Win-Win: The Game Theory Behind Venture Capital
In a zero-sum game, the positive actions of one participant directly result in a negative outcome for other participants. For every gain, there must be a loss of equal magnitude. Attempting to model the strategies behind zero-sum games introduces the topic of game theory. Game theory is a method of modeling the causes and effects of decisions made by a given participant and the decisions made by other participants in response. Game theory is effective at modeling competitive zero-sum environments, but what can it tell us about non-zero-sum games?
The game of raising venture capital (VC) can easily be misconstrued as a zero-sum game. If two companies are pitching to the same firm in hopes of raising capital, it is natural to assume that they are competing for the same capital. However, this is not always the case. In a scenario when a VC firm has a surplus of capital, raising capital is a non-zero-sum game. A venture capitalist will most often focus on investments with high value propositions – these are investments that promise the highest returns. Consequently, even if two companies try to anticipate the other’s actions and compete with one another, a venture capitalist will still focus on the value proposition of each deal. When the two companies misconstrue venture capital as a zero-sum game, the following scenarios are possible:
- Both companies value themselves below true value and the VC firm invests in both.
- Company A values itself below true value and Company B values itself above true value. The VC firms invests in Company A.
- Company B values itself below true value and Company A values itself above true value. The VC firms invests in Company B.
- Both companies value themselves above true value, and the VC firm invests in neither.
These scenarios elucidate why viewing venture capital as a zero-sum game can be dangerous. By trying to anticipate the moves of the opposing company, the companies undermine themselves. A zero-sum game ends in a lower valuation or zero funding for a company. In fact, the Nash Equilibrium for the scenario occurs when both companies value themselves below true value. However, if the companies realized that they were not truly in competition with one another, and that they were in a non-zero-sum game, then they could have both received higher valuations.
My exploration above was ignited by the following article from Harvard Business Review: https://hbr.org/1995/07/the-right-game-use-game-theory-to-shape-strategy
My reflections after reading the HBR article were then supported by the following article: https://e27.co/what-john-nashs-beautiful-theory-can-teach-startups-about-funding-20150528/