How GV Closes Information Asymmetries and Creates Value
I wrote this while taking a class in the Information School at UC Berkeley
When it comes to investing in startups, venture capitalists constantly operate in a world of hidden information. The ability to evaluate companies and pick out future winners relies as much on intuition and experience as it does on known information and concrete facts such as financials statements and cash flows. Because of these discrepancies, firms are always trying to find ways to close information asymmetries in the investment process. This leads to firms building relationships with competitors as well as creating innovative ways to manage the companies they invest in.
Competitor relationships in venture capital tend to be much different than those in more consumer facing industries because an investment in a company by one firm does not exclude other firms from investing. This causes firms to pay attention to the current rumors and dealings going on across Silicon Valley, and make assumptions based on the actions of others. This concept is referred to as “investor signaling” and it plays a huge role in venture financing dynamics. For example, GV could hear a pitch from a startup they are unsure about and after the pitch decide to conduct further due diligence on the company. Hypothetically this due diligence may show that another top firm has invested in them. While GV is unable to know the exact reasoning of the competing firms decision, if they have respect for the firm and their track record, they will factor this decision into their own. This can cause somewhat of a snowball effect; with one firm’s investment triggering several follow on investments. On the other hand, this trust in other firms can work against a fundraising startup. Prominent venture capitalist Chris Dixon gives an example of this investor signaling in a recent blog post.[1] He gives the example “If Sequoia wants to invest, so will every other investor. If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.” This stems from the lack of hard metrics in venture capital and reliance on opinions, intuitions, and experience.
The lack of information does not stop after the investment is made in a company; however, it continues as the company scales and develops their product. Founders usually give monthly updates to their investors, but, without being on the ground observing day-to-day operations, venture capitalists are still somewhat in the dark. While most companies are honest with their investors regarding progress and growth, the pressure to perform and meet expectations can cause companies and founders to hide the bad and simply report the good. The most recent case of deceitful reporting came from the former healthtech “poster child” Theranos. Theranos has raised a total of $638 million[2] in funding since its founding in order to revolutionize the way blood tests are conducted and make them available and affordable to a larger market than ever before. In order to protect their technology and keep a competitive advantage in the market, Theranos, and CEO Elizabeth Holmes, became obsessively secretive about their progress and day-to-day operations. This secrecy went under the radar until a Wall Street Journal article[3] broke the story. It quickly became clear that Theranos’ technology was not as far along as it had claimed that it was and the company was allegedly conducting tests and examinations illegally. This lack of disclosure is currently putting Theranos in legal trouble, jeopardizing the future success of the company. While this masking of information isn’t exactly common in Silicon Valley, it is a possibility and firms need to be aware of it. In order to increase exposure to the daily dealings of portfolio companies, firms are creating ways to stay involved during the growth stages that benefit both the firm and the company. One way in which firms can do this is by implementing a venture capital service model. In fact, GV was one of the first companies to employ this model, providing portfolio companies with hands on help in design, product management, marketing, engineering and recruiting. This provides portfolio companies resources available only to GV backed startups, while at the same time giving members of the GV network access to the ground floor of companies, subsequently closing information asymmetries. This model has led to the creation of one of GVs core services, the Design Sprint.
It is a five-day intensive design process that GV specializes in and employs during their advisory of companies. It provides companies a framework to test hypotheses and quickly iterate on current products without wasting valuable resources and time. This process gives GV the necessary information regarding the progress and direction of their companies, leading to trusting relationships as they grow.
In venture capital, data collection and due diligence play a crucial role in each investment decision made by a firm. The more information a firm can gain about a startup’s target market, founder(s), and industry, the lower the risk the firm has of potentially making a poor investment decision. When it comes to venture capital due diligence there are two important categories: quantitative data and qualitative information. Quantitative data includes financials, such as balance sheets, burn rate, income, and cash flows, as well as customer information such as market size, retention rate, and traction. Among these, data traction may be the one stressed the most during venture capital pitches and investment decisions. During the beginning of a startup’s life, traction numbers may be small, ranging from hundreds to thousands of users or customers. While the numbers themselves may not prove the idea as a viable company, traction closes information asymmetries by providing early evidence of product market fit and showing future potential for growth and consumer adoption. Qualitative information focuses on the startup’s position in the market, how the idea came to fruition, and why these people are the right team to tackle this specific problem. Both categories are factors when it comes to the final investment decision, but because of the fundamental differences between the two it is tough to pinpoint exactly how much each type of data weighs. This intersection of data and intuition is where great venture capitalists use their own experiences and networks to exploit their competitive advantages and earn larger returns than the competition.
In recent years, GV has been ranked[4] the most active Corporate VC firm in the world, even with its young age. While this is partly due to the size of its fund, $300 million renewed annually by Google, the biggest enabler of this activity rate is its vastness and experience of its investor and advisor networks. GV has investors with vast amounts of knowledge in industries such as the life sciences, artificial intelligence, and consumer tech, as well as experienced advisors with industry experience in design and engineering. These investors and advisors allow GV to extract as much possible value from its due diligence, without having to consult with anyone outside of the firm. This network is the main competitive advantage for GV when it comes to their data strategy. Every venture capital firm has experienced entrepreneurs who know how to tackle startup problems such as scaling a business and growing a team, but not every firm has the technical and industry experience that GV has to be able to invest in ever-changing industries such as Biotech, Artificial Intelligence, and Enterprise solutions. This causes VC firms to specialize in specific industries and pass on any company that doesn’t fall in line with their focus. While this isn’t necessarily a bad thing, or mean a firm can’t provide good returns, it does limit the firm’s investment opportunities. GV is able to hear pitches from almost any industry, setting the firm up with a greater opportunity to uncover a winner.
The biggest challenge during due diligence for venture capitalists is deciphering which statistics and graphs are actually meaningful and not simply formed by the startup to convey a message that is only marginally true. One example of this issue appears in the calculation of potential addressable market and the company’s intended market share.
This type of slide is expected in every pitch deck so there is no way around addressing the size of the market, even if it is not seen as impressive. However, every founder wants to show that his or her company has an immense potential market, which leads to the use of numbers that were arrived at illogically to inflate their market. The slide itself gives investors a good illustration of the market, but the actual numbers need to be calculated by the investor to avoid skewed statistics. The investor is not involved in the startup, which allows him or her to remove pride and ego from the calculation, leading to a more accurate calculation. Market size is not the only number that must be scrutinized by investors when making a decision. User statistics like conversion rate and retention rate can also easily be skewed. It is important to dive deep into each data point and truly understand how that number was calculated before making an investment decision.
While GV does a tremendous job closing information asymmetries, there are areas where they can improve. One of these areas is the pre-seed and seed stage investing GV is involved in. Over the past five years, GV has increased its involvement in these early stage investments by over 15%.[5] While this expansion into early stage has potential for huge returns because of the early timing of investment, it also increases the difficulty of evaluating companies because of a lack of information. In these stages, any extra research and information can make or break a deal. Google has recently announced an in-house incubator[6], Area 120, to increase innovation inside the company. This will allow Google to be the first eyes on some of the best innovations occurring in tech. Google will be able to observe these companies from day one, minimizing the amount of information being lost or hidden. Instead of creating their own accelerator, because of both GV’s close ties with the company as well as the vast amounts of successful incubators and accelerators already in the space, GV should look into a university-centered fund similar to 1st Round Capital’s Dorm Room Fund. DRF is a student run venture capital firm that invests in student entrepreneurs across the nation. There are only a handful of funds targeting students, like Rough Draft Ventures or the recently dissolved XFund, mainly because of the freshness of the idea. Having a fund that focuses on universities would allow early exposure to companies, helping close information asymmetries with minimal risk. While this may be out of GV’s domain, for it has had no problem finding worthy investments, having made over four hundred investments in over two hundred companies[7], it is an interesting expansion possibility for the firm.
The venture capital industry’s relationship with information asymmetry and data collection and strategy is unparalleled in the business world. The uncertainty involved in starting a business, partnered with the difficult nature of investing, makes each piece of information extremely valuable. However, at the end of the day venture capital will never be an industry driven solely by concrete facts and data. Finding the best startups and entrepreneurs will always rely on intuition and personal experience, making venture capital one of the most alluring, yet difficult industries out there.
[1] http://cdixon.org/2010/03/12/the-importance-of-investor-signaling-in-venture-pricing/
[2] https://www.crunchbase.com/organization/theranos#/entity
[3] http://www.wsj.com/articles/theranos-has-struggled-with-blood-tests-1444881901
[4] https://www.cbinsights.com/blog/active-corporate-vc-firms-h1-2015/
[5] https://news.gcase.org/2015/07/22/cb-insights-report-google-ventures-slows-down/
[6] http://www.theverge.com/2016/4/24/11497684/google-in-house-startup-incubator-area-120
[7] https://www.crunchbase.com/organization/google-ventures#/entity
