VC's: Out With the Gut, In With the Algorithms

Remember Moneyball? The The 2003 book by Michael Lewis, and 2012 movie starring Brad Pitt, was about Oakland Athletics baseball manager Billy Beane's then-revolutionary attempt to approach competitive baseball by using an analytic, evidence-based, sabermetric approach in making decisions. Similarly, the traditional method of Venture Capital firms making investment decisions based on the observations of high-paid associates seems to have met it's match.

Much like how political insiders have begun to realize the beneficial implications of quantitative analysis of big data in predicting election results, large Silicon Valley firms are building their investment theses on data they can gather. Reliance on numbers appears to rid these firms of natural human bias, but the question still remains whether such algorithms can truly do a good job in deciding the future of a technology startup.

In this article, author Christina Farr discusses the new phenomenon with a number of investors. It appears that although a few venture investors still prefer their own judgment over data points, the sheer number of venture-backed failures provides the necessity to at least venture into this realm of analysis. Late stage investment firms have been doing so for years, with most believing that the tool is one of a few that allow them to stay competitive.

The analysis works by reviewing a few key performance indicators, or KPIs, that are aggressively collected from both public and private sources of information. These numbers are then compared with similar companities to calculate a company's fundability and risk profile. Factors that appear to be consistently present in successful firms include the ability to move on to new ideas if old ones fail, a team size of two or more people, and a team dynamic with one business founder and one technical founder. Surprisingly, mentorship and speed of growth are often irrelevant.

“What really mattered was the diversity,” Google Ventures’s partner Joe Kraus told VentureBeat in a recent interview. “In the seed stage, you’re only gonna focus on the team; the product is too nascent.”

This new trend sure seems promising, but raises many concerns. Will this new method of analysis replace venture capitalists? How does it factor in the human elements necessary in successful entrepreneurship-- a founder's ideas, drive, work ethic, or management skills? While I believe this is a tool that must be accepted in order to stay competitive, it is certainly too early to think that it can replace a large portion of the industry. The article ends by citing a counterexample in Paul Graham, who specifically pursues entrepreneurs who stray off the mainstream path-- thus demonstrating that there are limitations to numbers-driven investing.