Trading On Volatility In Venture Capital

Nearly half — 49% — of unicorn startup founders have previously started at least one company, according to Endeavor. In Europe, it’s even higher at 65%, Mosaic Ventures estimates.

On the surface, these figures seem to validate a common assumption in venture capital: Prior entrepreneurial experience leads to better outcomes.

However, the disparity between these numbers points to something more complex.

It’s little surprise that serial founders are more common in Europe, where VCs tend to be more risk-averse and more closely scrutinize track records. Indeed, European VCs have outperformed their American counterparts on average, thanks in part to a more disciplined investment strategy.

However, this caution also limits the potential for outlier success — the kind of outsized returns that stack lists of top VCs with firms from the U.S.

Therein lies the risk of overreliance on patterns, and an important lesson about averages in venture capital.

The risk of missing out on outliers

To paraphrase a common saying: You can only lose 1x your money on an investment, but you can lose 1,000x on an investment you miss.

A paper by Gompers, Kovner, Lerner, and Sharfstein looking at performance persistence on entrepreneurship observes that both the best- and worst-performing founders tend to be first-timers.

First-time entrepreneurs, driven by a pursuit of their life’s work, may create the next Facebook, Airbnb or Amazon, while others fail spectacularly and quit entrepreneurship for good.

This is venture capital’s central tension: Finding extreme success means tolerating frequent failure.

By pattern-matching too strictly to serial founders, VCs may lower their failure rates but also risk excluding themselves from the highest potential returns.

Understanding success and failure

Interestingly, a paper by Rajarishi Nahata indicates that repeat founders can raise capital faster (and at more generous terms) regardless of their previous ventures’ outcomes.

However, according to Charles Eesley and Edward Roberts, it is successful exits (via IPOs or acquisitions) that correlate with stronger future performance in terms of revenue growth. In line with this, another paper by Gompers and colleagues found that previously failed founders and first-time founders have roughly similar odds of success.

Moreover, when VCs back successful serial entrepreneurs, their own experience as investors doesn’t seem to influence the outcome.

Indeed, Gompers and colleagues found little difference in performance between experienced and inexperienced VCs investing in exited founders. This suggests that VCs are adding little value (and demonstrating no real differentiation) in these cases. Building your case as a GP on access to these deals puts you in the fragile position of being heavily supply constrained and in constant competition.

To outperform in venture capital, you must go beyond pattern-matching — to identify outliers, whether the founder is experienced or not. Backing serial founders may help you reach a “good” outcome, but achieving greatness requires going against consensus, believing in the nonobvious ideas and founders.

Nothing in venture is ever obvious

The bottom line here is that you cannot build a focus on repeat founders into any kind of coherent fund strategy. You would have to fight for access to those deals against bigger-brand firms, without having much in the way of value-add to barter with. Successful founders can raise from whomever they choose without too many factors to consider, and as such are a difficult market to cater for.

Past success should be a consideration when evaluating founders, but it’s unlikely to be the difference between a yes and a no, and nor should it be so black and white: When building the improbable, the most qualified candidate may be someone who lacks the experience to know how unlikely it is to work.

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Dan Gray, a frequent guest author for Crunchbase News, is the head of insights at Equidam, a platform for startup valuation, and a venture partner at Social Impact Capital.

Illustration: Dom Guzman