Statistical Analysis is Sexy: Quantitive Venture Capital

Credit: mas.gov.

by Peter Ryan

March 10th, 2015

    Statistical analysis is sexy. In recent years it has begun to gain popular recognition; as seen with the book “Moneyball” by Michael Lewis, later developed into the movie of the same name starring Brad Pitt and Jonah Hill. Lewis tells the story of the Oakland A’s innovative strategy of using statistical analysis, specifically saber metrics (baseball data analysis) to their advantage. They built a winning team based around the probabilities of success of certain key metrics. Instead of focusing on qualitative measures to make decisions, they relied much more on math to do the deciding for them. They are not alone, for teams such as the New York Mets, New York Yankees, San Diego Padres, St. Louis Cardinals, Boston Red Sox, Washington Nationals, Arizona Diamondbacks, Cleveland Indians, and the Toronto Blue Jays have hired full-time sabermetric analysts. Statistical analysis has also caught the eye of soccer fans, shown by the recent Goldman Sachs Statistical Model of the 2014 World Cup. The model predicted all but one semi-finalist. Even a local NYC startup, numberFire, offers statistical analysis of other sports like the NBA and NFL. It’s hit Hollywood and professional sports, and now it’s hitting venture capital.

    Let’s dive into the current state of venture capital ecosystem. Here’s a breakdown of a typical venture capital firm’s successes and failures according to Paul Singh’s Disruption Corporation:

80% of deals lose money

10% of deals return the original investment

5% of deals return double

4% of deals return better than double

1% of deals return homeruns

    The homerun deals are what drives venture capital and allows it to have such dismal odds of success, because that one success brings huge returns. There appears to be a trend of the traditional venture capital asset class moving away from earlier rounds of investing to later ones, perhaps due to the high risk of seed stage startups. Seed round investment deals are decreasing as a percent of total investment deals per year. In 2013, they only represented 6% of total deals. This decreased from 8% the year prior, and Q1 of 2014 shows them at just 4% of total deals. Thus, at first glance there seems to be less startups getting funded in the seed round (Source: PWC MoneyTree Report). This trend is compounded with what is known as the Series A Crunch, where typically 61% of seed funded startups will not get follow on investment in Series A (Inc. and CB Insights).

    So, naturally one might ask – why is capital moving away from seed stage companies? There are two possible answers to this:

    One, is that the costs of starting your own business has decreased drastically allowing for more people to enter the market for venture capital yet don’t have the chops to be successful. Another could be that venture capital firms have been increasing the size of their funds every year. For instance, the average venture capital fund size was $40.3 million in 1993, $94.4 million in 2003, and $110.3 million in 2013. The amount of venture capital being raised each year has also increased: $4.5 billion in 1993, $9.1 billion in 2003, and $16.8 billion in 2013 (Source: AVC and NVCA). This leads to the question: what does fund size have to do with seed stage companies? Well, if you have a larger and larger fund to support, you need a larger and larger return. It seems that firms have more incentive to fund deals that have a higher likelihood of getting a homerun return.

    Two, is that what is considered, the “venture capital asset class”, is getting clouded by a couple new factors. Traditional venture capital firms are creating growth and opportunity funds to provide funding to late-stage private companies, thus moving their capital later. Traditional public company investors, like hedge and mutual funds, are moving earlier due to the trend of private companies staying private rather than going straight for an IPO. Corporate venture capital is also coming in and shaking things up. Companies like Google and Alibaba are providing more and more late-stage venture capital to private companies. The nuance is that there’s no lack of seed funding, and it’s actually increasing from a 2012 value of 54% of all funds to 67% of all funds. Instead there’s more dollars coming into the venture capital asset class that would have otherwise gone to public companies. It appears to be more of an illusion of a bifurcating market rather than a depressing trend in early stage investments (Source: Mark Suster – Upfront Ventures).

    Whether the answer is bigger fund = bigger returns or that the market is splitting in two, it’s clear that venture capital is ripe for innovation or innovating already. AngelList is becoming a force in the new era of that innovation. They are allowing streamlined and easily accessible information into the private market. It allows smaller investors to connect and pull together smaller investments into syndicates of other investors. A lead investor can control the syndicate and make the decisions for the rest, and the smaller investors go along for the ride. It is similar to how the Oakland A’s, a poor team, were able to gain success based on better insights into data. This allows the average person more potential to generate wealth. AngelList is opening doors for the private market that the NASDAQ did for the public one. They are not alone, for they have teamed up with SecondMarket to create better pathways for investors to buy and sell their private shares in a company. More companies are jumping on the private market bandwagon, as seen by MatterMark – a big data aggregator and analyzer that makes it much simpler to rank, research, and evaluate private market companies. These companies are allowing for not only more investments, but also smarter ones. They are using data to their advantage and making opportunities where there were once none.

    Quantified venture capital is happening and there’s no questioning it. It includes professional firms and the average investor. It appears that the increased insight into data through quantitative measures is allowing for more companies to get funded that otherwise wouldn’t. If a Series A Crunch does exist and if companies with modest returns are indeed getting the passed over, this new form of venture capital is solving those problems. This suggests even greater relief for the NYC region, with CB insights suggesting, “NY will see the highest proportion of orphaned startups”. If the market is indeed bifurcating, then these innovations will only continue to expand and generate more capital for seed round companies. Time will tell which trend will win out, however as of now there is no denying that statistical analysis is sexy.

Peter Ryan is a contributing writer at the Economics Review at NYU. He can be reached at par316@nyu.edu.