What the enthusiasm for funding startups means for the VC world

FINANCIAL MARKETS are fuelled by stories, and the most skilful storytellers are found in venture capital. For a start, venture capitalists have to listen to a lot of fairy tales from the would-be entrepreneur. “The world will look different in a decade,” he says. “My startup will be the leading business in a new industry.” VCs tell themselves stories about how they can foresee what others cannot, and how this stands to make them a lot of money. And they retell them to potential investors in their funds.

Who to believe, when you cannot easily verify such tales? This difficulty is a version of the agency problem of asset management. When venture capital was clubbier, it was manageable. But in recent years investors who are new to the terrain have been piling in. A VC trying to raise money may favour startups of the kind that has done well recently, even if they are not the best long-term bet. Oddball startups with more potential might then be starved of capital.

There is thus a nagging fear that the more money that is funnelled into Silicon Valley and other centres of venture capital, the less “true” innovation will occur. Well perhaps. But it is not obvious that great business ideas are being ignored. The downside of the flood of venture capital is more prosaic. Run-of-the-mill startups are overindulged. And prospective returns are depressed.

More and more pension schemes are looking to alternative investments, including venture capital, to juice up their returns. VC funds have on average beaten the public market, net of fees, over the long run. The best funds do a lot better than the average. But it is not only a matter of returns. Smart investors in public markets realise that they own a lot of companies that are at risk of disruption from emerging technology firms. A good way to balance that risk is to own a stake in the next generation.

More money for new businesses is surely a good thing. Nevertheless there is a lingering disquiet. One source of discomfort is that funds are often narrowly segmented by region, industry, or stage of investment—and sometimes all three. This helps with marketing. Money is attracted to themes that have worked well recently. As Hollywood has discovered, it is easier to sell a variant of an old story than a brand-new one.

There are drawbacks, though. A truly game-changing business may sit astride several themes and be ignored, says Ajay Royan of Mithril, a VC firm based in Austin, Texas. In the public markets buying stuff that has worked well recently is called momentum trading. It does fine much of the time, and has an appeal to the investor who is out of his element in venture-land. By “social-proofing” VC investments the anxious can get more comfortable with the risks, says Mr Royan. “But it can devolve into the VC equivalent of ‘you can’t get fired for buying IBM’.” And the trouble with crowded trades is that they are prone to crashes.

Some VC funds will fall prey to the vices of asset gathering—telling a good story about the latest fad to maximise the amount of fee-paying money under management. But there is a culture that militates against this. The best VC firms pride themselves on being oversubscribed. They turn money away. And an industry that hears a lot of fairy tales has some inbuilt discipline. Venture capitalists have to kiss a lot of frogs to find a prince—even a halfway handsome frog. The average VC firm screens 200 targets a year, but makes only four investments, according to one study.

And thematic VC can sometimes have a logic to it. Regional funds make sense for consumer-facing startups, because of local variations in tastes and habits. Increasingly, the seed or early-stage venture funds with better returns tend to have a thematic focus, says Simon Levene of Mosaic Ventures, a London-based VC firm. Nor is it obvious that moonshot ideas are starved of funding. SpaceX, Elon Musk’s space-exploration firm, was valued at a whopping $74bn at its most recent funding round. Even borderline scams are given a respectful hearing.

The trouble with abundant capital instead is more straightforward. More money chasing scarce ideas and talent means that the prices paid for startups rise, which all else equal means returns fall. And the absence of cash constraints can spoil a promising startup. If it blows a lot of money on marketing, the resulting growth can distract the founders from underlying faults with the product. Telling a good story is vital in the startup business. But there is a danger in believing your own fairy tales.