[Disclaimer: The content below is not an original thought. Rather, an extension of Glenn C. Loury’s work in the Anatomy of Racial Inequality.]
Over the past 30–40 years, Venture Capital (VC) has played an important role in the growth and success of multiple early-stage startups.
Uber, Airbnb, Stripe, Coinbase, Palantir, and numerous other hyper-successful companies today were backed by VCs in their early stages.
But if you’re somewhat familiar with how the industry works, I would guess that you’ve come to realize how messed up the whole shenanigan is.
Speaking of shenanigans, if you’ve never heard of a Keynesian beauty contest, here's my rant on it.
It was named after the renowned British economist - John Maynard Keynes. As Keynes was reading the newspaper one day, he noticed a section that depicted facial profiles of 6 different women. It was a beauty contest and the game was to pick the most beautiful face out of the 6. If the majority of the people reading the newspaper picked the same face, they would all get a prize.
Keynes immediately recognized that this game was pointless as individual preferences were subjective. Not to mention the fact that some of the readers, or at least the ones who understood the game, would try to pick the candidate that she expects everyone else to pick. This futile endeavor continues in an infinite loop where everyone tries to predict what everyone else will do. And everyone tries to predict what everyone else predicts everyone to do. Thus an infinite loop.
VC is not all that different from a Keynesian beauty contest.
Young startups that aim to raise money from VCs do so in stages. Usually, there’s a pre-seed round, seed round, series A, B, and C. And eventually, if the company decides to go public they can do so via an IPO, direct listing, etc.
An individual will invest in the series A of a startup, only if she expects to generate a positive return. Meaning that she expects her infant startup stonks from series A will be bought by someone else at a higher valuation during the series B round (or at a later point in time).
To bring this point home, imagine a world where all investors are rational (surprisingly, VC seems to be one of those exceptions where market participants do indeed act somewhat rationally). Let’s call this ‘Rational World’ (RW).
In RW, one invests in a startup only if the founder(s) has a unibrow.
A startup could have the most sophisticated product with a high demand for it. But if the founder doesn’t have a unibrow then no one invests in it.
But let’s assume that angel investors in the pre-seed stage don’t really care about unibrows at all. They’ll invest in any team that checks all their boxes (and having a unibrow is not a box that needs to be checked). But these angels happen to think that the ones who will invest in the subsequent seed stage do indeed care about unibrows. Therefore the angels — acting as profit-seeking rational individuals - will choose to throw their money at only unibrow founders.
Now let’s take this a step further. Perhaps the seed investors also couldn’t care less about unibrows. The expectation of pre-seed angels that seed investors care about unibrows was incorrect. But unfortunately, the seed investors strongly expect series A investors to have an affinity for them unibrows. And under the assumption that individuals are acting rationally, this pattern plays out through all stages of fundraising. Ipso facto, VC turns into a socially inefficient mechanism for investing in companies.
In short, everyone ends up acting in a way that satisfies their expectation of how others will act.