Thursday, April 18, 2013

Cooperation & Competition in the Venture Capital Market

Yael Hochberg, Michael J. Mazzeo and Ryan McDevitt have conducted some interesting new research on competition and cooperation in the venture capital market.   They found that competition has a different impact in the VC market as compared to most other industries.   Mazzeo explains in a write-up on the Kellogg Insight website:

"In other industries what you see is that the first competitor that is similar to you to enter the market hurts you a lot, and the second competitor hurts you a little less, and the third even less.  But that flips around in the venture capital industry, where the first competitor that is similar to you to enter the market doesn't hurt you very much, but the second competitor hurts you a little more and the third hurts you even more.  This makes sense because there is a beneficial element to the first competitor in the market if you are working together and sharing resources. But that benefit begins to go away with the second competitor, and it's even less with the third."

Cooperation is key in the VC market because some firms may be very adept at providng the expertise required to help a particular start-up grow, but may want to spread the risk by bringing in a partner to provide some of the needed capital.  In certain cases, a start-up may need different types of expertise, access to networks, etc.  One VC firm may provide some of that assistance, while another VC firm may provide other forms of support and guidance.   Once firms work together on one deal, they may learn that they can work together effectively, and that each has important capabilities to contribute.  That makes them likely to want work together again.   Thus, cooperation becomes crucial to success in the VC market. 

On the other hand, VC firms still compete to find the best deals, get the most favorable terms, identify the next hidden gem so that they can get in early, etc.   What that means is that a feeding frenzy can eventually take place, where too much money is chasing too few deals... as a result, diminishing returns eventually can kick in, and returns on investment can fall.   Cooperation doesn't mean that rivalry won't harm returns.  That still happens, as it would in any industry. 

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