Investors back obviously bad companies because hype beats scrutiny

I feel like I’ve mostly been writing about my own thoughts lately, so it’s been a while since I’ve written about something someone asked me.

Why do investors, who are supposed to be extremely intelligent, pour huge sums of money into companies that an amateur can spot at a glance as “100% a landmine, lol”?

News about investors and VCs (venture capitalists) putting billions of yen into incomprehensible companies turns up all the time. A friend whose career path—from a large corporation to a startup—has quite a bit in common with mine asked me the question in the title the other day, and I gave him my own take. He didn’t cite this as an example himself, but if we’re talking about recent cases, Adam Neumann’s is probably the archetype.

Adam Neumann

“What exactly is ‘Flow,’ the controversial new company from WeWork founder Adam Neumann?” https://www.esquire.com/jp/news/a40928695/what-is-flow-wework-ceo-adam-neumanns-new-company/

“A hazy sense of opacity… a16z puts $500 million into the WeWork ex-CEO’s new ‘rental housing community’ venture. The explanation doesn’t add up” https://www.businessinsider.jp/post-257929

He’s the founder of WeWork, famous for causing a huge stir with one scandalous revelation after another before the company went public. It also came out that he sold a personally owned domain to the company at an inflated price (he later paid it back), so it seems fairly certain he’s a person seriously lacking in ethics (I have no direct or indirect connection to him, for what it’s worth). For a person who screwed up in that particular way (this wasn’t simply a case of a business not working out), a hugely famous Silicon Valley VC backing his comeback with a massive investment makes many people feel that “even granting that welcoming failure is part of Silicon Valley culture, isn’t this a bit much?”

Honestly, I’m one of those people too.

It’s not just Adam Neumann, and it’s not just Silicon Valley

For example, GrooveX, the company developing LOVOT, is another one we could cite as

“a company that’s received a huge investment even though it’s not really clear it has growth potential.”

Sure, the product is well made, and it’s meticulously crafted down to the smallest detail. I imagine the designers must have had a lot of fun. But on the “obvious point” of returning the investment, a lot of people probably wonder whether sales plus a subscription model can really produce a growth curve that justifies the investment. If anything, most people probably thought that from around the time the company was founded. And yet a lot of money has gone in.

It’s fair to call Seven Dreamers one of Japan’s leading examples of a spectacular flop (the verdict is already in). They raised over $5.7 million, built a fully automatic laundry-folding machine, and it didn’t sell at all—a wonderfully clean failure.

GrooveX is one of several Japanese startups that stand out for genuinely exceptional technical skill and vision. The field is a mix of gems and junk, but the gems are real.

As I wrote in another post (Q. Is it true that most jobs will be replaced by AI?), it’s actually pretty common to find projects that are “technically interesting” but where, if you step back and think calmly for a moment, you immediately realize “wait, who’s actually going to buy this?”—in other words, projects with no visible PMF (Product Market Fit) at all. Once you get the hang of it, coming up with a sharp idea is easier than you’d expect. But whether it will actually sell is an entirely different question. And yet cash piles up to build things like that anyway.

The world of startup investing is one where this happens with a frequency that’s honestly hard to stomach.

Before answering the “why?” in the title, let me lay out the textbook explanation first.

Investing, not just for VCs, is always done as a portfolio. Betting everything on a single company isn’t investing. It’s a hobbyist’s gamble. (Even people who take gambling seriously diversify.) How a portfolio gets structured varies, but a common pattern sets the budget by category. Naturally a budget is a budget, so it doesn’t necessarily have to be spent, but for a “salaryman capitalist,” that budget probably shapes their thinking in most cases. In other words, if a huge investment budget is fixed for a given category, finding places to put it is hard work. Rather than painstakingly hunting down startups that are certain to deliver results and doling out a few million dollars here and there, it’s only natural psychologically to want to hand over a large lump sum to an entrepreneur you trust to go all-out, flamboyantly, up to a certain point.

Most individual investment decisions can be observed from the outside, but the full picture of a portfolio isn’t visible externally, so from an outsider’s (a layperson’s) point of view, this can be one trigger for “why did this company get this much money?”

<Hitting 1 out of 20 is doing well>

People often say the five-year survival rate for startups is around 0.5%. That figure includes companies that students started on a whim, so the real number probably has some variance. On the other hand, once a company reaches the level where a VC is willing to invest, the probability of it reaching some kind of proper exit is said to be excellent if it’s around 5%. That’s 1 out of 20. Of course this depends on the investment amount and the scheme for recovering it, so in practice a lot of complicated factors are involved, but roughly speaking, this figure explains it.

It’s fine if 19 out of 20 companies fail.

If anything, it would actually be more of a problem if you hadn’t attempted 20 companies.

Failure is important.

For example, people have been talking a lot lately about the contrast between Showroom and Pococha, and some are probably struck by a certain shock at seeing what could be called a rival service emerge from the same group.

But this kind of thing is completely normal in the world of launching new businesses, not just startups—you try something, it fails, and you use that failure to build a better business. It’s very simple.

So Showroom, launched earlier, might look like it was cut loose and abandoned, but that’s entirely normal—it failed to make the most of the chance it was given, so at least it didn’t die unnoticed; by leaving behind some trace that could serve as a reference for those who came after, it arguably did considerably better than it might have.

The more failures there are, the better the future becomes. And for that, 19 companies have to miss.

The equity funding scheme was an invention that made that possible.

<Some things can be due-diligenced, and some things can’t>

Warren Buffett, hailed as the god of investing, is said to hold to the principle of “don’t invest in a business you don’t understand,” and it’s said that, in keeping with that principle, he now regrets not investing in early Amazon. My own personal feeling, though, is that investing in a company you can’t due-diligence is sheer madness. (Buffett’s got it right.) That said, most capitalists are finance people; only a small minority come from engineering or research backgrounds. And at best, most of the rest come from consulting. In other words, the chances of being able to conduct proper due diligence, especially in technical domains, are extremely low. (Top VCs in the US and Europe are quite different in this regard, but for now I’m talking about the general case.)

When a startup runs an investment round, the terms “lead” and “follower” get used. The lead is the person who runs the round, and the followers are the people who invest in line with how the lead sets things up. Usually the lead gets decided first, and the followers, true to their name, come along afterward. In other words, there are sometimes followers who simply trust the lead’s due diligence results wholesale and go along with it. No—there are plenty of them. No—it’s mostly like that.

I imagine many VCs would object, “we’re not that sloppy about it,” and a small number of sincere, capable people would probably genuinely say “you’re right, sorry about that,” but a whole string of tragedies and comedies has proven that “the world isn’t always that well-run.” The Theranos case is probably the famous example. (Theranos had every startup cliché packed into it)

But if VCs refused to invest in companies they couldn’t due-diligence on their own, the categories and stages they could handle would become quite limited, and they’d lack real room to grow. In most cases, VCs also have to listen to some extent to the wishes of their LPs (the people providing the money), and they have to keep up with the trends and currents of the times.

Since personnel costs make up essentially all of a VC’s expenses, they’re often run with a surprisingly small number of people (that’s how they turn a profit). There’s a limit to how many diverse people they can bring together, and being too fixated on that will eat into profits. Given that, going along with a couple of investments based on a capable lead’s judgment isn’t an unreasonable thing to do.

So far I’ve laid out three commonly cited factors. Stepping back, you can see a certain rationality behind the behavior. (Of course there’s plenty of room to debate whether that’s the best approach.) I think cases of “huh? why did this company get this kind of money?” will never stop happening going forward. Human psychology plays a large role in this as well. Some economists say that “it’s healthy for an economy to have bubbles that arise and pop at some reasonable frequency,” and historically there does seem to be some truth to that. There will always be people willing to take on the risk of a life like John Law’s—celebrated as the darling of the age, only to end up a hunted man—and no doubt the times will keep turning as the leading players swap out. (Reference: Running away isn’t even shameful—it’s the smart move: toward a way of living that doesn’t depend on madness)

Investors, “supporting characters of the age,” are always waiting for someone to come dance on the stage they’ve prepared.

Originally published in Japanese at https://clazytech.com/2022/10/1494/. Translated with LLM assistance and reviewed before publication.