I recently read the  “The Big Market Delusion: Valuation and Investment Implications” paper by Prof. Aswath Damodaran. I just wanted to summarize the reading based on my understanding and why it is relevant for startups. I did leave many other details and you can refer to his paper.

Disclaimer: If you think you will get a profound insight or interesting facts, please tone down your expectations or look elsewhere.

What?

Perceived presence of a big market for products and services. For entrepreneurs and VCs, these big market perceptions offer a potential for easily scalable revenues, large profits, and high valuations (Every startup pitch).

A big market is good for startups provided it can capture a reasonable share of the market, generate profits in the big market and build a strong moat for itself. There is a slim chance that all three can happen in the future for a newly founded (funded) startup.

A hypothetical entrepreneur who built a product for this perceived big market convinces the venture capitalists and secures funding.

Each cluster (A startup and the VCs who fund them) will be convinced that they will be the eventual market leader. The overconfidence will be reflected in the pricing of these startups and collectively the market will be overpriced. In a rational market, we expect that factors like the probability of success, the existence of current and future competitors will be baked into the pricing mechanism but most of the time it is not.

Why?

Startups are overconfident about the superiority of their products while investors are overconfident about their ability to pick the winners. As the market gets hot, more entrepreneurs enter the fray and VCs have a fear of missing out (FOMO). VCs are OK with false positives (a startup that is promising but crashes without any returns to VC) but cannot digest false negatives (a startup they turned down but later became a unicorn or decacorn). It is because VC industry returns are right skewed or power law based, i.e., most of the companies they invest in give no or low return (less than 2x). On the other hand, very few companies (around 4%) give more than 10X returns. They tend to spread the bets to find big winners.

As larger VCs warm up to this market, the smaller VCs also invest aggressively. It keeps the valuation higher for startups in the market.

How it unfolds?

Eventually, there is a crowding of startups in this market, and it becomes competitive. While revenue growth in aggregate may confirm that the market is big, the revenue growth and operating margins at these firms will collectively fall below expectations because each of these firms overestimated its own prospects.

In due course, these clusters will realize the gap between their expectations and reality. When it happens, it triggers market correction. When they do, many of the entrants will shut down and the aggregate pricing of the sector will move downwards. There will be a few big winners who capture a huge market. These big winners will act as fuel for the next cycle of enthusiasm and the story continues.

Determinants of Overpricing

The following determinants have a direct correlation with overpricing of startup/young companies

1. Degree of Overconfidence – Higher the confidence bigger the delusion and overpricing
2. Size of the Market – Bigger the size of perceived market, higher the overpricing
3. Uncertainty – More uncertainty about revenues or business model makes entrepreneurs and VCs projecting a rosy scenario leading to overpricing
4. Winner-take-all markets – The presence of winner-take-all-markets makes the frontrunner in the industry think that they will be the eventual winner and they all will be overpriced

Overconfidence – Root Cause

Of all the determinants for overpricing, the top choice of researchers is overconfidence. Among the players in the startup ecosystem, from entrepreneurs to venture capitalists, overconfidence is the norm rather than exception.

For the sake of clarity, overconfidence is defined by behavioral economists as “Tendency of individuals to overestimate the quality of information they receive, their ability to analyze that information, and their capability of using that information to influence future outcomes”

Daniel Kahneman considers overconfidence as the most significant of the cognitive biases. Why overconfidence is important in this discussion is that it affects in multiple ways the decision making and pricing.

1. Over Ranking – Better than average phenomenon – If you survey people about their driving ability most of them would rate themselves as above average drivers which cannot be true
2. Illusion of Control – People believe that they have far more control over outcomes and situations than they do
3. Timing Optimism – We always underestimate how much time it takes to accomplish a specific task. In investing it is with regards to time estimate for break even.
4. Desirability Effect – We overestimate the chance of something happening when we desire that to happen

Why is it relevant in startup ecosystem?

In high growth startup areas like AI, Internet of Things, Batteries & Electric vehicles, Web3, etc. you can clearly see the big market delusion playing out. As an early-stage VC, it is in your best interest to price them reasonably to get good returns. In all those startup pitches, apart from founders, total available market (TAM), competition and growth are some of the important factors in pricing the startup.

Total Available Market (TAM) – These big market stories usually manifest as a single TAM value in startup pitches. They are just extrapolated stories at best with shaky assumptions. As an entrepreneur, you must apply more rigor to your assumptions to arrive at this number to avoid disappointments later.

As a VC, you must carry out more due diligence with domain experts and practitioners to verify these claims to avoid losing your money.

Competition – In every pitch, you will see that entrepreneurs place their product as far superior to competitors in a X-Y quadrant by choosing random features along X and Y that will make them to be the best. For example, I can make myself standout from the competition by choosing people who have “Vasan Churchill” as first name along X axis and “Srinivasan Chandrasekaran” as last name along Y axis. By this measure, I will be the only one standing out. If this sounds nonsensical, I suggest you go through many startup pitches, and I will sound saner to you. With big market delusion, people usually downplay competition. It is in the best interest of entrepreneurs to think that they are better than competitors, so it will be difficult for them to acknowledge the competition. For VCs they should price in the fact that at least in initial stages, the growth will be shared between existing and future competitors.

Growth – In the last decade, you must have seen hockey stick growth, which is mostly revenue or users. They often set aside or ignore business models and fundamentals like how you will be profitable in a concrete way. Of course, many of those pitches have some explanations but it is mostly smoke and mirrors. The greater the disconnect from fundamentals, the greater the gap between price and value of these companies. Once again, entrepreneurs will not correct for this growth because of agency problem. Early-stage VCs due to lack of data should be aware of this phenomenon to price the company appropriately. VCs during mid stage, they also may not correct it because they want to show this growth and sell it at higher pricing in the next round of funding. As I mentioned at the start of the article, it is my understanding and view of the paper “The Big Market Delusion: Valuation and Investment Implications”. Comments and constructive criticism are welcome. I am trying to understand various business aspects of startup ecosystems both from an entrepreneur and a VC perspective. Looking forward to sharing my perspectives and learning from you all.

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