Venture Capitalists and Irrational Exuberance

The Dotcom Boom and Irrational Exuberance

For those who started their careers in the late 1990s and early 2000s would remember the Dotcom boom when the internet and software based businesses were expected to drive the future economic growth in the United States and elsewhere. Named because companies with a .com address were projecting high growth and endless revenues, this boom sparked frenzy in Venture Capital investing in these firms.

However, the boom soon went bust leaving in its wake a string of failed companies, entrepreneurs who went bankrupt and venture capitalists who suffered huge losses sometimes of their own money.

If there was a lesson from this boom and subsequent bust, it is that irrational exuberance in economies must be tempered with rational and cool headed thinking where people are not carried away by the transient and temporary.

History Repeats Itself

Having said that, the nature of the markets and economies is such that lessons are rarely learnt from history and within a gap of a few years, another boom in the US economy started where venture capitalists again started funding entrepreneurs with little or no experience in running companies.

Before we proceed further, we would like to make it clear that we are not per se against investing in startups or funding brilliant ideas.

Indeed, the nature of capitalism is such that disruptive innovation and creative destruction are the norm. However, what we are against is the mass mania kind of investing cycles where irrationality takes over and VCs start pouring in money in firms that do not have fundamentally strong business plans. Thus, what we caution against is irrational exuberance and illogical investing.

Are VCs Rational ?

One might very well ask, why do the VCs who are industry veterans with decades of experience in investing and funding startups go wrong?

Further, why would they want to invest badly and lose even more badly? The answers to these questions lie in the mechanics of global capital wherein “Easy money” and “high liquidity” means that the money has to go somewhere and this is where sometimes VCs tend to display irrational exuberance.

Further, given the fact that returns on keeping money idle is less and the opportunity costs are more, it makes sense for these VCs to look to invest in companies that promise returns if only on paper. This is the reason why periodic bouts of market madness are witnessed wherein even the most venerated and experienced VCs tend to go wrong.

Hunt for Value Investments

Of course, this is not to say that VCs fund every entrepreneur who comes knocking. Indeed, research has shown that out of hundreds of applicants for funding, a handful are finally funded meaning that competition is intense. Therefore, it follows from this that VCs are always on the lookout for opportunities because they want to invest in companies with a bright future. Considering that they have to deal with “junk ideas” on a daily basis, they usually zero in on what their models of investing suggest would be profitable.

A Recent Example

A recent example is the Indian e-business portal Flipkart receiving a Billion Dollars in capital infusion from abroad.

While there are many who question whether Flipkart would be able to justify such huge investments, there are others who believe that given the rather weak market for funding in recent years, this company has a solid business model and hence, can be trusted to deliver.

The key take-away from this example is that we are of the view that such deals should be based on rational and logical valuations and not because the VCs have money to spare or because the future lies in the emerging markets.

In conclusion, as long as there is money to invest there would be VCs and as long as there are VCs, there would be entrepreneurs on the lookout for funding. Therefore, the key point to note here is that it is important to find balance and not get carried away by the crowd.