Is Venture Capital An Efficient and Transparent Market?
Kareem left this comment on my post about Andreessen’s posts:
"When you’ve got an efficient and transparent market"
Can you dig into this a little more, Fred? In my (limited)
experience, the VC market seems anything but efficient, and one website
does hardly makes the industry transparent.
I suppose using the word efficient was a mistake because "efficient markets" describes a hypothesis about market behavior put forth by Eugene Fame in the early 1960s. To quote from Wikipedia in case you don’t wan’t to click on that link,
Efficient Market Theory asserts that financial markets are "informationally efficient", or
that prices on traded assets, e.g., stocks, bonds, or property, already
reflect all known information and therefore are unbiased in the sense
that they reflect the collective beliefs of all investors about future
prospects. Professor Eugene Fama at the University of Chicago Graduate School of Business developed EMH as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school.
The efficient market hypothesis states that it is not possible to
consistently outperform the market by using any information that the
market already knows, except through luck. Information or news
in the EMH is defined as anything that may affect stock prices that is
unknowable in the present and thus appears randomly in the future.
I do think it’s possible to outperform in the venture capital market using information the market already knows. It happens all the time. You can do it by having insights into that information that others don’t make. You can do it by backing the better team. You can do it by having a brand (like Sequoia’s) that allows you to win the best deals when everyone already knows they are the best deals.
So venture capital is not an efficient market in that sense. Venture capital is a private equity market and I believe that private equity markets will never be truly efficient in the way that Fama described because the shares of venture backed companies don’t trade in the classic sense. You may want to be an investor in YouTube and you might be willing to pay twice the price that Sequoia paid, but if YouTube doesn’t need the money,or if Sequoia’s supplying it to YouTube on terms that YouTube is happy with, you aren’t going to be able to be an investor in YouTube. Venture capital is not a true market.
But there are market forces at work. Entrepreneurs work hard to understand where "the market" is in terms of valuation. And they generally make an effort to get at least several firms interested in their financing so they can get enough "bids" to determine what the right valuation is. Anybody who has been paying attention to the web services segment of the venture capital market knows that valuations have been steadily on the rise in this sector for the past three years. When you see Geni.com or Mahalo.com raise money at $100mm pre money, you know that the market is frothy and it’s a good time for entreprenuers to be raising money. It’s also equally true that VCs look at those numbers and know its not exactly a great time for us to be investing in this sector.
But as Marc Andreessen points out in his third (and supposedly last for a while) post on VCs:
And that’s why, from where I sit in Silicon Valley, there are
probably 200 venture capital firms within 20 miles with likely over $20
billion of capital at their disposal chasing a very small number of
good potential investments, despite terrible average returns for the
asset class over the last seven years.
What is a venture capitalist who has capital to invest do when the valuations in their target sector rise to unsustainable levels? Keep investing, of course. That’s what we are paid to do. At Union Square Ventures, we are working hard to manage this risk of elevated valuations. We’ve seen it before, felt the pain it inflicts, and don’t want to feel that pain again.
But regardless of what any one firm is doing to mitigate risk, the market for venture capital in the segment that I know well, web services, is white hot. I believe that any good entrepreneur with a good business idea will get funded in this market and will get funded at a fair and reasonable valuation. If you can’t raise money in this market, you really need to look at what you are doing and figure out why it’s not working. The market is certainly not to blame.
That’s what I was referring to when I used the work efficient. I meant that it’s a very efficient time to be raising capital if you are an entrepreneur.
I also believe the market has become more transparent. There are many new ways that VCs can figure out where to invest, what to invest in, and who to invest with. Blogs like TechCrunch, Om Malik, Read Write Web, and many others are doing the VCs an incredible service by pointing out new web services to invest in every day. Blogs like this one, Marc Andreessen’s, Brad Feld’s, and many others also are providing ideas and transparency to VCs and entrepreneurs alike.
And there is already one "rate your VC" website and possibly others to come. I agree that one website doesn’t make a market transparent, but I linked to it just to make a point. Never before has the entrepreneur had resources like what’s available now to navigate and figure out the venture capital market.
Venture capital (and all of it’s private equity brethren) will never be efficient in the academic sense of the words. Private markets lack several important forces that create true efficiency. But from where I sit (to use Marc’s phrase), the venture capital market has never been more entrepreneur friendly than it is right now. Even in 2000 when $100bn+ was invested, the entrepreneurs knew a lot less about what was going on than they do know. And this trend toward more transparency and liquidity is not going to stop anytime soon. This is how we are going to operate going forward. If you are a VC, get used to it. If you are an entrepreneur, get going.