Herd Behavior in Venture Capital: The Rise and Fall of Everything

Venture Capital is based in the expectation of returns, and that involves mainly two things: trying to predict future scenarios for a particular company, and comparing that future with other company futures to determine which to pick (if any). The fact is that some will become global, others will die miserably, some will gradually rise or graciously fall – and all that is like the birds and the bees for founders and investors.

Nevertheless, even after unveiling the mists of venture capital intercourse, most entrepreneurs take some time to notice a simple truth… that not all investors are bright, but most think they are.

Herd Behavior

To understand how good and bad decisions are made in Venture Capital, let’s segment investors under two simple criteria… how much they really know about the VC market, and how pretentious they are about that:

  1. those who don’t know much, and are aware about that
  2. those who don’t know much, but think they are wise
  3. those who are wise, and recognize their own wisdom
  4. those who are wise, but know there’s so much to learn

Group 1 is the Conscious Herd, mostly formed by angels and wealth managers who invest in startups to diversify and experiment, not necessarily expecting a massive return. A lot of novice LPs and executive-angels also fall into this first category. Recognizing their limitations and low expectations is key for their survival since they have no wish to risk more than they should – and that’s why they intend to follow the market and bet on information symmetry.

People in group 2 form the Unconscious Herd. They are following whatever venture capital trends published by media or celebrity investors, so they can mimic their bets. “Clean tech is the new bubble” and “50M is the new series A” are remarks they use that end up driving the market sideways and creating a zero-sum game. Those VCs sometimes are the ones who provide easy money for bad founders (since great founders tend to avoid them).

The Elders are in group 3. They look from afar and wait because they can’t run too fast. Most billion-dollar funds and experienced investors are in that category and feel no need to move fast because they’ve been there and done that (and that is millions/billions in return).

Founders should always be good friends with the VCs in group 4. They know their kung-fu, but know they can never be too fast. Their gut feeling and experience play an important part in deciding who will get a term sheet, but they also know data, experimentation, and sometimes pure luck and serendipity, carry a lot of meaning. They are The Leaders, and that involves leaving elders and the remaining herd behind if they can.

So what?

When people are looking for problems where no problem exists, I use an old Brazilian saying: “You’re looking for a horn in a horse’s head.” In the VC world, it might just as well mean that you shouldn’t search startups for future unicorns… but a lot of investors think they’ll bump into one.

Venture Capital is a strange industry because some of these groups act and interact for emotional reasons. There will rarely be a bubble in a market when there are only Leaders and the Conscious Herd; bubbles are caused by Elders (in the higher atmosphere) and the Unconscious Herd (who agree to inflated valuations in early and seed stages).

The rise and fall of everything in venture capital start with a herd behavior of those two groups. Either a small trend that suddenly escalates, a specific snowball effect that changes habits in 1-2 years or a strange move that seems good at first but rationally makes no sense. Here’s what happens next:

  1. The Conscious Herd experiments more or follow the Leaders
  2. The Unconscious Herd will stay behind and moan their dead
  3. Elders co-invest with larger bets
  4. Leaders lead because there’s no other way

Groups 1 and 2 generate waste. The ones in group 3 don’t care about waste (but may change their minds when the market turns). Lean VCs are mostly in group 4 because there’s no worse vision than waste in capital. Being conscious about your limitations as a VC – regardless of past wins and losses – is a fundamental feature of a lean investor.

The secret is to make a move, no matter where the market is going. There’s no bubble for startups that grow fast and strong, and for VCs that ignore the herd.

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