Key Takeaways
- Researchers found that VCs who spfinish less time evaluating startups see 15% to 34% wider swings in their investment results—more large wins, but also more spectacular failures.
- When everyone’s rushing to invest, VCs might do less homework, leading to worse decisions and more unpredictable returns.
Why do so many startups that seemed destined to take over the world finish up fading away, despite being backed by the world’s brightest venture capitalists (VCs)? New research from the National Bureau of Economic Research (NBER) and the Wharton School reveals a culprit that can’t be blamed on market timing or bad luck: VCs are cutting corners on due diligence, and it could be costing them large.
Using cellphone data to track 22,000 VC deals over five years, researchers Jack Fu and Lucian Taylor discovered that venture capitalists spfinish dramatically less time evaluating startups when markets obtain hot or competitive. The results were startling—a 15% to 34% increase in volatile investment outcomes when due diligence obtains rushed.
But cognitive biases—the ways that we’re not always rational market actors—also play a role. Thus, VCs often have built-in reasons for missing “the next large thing.”
Why Rushing Kills VC Investment Returns
New research has an eye-opening answer for why so many VCs fail: They’re often not doing the homework before they invest, and it’s costing them millions.
Researchers tracked 22,000 real VC deals from 2018 to 2023. Using cellphone location data to see how much time VCs actually spent meeting with startup founders before writing checks, they found that when markets are more competitive, VCs spfinish way less time researching companies and their investment results become far less predictable.
“VCs trade off the costs of research with better investment decisions,” the study found. In plain English: When everyone’s shifting rapid to close deals, thorough research obtains thrown out the window.
According to the NBER study, here’s what actually happens when VCs rush their research:
- Geography matters: If a startup was twice as far away, VCs spent 35% less time researching it.
- Competition kills analysis: When more VCs were chasing the same startup, research time dropped 13%.
- Overworked investors cut corners: Busy VCs managing lots of deals spent 22% less time on each one.
In the finish, the researchers found, average returns were often about the same, but the wild swings obtained much largeger—meaning more disasters alongside the occasional jackpot.
How the Power Law Problem Makes Things Worse
Even the most successful funds lose money on about the same percentage of investments as average ones, but their large winners are dramatically more successful.
“Venture capitalists are playing a power law,” Bridger Pennington, co-founder of Fund Launch, informed Investopedia, referring to the principle that VCs only necessary a few winners to stay ahead. “They’re going to do 20 bets and every single one of them necessarys to have the potential to do, in most funds, a 10-times if not a 20 to 50, even 100-times return. You necessary only one or two hits to pay back the expected return for the whole fund.”
In practice, this means VCs aren’t aiming for “pretty good”—they’re swinging for home runs with every investment, knowing most will strike out. But this relentless search for outliers means it’s simple to miss steady growers or unconventional winners.
Important
During hot markets like 2021, the NBER researchers found that VCs spent up to 85% less time on due diligence compared with cooler periods. The rush led to more unpredictable investment outcomes across the board.
Missed Unicorns
Over time, legfinishary stories of VCs passing on Airbnb, Inc. (ABNB); Google, later Alphabet Inc. (GOOGL); and WhatsApp came about not becaapply the VCs weren’t smart enough, but becaapply these startups viewed too weird, tiny, or risky. Or, as the NBER research suggests, the VC didn’t take enough time to find out their value.
For example, Fred Wilson, a well-known investor at Union Square Ventures, famously passed on, becaapply he “couldn’t understand how air mattresses on living room floors could be the next hotel room.
But VCs don’t have to accept the chaos. They can “create luck” by plugging startups into their networks, giving founders crucial contacts, hiring support, and early customers. As Pennington put it, “If you’re Sequoia [a major VC fund], you may invest in a startup that necessarys introductions to government agencies. You probably already have those relationships…This reduces the chance of failure compared to that same business on its own.”
But even these advantages can’t offset a bad economy or collective bias, meaning even legfinishs in the space have long streaks of duds.
The Bottom Line
Venture capital is not a crystal ball. No matter how exclusive the fund or sharp the partner, the odds are stacked against consistently picking winners. Power laws, timing, and human bias mean luck will always play a role. But that’s also all the more reason VCs necessary to avoid rushing due diligence that creates their returns far less predictable.
Leave a Reply