations of these firms plummeted. We hear stories of #startups 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 #gametheory where each 𝐕𝐂 𝐟𝐢𝐫𝐦 𝐥𝐨𝐨𝐤𝐬 𝐭𝐨 𝐦𝐚𝐱𝐢𝐦𝐢𝐳𝐞 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫 𝐯𝐚𝐥𝐮𝐞 𝐛𝐲 𝐚𝐧𝐭𝐢𝐜𝐢𝐩𝐚𝐭𝐢𝐧𝐠 𝐜𝐨𝐦𝐩𝐞𝐭𝐢𝐭𝐨𝐫 𝐦𝐨𝐯𝐞𝐬.
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 𝐍𝐚𝐬𝐡 𝐞𝐪𝐮𝐢𝐥𝐢𝐛𝐫𝐢𝐮𝐦. Simply put, Nash equilibrium is a dominant strategy where the expected behaviour converges with the actual behaviour.
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, 𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐟𝐫𝐨𝐦 𝐬𝐭𝐚𝐫𝐭𝐮𝐩𝐬 𝐰𝐨𝐮𝐥𝐝 𝐫𝐞𝐝𝐮𝐜𝐞, 𝐦𝐚𝐱𝐢𝐦𝐢𝐳𝐢𝐧𝐠 𝐭𝐡𝐞 𝐚𝐠𝐠𝐫𝐞𝐠𝐚𝐭𝐞 𝐫𝐞𝐭𝐮𝐫𝐧𝐬 𝐨𝐟 𝐚𝐥𝐥 𝐕𝐂𝐬. However, the rational pursuit of 𝐬𝐞𝐥𝐟-𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐨𝐟 𝐕𝐂𝟏 𝐚𝐧𝐝 𝐕𝐂𝟐 𝐝𝐫𝐢𝐯𝐞𝐬 𝐭𝐡𝐞𝐦 𝐭𝐨 𝐭𝐚𝐤𝐞 𝐚𝐜𝐭𝐢𝐨𝐧 𝐭𝐡𝐚𝐭 𝐢𝐬 𝐮𝐥𝐭𝐢𝐦𝐚𝐭𝐞𝐥𝐲 𝐝𝐞𝐭𝐫𝐢𝐦𝐞𝐧𝐭𝐚𝐥 𝐭𝐨 𝐭𝐡𝐞 𝐜𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐯𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 of all investors.
We call this conflict between self-interest and collective interest a 𝐩𝐫𝐢𝐬𝐨𝐧𝐞𝐫’𝐬 𝐝𝐢𝐥𝐞𝐦𝐦𝐚 because in pursuing self-interest, each VC imposes a cost on other VCs, driving up other overall startup valuations.