Try to get a venture capital company to reveal its secrets.
Stanford Graduate School of Business Finance Professor Ilya Strrebulaev set out to solve this challenge when he created the Stanford Venture Capital Initiative. The initiative has steadily accumulated an extensive and unique database to determine how the VC industry works.
Strebulaev and his co-researchers have already derived two highly-respected papers from the data. The first paper, ” What Do Venture Capitalists Think?”, was almost anthropological, based upon surveys completed by 900 professionals from more than 650 VC firms. The study found that the main factor in VC investments was not the product quality but the team.
Strebulaev and his team conducted a second study that raised eyebrows. They found that VC-backed companies with valuations above $1 billion — the so-called “unicorns,” as they are called — consistently reported valuations far over their actual market value. The study, ” Square Venture Capital Values with Realityopen in a New Window,” examined 135 unicorns founded after 1994. It concluded that each had been overvalued by at least 100%.
Strebulaev said that although gathering data for this research was challenging, VCs were becoming more willing to support the project. He and his team are hoping to produce further groundbreaking studies shortly. He says, “This is only the beginning.”
Stanford Insights sat with Strebulaev recently to discuss what he has learned so far and what he wants to learn about an industry that continues to have a disproportionate effect on innovation worldwide.
Why do you need to study venture capital firms
The VC industry is unique because it is a tiny sector in terms of funding. The VC industry is much smaller than a large sovereign or pension fund, but the relative impact is enormous. Venture capital accounted for a large portion of research and development costs in all 1,300 companies that went public in the U.S. during the last four decades. Eight of the ten companies that became the largest, measured by their market capitalization, began with VC financing.
We know little about VCs’ decisions or how their funds are run. What are the most effective contracts for incentivizing entrepreneurs? What is the best way to increase value for these young firms? There are many unanswered issues.
Are VCs notoriously secretive because they are a sect
Yes, there are many secrets. But that is a problem for all private companies, not just venture capitalists. There aren’t as many documents filed and made available by VCs as there are for public companies.
When did the campaign begin
The first time it happened was about three to four years ago. I was researching venture capital and teaching the Venture Capital course, which was very popular. I spoke to the Stanford GSB Dean at the time, Garth Saloner, and together, we created the Stanford Venture Capital Data Initiative (recently renamed the Stanford Venture Capital Initiative). We started by contacting the National Venture Capital Association and some other people from the VC Industry. We received a lot of support, and data began to come in.
What type of data is available
We have thousands of contracts signed between VCs and the companies they invest in. The paperwork is what defines the relationship between the shareholders. It’s not easy to find. Some information is available in the company articles of incorporation, which every business must file. But for the most part, it’s hard to locate. The contracts are difficult to read, so the real work starts once you have them. Every arrangement may have hundreds of variables that have never been collected consistently.
How many coins have you collected so far
We’ve only analyzed about 1,000 of the thousands. We built a massive infrastructure of lawyers, data analysts, and research assistants to help us read the contracts.
Does it seem difficult to compare apples with apples
It is very, very hard. Each contract is the result of a lot of negotiation and bargaining. There’s a lot that is unique to each contract. Things start to get interesting once you can link contracts using different data sets. We were able, for example, to use the data to estimate the value of companies that were already in existence and had received venture capital funding.
This is a study on unicorns
Yes. Yes. First, we created a framework to help us value these private companies. The second part involved getting dirty with the data. We read every contract carefully and understood the implications of cash-flow rights and the preferences of different shareholders. It took a lot to get there. It took a lot of work.
I can imagine that some people were not happy with your conclusions
Absolutely. People at Company X are not happy if I tell them that the company is overvalued 100%. I spoke to some of their general attorneys.
Was this worrying
No. I am confident in our framework and what we did. I responded to each communication and invited them to provide all the data they had about their company. We may have missed some documents, which could affect our value estimation.
What did you say
One company gave us some additional information to clarify their contract. We have not received any further information on the other cases. This suggests that the companies agree with our interpretation of their contracts.
When deciding on what type of research to conduct, do you consider the audience
Four audiences are in mind. First, we have students – both at Stanford GSB and students from around the globe – who are learning to be VCs, entrepreneurs, and investors in innovation. Everyone must understand the economics behind what’s going on. The contracts investors sign with fund managers also determine the economics of the funds. Second, academics are interested in learning more about venture capital and innovation. Third, practitioners have already been VCs, limited partners, investors in VC funds, or corporate executives. It’s valuable to show them how to improve and best practices.
