The “Winner’s Curse” and Venture Capital
Source: https://hbr.org/2022/04/how-vcs-can-overcome-the-winners-curse
This recent article from this year discusses the winner’s curse in relation to venture capitalists. When startup owners provide overly optimistic outlooks, oftentimes VC investors might end up investing in the startup with the highest expected valuation, only realizing too late that the startup is less profitable than expected. The article suggests one method of guarding against this curse: using a “contingent contract”. In such a contract, the amount of money a startup gets from the investor would depend on the startup’s performance. For instance, as the example from the article explains: if a startup founder predicts their company will be worth $10million dollars in two years and asks for $1million from an investor in exchange for 20% of the startup, the investor could counteroffer by offering $1million for:
- 15% of the firm if the startup meets or exceeds the prediction in 2 years.
- 20% of the firm if the startup is worth between $8-10million in 2 years.
- 30% of the firm if the startup is worth less than $8 million in 2 years.
If the startup is confident in their abilities to raise the funding, then this offer by the VC investor is actually more lucrative than the initial ask. If the startup passes on the contingent contract, however, then the VC investor can be more confident that investing in the startup was overstating their outcomes to begin with.
The winner’s curse describes the phenomenon in which the winner of the auction likely overshot the item’s actual worth on the market. I think the bidding wars over startups described in the article are most akin to ascending bid auctions, since, theoretically, the investors make bigger and bigger offers until the startup chooses the best offer. The dominant strategy in an ascending bid is bidding up to one’s value and then pulling out once the price exceeds that value. However, this strategy can be difficult when put into practice in a VC environment. I would guess that an investor values a startup based on how much they believe the company will be worth in a certain number of years, but the issue arises when it’s hard to determine when startups are too optimistic about their prospects. The contingent contract strategy, thus, seems like a way to hedge the risk associated with investing in startups. Adding conditionals to an offer based on performance, like the article states, prioritizes accuracy over optimism. If a startup company accepts the conditional offer and is accurate in its projection, it will receive a better outcome than a standard offer. In this case, the investor is also satisfied since the company they invested in is doing well. Likewise, if the startup owner refuses the conditional since they are less confident about their prospects than they would like to admit, the VC investor receives a signal that the company is likely be overvalued and that they wouldn’t want to invest in it anyway.
When the dot com bubble burst back in the late 1990s, much of it was due to the volatility of tech stocks from the overvaluation of many startups. Now that we’re currently in another era of high amounts of investments in startup companies, I think considering VC investing strategies in the context of auction theory could be quite useful in understanding why investors overbid and how to stop it from happening.