Uncertainty Wednesday: Network Effects and Prices and Investment Returns, Oh My!

In today’s edition of Uncertainty Wednesday, we will look at how uncertainty in markets is highly dynamic. Something can be a sure thing for a while but not forever.

There is a – potentially apocryphal – story about Ron Conway’s first fund: every single investment was a write off except for Google, which resulted in a 7x return for the fund as whole. Thus is the power outsized returns in a world of network effects and winner-take-all (or most) markets. One winner more than offsets many losers. And the approach of making lots of investments turned out to be a great strategy for many years and different firms.

Along the way though, as this strategy became more and more widely understood, the inevitable started to happen: prices and round sizes went up across the board. The average seed round today is as big as a Series A was a ago. And the pricing for later rounds for a company that has momentum and some story about how it might have network effects is often premised on that company becoming dominant in its market.

So the strategy will stop working. At least it will stop working for small fund sizes. As price and investment amounts go up, you need to make ever more and larger investments to have enough winners (and enough of a stake in the winners) to pay for the losers. Not surprisingly then, we have seen an explosion in fund size. Much like in a casino, somebody will still win in the end (including possibly a small fund), but the probability that it is you becomes tiny and the expected value of the strategy turns negative.

This is the power of markets and the price mechanism. It does away with sure bets. The “spread money among a bunch of network effects companies and sit back” strategy was a sure bet when prices were low. Now prices are high and uncertainty has returned in full force. 

It will take a long time for the effects of this to work themselves through the venture capital market. Fund cycles are long and if you have had several successful funds you can raise a new fund even after one (or possibly several bad ones). As a result strategies tend to persist far past their expiration date and that will be true for this strategy as well.