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Herding in Venture Capitalism

The amount of money poured into startups is astounding, yet it is not completely certain if it is a bubble. Investments are increasing but they are not close to the levels of the dot com bubble. The first article I came across was from TechCrunch which pointed out that the level of investments we see in startups today is not a sign of a bubble ready to burst but reflects a shift in how venture capitalists perceive their investments. Danny Crichton, the writer of the article, called it the “fundraising acceleration”. Venture capitalists have always known that largest return on investments come from the companies that make the biggest exits. In the past few years the industry has also come to accept that these winners beat the rest of the competitors by a staggering amount. It used to be that the difference between valuation of the winners and the competitors varied by 5 or 10 times. Now the valuation difference between the winners and the competitors are on the scale of 100 or even 1000. The staggering difference between the winners and the losers has been in part to the information cascades and herding effect we learnt about in class.

Facebook for example is now worth over $200 billion and dominates the social networking market. Its direct competitors like Myspace are virtually nonexistent now so the difference between them is over 5 orders in magnitude. VCs have understood this fact of the winners in technology which is why we see such large investments in startups. The VCs know that successful companies need 100x more money than their competitors so we see VCs investing in startups which already have a lot of backing. There is a direct benefit of backing companies that have other companies funding them. As more VCs back up the company the value will increase therefore making the value almost 100x the value of the competitors. This is the kind of situation that VCs are trying to achieve. There is no middle ground here, either the company wins by a huge margin or it does not win at all.

Another interesting application of direct-benefit is how customers use services from certain startups. An article from BBC showed how companies like Lyft and Uber are trying to capture the market. Both these companies are vying for the same market yet there is no significant technological difference between them. At the same time, it is not stable for the market to have both the companies. In the Lyft and Uber system the consumers feel the direct-benefit effects as more people join the network. For example, if more people start using Uber, then taxi drivers will have more incentive to use Uber. If there are more taxi drivers available with Uber more people would want to join the network. It is a rolling effect. Because of the direct-benefit effect it makes sense that this market would be good for a single major player. Lyft and Uber are trying to capture the entire market because that seems to be the equilibrium state.

Similar to other spaces, the technology startup space is dominated by the information cascades and direct-benefit effects we learnt about in class. Network effects drives the market and we see more companies getting into spaces where it is a winner takes all. Because of the winner takes all situation and the staggering difference in value between the winners and the competitors we see VCs making large investments. Although startup valuations have drastically increased it does not reflect a bubble ready to burst. Rather the high valuations are driven by the new idea that the winners are usually valued 100 times more than their competitors.

 

http://techcrunch.com/2014/11/02/fundraising-acceleration-is-the-new-vc-investment-thesis/

http://www.bbc.com/news/business-29653830

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