On Twitter, Robin Hanson asked a question yesterday I have given a lot of thought to, which is why the bigger venture capital firms dominate the market and make oversize profits while the other firms taken together make almost no profits. Most industries do not work that way, so this requires explanation. I attempted to explain my view on Twitter, but was largely unsuccessful. Marc Andreessen did a better job of explaining a fully compatible position, but Twitter still is not the best medium for a question this important and complex, so I am going to consider the question here in more detail. I agree with everything Marc said, but my view of the problem is that it goes deeper, and is more insidious, than his observations imply.

Consider a start-up whose business plan requires venture funding. Most companies that require venture funding need to get such funding, or at least are better off seeking such funding, multiple times; there will be seed money, then a series A, then a series B, and so forth. It would not make sense in the first funding round to give the company enough money to see itself all the way through to stable profitability, since most companies will fail long before that happens and the company is not yet worth enough to take that large an investment.

A goal of every start-up is to avoid having ‘down’ rounds where the valuation of the company declines. These rounds are essentially doom for a Silicon Valley style technology-based startup, as they play havoc with the equity table, reduce the available incentive pie and send the signal that the company is doing poorly and could not avoid sending the signal that the company is doing poorly. Often the company more or less falls apart rather than attempting to soldier on, to free up valuable human capital.

Being a start-up is essentially a giant signaling game played on multiple meta levels; starting a business is not about doing business. Starting a new business is about raising investment. MetaMed is a great example of this phenomenon. We made the deadly mistake of thinking of MetaMed as a business that was trying to turn a profit and grow organically, rather than a start-up whose ‘profits’ would come from selling its stock to investors at a higher price. Even in the explicit context of a profitable case, this was still true. If we had closed an additional $100,000 case and made a marginal profit of $50,000, then we would have added $50,000 to our bank account, which is great, but the valuation of the company likely would have gone up by a million dollars or more and our ability to close investment at all would have gone up substantially. If MetaMed had raised another funding round, it would have sold between 10% and 20% of itself to those investing, which means $100,000 to $200,000 in direct additional cash and another $800,000 of equity to distribute.

The only good reasons to charge your customer money is to test what will cause customers to pay money, and to signal that you can successfully charge your customer money!  The purpose of a start-up is to turn itself into a future business, and the potential profits of that future business are what is valuable and what everyone is working to create. It raises money by convincing others of these potential profits, then selling off a portion of those future profits, and then uses that money to enhance its ability to signal its future profits. The system works, to the extent it works, when the signal is both correlated to the company’s ability to succeed (better founders with better ideas can signal more effectively) and the signaling actions themselves serve to create a real company. Founders who understand the dynamics involved will be hill climbing in order to send the best signals possible and raise the most money, so it is very important that their doing so results in actual companies that hopefully do actual valuable things for people.

A venture capitalist is listening to a pitch from a start-up founder. The start-up founder is explaining why his company is exciting and the venture capitalist should invest. What criteria does the venture capitalist use to decide whether to invest?

Fundamentally, the venture capitalist is asking: will this company be able to raise money in future rounds? If the answer is yes, and they are a good fit with the company, then the capitalist will likely invest. If the answer is no, the capitalist will almost certainly not invest. Even if the capitalist believes that the company would, if it was funded, be likely to succeed, the capitalist will refuse to fund it now because it will not be able to get funding in the future. If the founder pitches the company poorly, that has a primary effect that a poor pitch is unlikely to sway the capitalist, but it has an even bigger effect of signaling this founder does not know how to give a good pitch. As a result, in the next round, he will give a poor pitch, thus signaling a poor pitch in the third round as well, and therefore he will not get funded, so I should save my money.

The founders’ potential partners and employees are thinking the same thing. They know the company’s success depends on raising money, so the easier it looks to be to raise money, and the more money has been successfully raised, the more eager everyone is to work with you, to partner with you, and so forth. Nothing succeeds like success, except the expectation of future success. It is often more important to have raised and be able to raise money, and to have raised your money from high-quality sources at the correct prices, than it is to actually be in possession of the money. Peter Thiel’s investment in MetaMed gave us $500,000 to make the company succeed, but the gift of being able to say that he had invested in the company, and on generous terms, was worth far more than the money. If that money had come from a random investor, even if we had gotten substantially more money, we would never have made it half as far as we did.

All the venture capitalists are trying to predict what other venture capitalists will do, and mimic those future decisions. One of their most valuable assets is their reputation for having a strong reputation. If your reputation is that your reputation is strong, then I expect others to expect the companies you invest in to do well, which means those companies will do well. If you instead go against the central tendency of the venture capital market, not only will the companies they invest in find it harder to raise money, but your own reputation will suffer. Others will look and say: Peter invested in a company that could not raise funds from others, so when Peter invests in a future company, I have to worry that he did it for his own quirky reasons rather than because he is predicting the actions of other investors. Peter’s decisions become less correlated with the market’s future actions, and the signal weakens.

When you have a strong meta-reputation, the signal you send by investing is strong, and enhances the value of the company. Everything the companies you invest in have to do becomes easier, and the shared belief that you can enhance the value of the company causes the company’s value to actually become enhanced. That also means that founders beat a path to your door. If one of them has a hot new idea or a strong pitch, they will go to you first, and prefer to take your investment rather than someone else’s investment. In order to get your name and reputation, they will not only take your money first, they will give you better terms, which is pure profit. Then you have them over a barrel, because once you have invested once, your failure to invest again in the future would be a horrible signal, so you can now drive a hard bargain and capture even more of the gains.

The biggest venture capitalists with the strongest reputations get the best founders at the best prices, and their names and reputations are hugely valuable to the companies they invest in, to the extent that people will (quite rationally) flat out give them stock in some cases in order to name-drop them or have them make a few phone calls. Meanwhile, others in venture capital play the game at a huge disadvantage, and on net get very poor returns, possibly negative returns. The good news for them is two-fold. One is that some of them will succeed, build a reputation, and be able to collect these reputational rents themselves. Two is that often they are investing other people’s money, which means that they can earn a fine living without having to get good returns.

The tragedy of all of this is that everyone gets caught in a meta-reputational meta-signaling trap that allocates resources extremely poorly and forces founders to focus solely on activities that can help them raise funds until the point where they have to get ready to approach the actual stock market, and thus need to build a real company. Deviating from this plan gets you punished on multiple meta-levels. The system as a whole does continue to be profitable, because it sucks in huge quantities of high-value human capital both in terms of founders and employees, pays everyone largely out of potential future profits, and hands them large amounts of money and powerful connections. Occasionally one of them build a highly profitable company, and much more often one of them proves that they have managed to hire high-quality human capital and sells that asset to Google or another similar company, since high-quality human capital employees are usually underpaid by orders of magnitude relative to their marginal productivity.

I wish I knew how to shift us away from this equilibrium and get us our flying cars, but for now, we are stuck with a hundred and thirty characters.