I’ve been reading many blog articles of late about the increasing use of analytics in early stage venture investing. I’ve heard the phrase “moneyball for VC” thrown around quite a bit by people who favor real data and analysis over guts and instincts in evaluating (or at least identifying) a potential investment. Though I’ve always believed in the use of data in investing, I have to ask: when you rely on a wealth of data to assign the probability of a binary outcome (return or no return on investment)…aren’t you just underwriting a loan?
Although the concept of equity has changed significantly over time, it still remains the legal entitlement to earnings after all other liabilities have been paid off (such as loans and bonds). In the early days, when bankers used to finance long distance sea voyages, the only thing you could invest in really was equity. Whether or not there was an interest coupon attached, you were in the first loss position and you just hoped the returns and/or interest rate were high enough to compensate for all that risk.
As financial services evolved, greater understanding of default behavior and more formal laws around it allowed lenders to slice risk into separate buckets. It became possible for a bank to consider how often you default and offer you a loan with an interest rate likely to at least cover this average default rate. This was the first instance of a non-equity investment—because the bank no longer held the first loss position, he could build a business upon a fixed income instrument, and thus modern banking was born.
Fast forward hundreds of years, and that remains one of the biggest differences between fixed income and equity investing: fixed income investors evaluate inputs in the context of a binary outcome (default or no default), while equity investors evaluate inputs in the context of a variable outcome (what the present value of future earnings will be worth).
Classic VC investing resembles equity investing – evaluating lots in inputs to determine the potential size of future earnings (and hoping the answer is “very large”). However, in “moneyball for VC,” whereby an investor leverages data and statistical analysis to assess whether or not a company will successful (and therefore whether or not to invest), VCs begin to look more like fixed income investors. When venture capital investors start focusing on binary outcomes, they more closely resemble underwriters of a high interest loan (a pretty interesting business these days, as long as you’re not a bank).
This data-driven approach opens the door to borrowing all sorts of customer acquisition tactics used in the consumer lending world. I’ve always respected Capital One as a leading institution for analytical underwriting and customer acquisition. I can’t wait for the day when Capital One gets into the VC game and one of my friends finds the following letter in their mailbox:
“Congratulations! You have been pre-approved for a startup investment of up to $75,000!
We see from your LinkedIn profile that you have a CS degree from MIT, four years work experience at a pharmaceutical company, five friends who are designers, and 12 friends with business development backgrounds. You and your future co-founders have been pre-approved for a Bio-Tech web startup investment of up to $75,000 in convertible note financing, which you may start spending with the included Founders Gold Card.”
It’s only a matter of time…
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