In the final days and weeks of 2015, the velocity of venture deal flow increased dramatically. Startups and VC firms alike sought to close deals before the arrival of the New Year; excitement around imminently closing rounds reached a near fever pitch and opportunities to invest in the hottest startups—it seemed—were quickly evaporating.
I was introduced to one such company in mid-December. The founders had already met with several top-tier VC firms. Many investors were apparently enthusiastic about the opportunity. If RRE wanted to get in on the deal, then we would have to act fast. This deal—I was told—would close before the end of the year.
As a first-year analyst, I got excited. What if I had found the next billion-dollar company? What if this was the one? Infected by the thrill of a fleeting opportunity, I nearly overlooked one critical question: Do I really believe in this company?
When the dust settled on that particular deal (the clock ran out on 2015, the round has yet to close) I was struck by how easily I had been swept up by a false sense of urgency. Why, I wondered, do popular deals seem better irrespective of actual quality? Why is it that when one firm commits to funding a company, the rest of the round is soon filled?
At first, I attributed this state of affairs to the phenomenon of FOMO (fear of missing out) and the fact that VC is an insular community which can be somewhat prone to groupthink. Investors see their peers—whose judgment they respect—participating in a round, and don’t want to be left behind. But when I discussed this question to fellow RRE analyst Jason Black, he gave a more nuanced answer, which led us to this statement:
@itsjasonblack: “In VC popularity means scarcity. Scarcity too often conflated with value.”
The first part is fairly obvious. Only so many investors can participate in a single round of financing. There’s limited space to begin with, and popularity implies commitments from VC firms and angels alike. The more popular a deal, the less perceived availability there is for additional investors. The more firm commitments to participate, the less actual space, making FOMO a legitimate concern.
The other side of the FOMO coin is the problem of groupthink. If a fear of missing out is the stick that drives some VCs ever faster along the road to funding companies, then groupthink is the carrot. All too often, investors hear that top-tier firms or renowned angels are already in a deal and assume that it must be great. Allowing others to drive their diligence process, and ultimately their decision-making process, even the best investors can be tempted to follow the herd.
But if FOMO and groupthink account for the first part of Jason’s statement, the second part is somewhat more puzzling. Of course, there exists plenty of historical precedent for conflating scarcity with value, so I’ll start there. Many works of art, for example, fall into both categories; take the paintings of Vincent Van Gogh.
The artist only created about 900 paintings in his lifetime, and today they are near universally praised and valued for a variety of reasons. In fact, one sold at auction this past November for over fifty-four million dollars. But the thing is, the scarcity of Van Gogh’s paintings is a necessary yet insufficient condition for their sustained value. While these works are inherently scarce, they have proven to be desirable independent of scarcity.
To illustrate the point, consider the works of another artist: Me. If I were to create 900 paintings, and then to announce that I would never again pick up a brush, it is highly unlikely that Sotheby’s would want to auction any of my works. It is even more unlikely that anyone would bid on them, and it is nearly unimaginable that a patron would pay fifty-four dollars for one, let alone fifty-four million. I am not an artist, and my paintings would likely not be aesthetically pleasing or desirable to art collectors no matter how scarce they became.
That’s an obvious example. But many things—the works of Van Gogh, for example—have so long fallen into both categories that it is now easy to forget that they are scarce and valuable for two different reasons. To some degree, I believe that the same thing has happened to startups. Decently promising early-stage companies are inherently scarce, and over the past decades there have been many highly publicized examples of these companies becoming exceedingly valuable. Somewhere along the line, scarcity was indeed conflated with value.
The issue, clearly, is that just as all paintings are not Van Goghs, all companies are not Facebooks. And moreover, scarcity doesn’t always yield value to begin with. History’s most famous and successful startups have proven valuable not because they were scarce, but because they were actually valuable. That they were also competitive deals to access for investors is—at best—a side note.
When meeting with the prospective portfolio company, I became convinced that the deal was scarce, and I accepted as an article of faith that the company would become valuable. I fell into the trap of forgetting that there exists a wide—if at times unseen—chasm between scarcity and value.
Especially for a green VC Analyst, that is necessarily an occupational hazard. I fell into a classic trap of venture investing (and probably caught a bit of FOMO too). Only later did I regain the necessary perspective to formulate an independent opinion. For a moment, I found myself overwhelmed by the excitement of a new company and a hot deal.
Despite the perils and pitfalls, getting swept up in the hype can be irresistibly fun. After all, maybe, just maybe, a deal is highly sought after because it’s the real thing. The trick, I’m starting to think, is refusing to get swept up in the moment’s zeitgeist without becoming cynical or losing your sense of excitement about what the future might bring. For me at least, finding the space between those extremes is what makes this industry so alluring.