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Monday, August 14, 2006
Why are start ups like Peacocks
"Enterning the Dragons Den..Know your VC"
Not all characteristics VCs look for in an investment actually help a company succeed; some may just reveal value the company already had. Evolutionary biologists have an interesting theory about venture capital. Well, they think the theory is about peacocks, but the same principles apply.
Biologists wrestled with the question of why peacocks have such big tails. After all, the peacock's tail is pretty to look at but completely useless to the peacock. Beyond useless, it can actually get in the way if a peacock is trying to escape a predator. In a world of ruthless efficiency weeding out evolutionary misfits, why in the world would a peacock evolve such a big, clumsy tail?
Sex, of course. Peahens like long tails, so a peacock with a big beautiful tail is more likely to mate and produce offspring. But that just pushes the problem back a level – after all, peahens shouldn’t like long tails if it makes their mates (and thus their children) more likely to be eaten.
Except that they have another incentive: they want to mate with only the best peacock to maximize their children’s success. But it’s hard to tell a good peacock just by looking at it (I know I can’t). You can’t tell if he’s healthy, has good eyesight, and can run fast. Since the peahen only sees the peacock during the mating ritual, she has to guess.
The tail resolves this dilemma. After all, it makes the peacock pretty easy for predators to spot and catch. It takes a clever, fast, healthy peacock to have such a ridiculous disadvantage and still survive. The bigger the tail, the bigger the disadvantage and the better the peacock has to be to survive. Though not useful by itself, it is useful in instantly communicating something that would normally take a long time to observe. For peacocks, size does matter.
By now, the relationship to venture financing should be obvious. Some features venture investors seek in a company are not directly related to the chances a company will succeed. Instead, many of the items are “peacock feathers” – ways for a venture investor to be sure the company is not just puffing up for the mating ritual.
Are you really worth $2 million more the day your first two customers write $10,000 checks? No, you’re worth $20,000 more. However, both a bad company and a good company can claim that they will sign up two paying customers in the next month. Only the good company can actually show you the checks a month later. Before you had the check, you were facing the “uncertainty discount” – you might be a bad company (or more likely, a well intended but overconfident company).
That’s why VCs pattern match on credibility factors when deciding to spend more time with a company rather than diving directly into the details. When having such a wide selection of available mates, sorting out the good from the bad can be a matter of looking for a nice tail. Feathers in this tail include a high quality board of advisors, a good law firm, a good bank, management with a past track record, or the first paying customer. While all of these things can be very valuable to a startup company, their value to a venture investor can appear out of proportion to the value they bring through their work. As a result, sometimes it may appear that management is sacrificing the long term goals of the company to establish the feathers necessary to get funded. In that case, they really can be peacock feathers - things that may slow down long term success, but that only good companies can take on. In certain models where significant funding can make the difference between success and failure, those actions may be required to succeed at all.
In economics, this is known as “overcoming the problem of asymmetric information through signaling mechanisms.” That’s why it’s much easier to understanding in terms of mating birds, but either way, a few peacock feathers will help you a great deal in raising funds from venture investors.