THE GAME

THEORY
BEHIND
VENTURE
CAPITAL

HAFSA JAHAN
THE GAME THEORY BEHIND VENTURE CAPITAL

HAFSA JAHAN
VENTURE CAPITAL (VC) IS A SORT OF PRIVATE EQUITY
AND FINANCING PROVIDED BY INVESTORS TO START-
UP ENTERPRISES AND SMALL BUSINESSES WITH THE
POTENTIAL FOR LONG-TERM GROWTH. BY
DISCOVERING, SUPPORTING, AND FOSTERING
PROMISING ENTREPRENEURS, VENTURE CAPITALISTS
(VCS) PERFORM A CRUCIAL ECONOMIC FUNCTION
WITHIN THE ENTREPRENEURIAL ECOSYSTEM.
GAME THEORY, ON THE OTHER HAND, PROVIDES A
THEORETICAL FRAMEWORK FOR IMAGINING SOCIAL
INTERACTIONS BETWEEN RIVAL PLAYERS. THE GOAL
OF GAME THEORY IS TO ENCOURAGE INDEPENDENT,
COMPETITIVE AGENTS TO MAKE THE BEST DECISIONS
POSSIBLE IN A STRATEGIC CONTEXT. IN A ZERO-SUM
GAME, IF ONE PARTY LOSES, THE OTHER WINS, AND
THERE IS NO CHANGE IN THE TOTAL AMOUNT OF
WEALTH.
THE PHRASE "ZERO-SUM" REFERS TO
CIRCUMSTANCES IN WHICH VICTORS MUST GAIN
AT THE EXPENSE OF LOSERS IN ORDER FOR THE
SYSTEM'S NET WORTH TO REMAIN UNALTERED.
TRADE AND EXCHANGE ARE VIEWED AS
INSTANCES OF POSITIVE SUM GAMES IN THE
FIELD OF ECONOMICS.
START-UPS ALWAYS STRIVE TO LOOK FOR THE
PROSPECT OF COLLABORATING WITH VENTURE
INVESTORS, RATHER THAN LAUNCHING A FIRM
INDEPENDENTLY, IN ORDER TO LOWER
BUSINESS RISKS AND MANAGE ITS OPERATIONS.
THE GEOGRAPHIC COMPATIBILITY OF VENTURE
CAPITALISTS AND STARTUP BUSINESSES
LOOKING FOR FUNDING IS CRUCIAL WHEN
STUDYING VC COMPETITIVENESS.
IT'S SIMPLE TO THINK THAT RAISING VENTURE
CAPITAL (VC) IS A ZERO-SUM GAME. LET'S
IMAGINE THAT TWO BUSINESSES, BLUEWAVE
CORPORATIONS AND BIG IDEA LTD., ARE
MAKING PITCHES TO ATOMIC VENTURES IN AN
EFFORT TO RAISE MONEY.
BOTH PARTIES CAN GAIN FROM THIS
ARRANGEMENT: BUSINESSES RECEIVE THE
FUNDING THEY NEED TO LAUNCH THEIR
OPERATIONS, AND INVESTORS ACQUIRE STOCK
IN PROMISING STARTUPS.
WHEN A BUSINESS RAISES MONEY FROM ONE
OR MORE INVESTORS, IT IS KNOWN AS A
FUNDING ROUND. THE SEED/ANGEL ROUND IS
TYPICALLY WHERE FUNDING BEGINS. A
PROTOTYPE OR PROOF OF CONCEPT MAY BE
DEVELOPED AT THIS POINT, OR THE PRODUCT
MAY BE INTRODUCED TO THE MARKET
STRAIGHT FROM THE CONCEPTUALIZATION
STAGE.
RAISING MONEY IS A NON-ZERO-SUM GAME IF
ATOMIC VENTURES HAS AN EXCESS OF CAPITAL.
WHILE SOME BUSINESS INITIATIVES CAN
GENERATE RETURNS THAT ARE SEVERAL TIMES
THE INITIAL INVESTMENT, MANY INVESTMENTS
COULD ALSO PRODUCE A LOSS. NO INVESTOR
WOULD WANT THE COMPANY THEY ARE
FUNDING TO FAIL.
INTERNAL RATE OF RETURN (IRR) IS A METRIC
USED BY VENTURE CAPITALISTS TO MONITOR
HOW FUNDS PERFORM IN COMPARISON TO ONE
ANOTHER AND TO DIFFERENT ASSET CLASSES.
A START-UP IS ESTABLISHED WITH A STRONG
BUSINESS PLAN, BUT IT NEEDS SIGNIFICANT
CAPITAL INVESTMENT TO BE SUPPORTED AND
ENABLE BUSINESSES TO DEVELOP AND MATURE
WITHOUT ANY PROBLEMS. THE INVESTMENTS
THAT GUARANTEE THE BIGGEST RETURNS ARE
THOSE WITH HIGH VALUE PROPOSITIONS,
WHICH ARE TYPICALLY THE FOCUS OF VENTURE
CAPITALISTS.
EVEN THOUGH THE VENTURE CAPITALIST
MIGHT GET SOME MONEY BACK IN DIVIDENDS,
THEIR MAIN RETURN ON INVESTMENT COMES
FROM CAPITAL GAINS WHEN THEY EVENTUALLY
SELL THEIR COMPANY SHARES AFTER A
PROTRACTED PERIOD OF TIME.
CONSEQUENTLY, A VENTURE CAPITALIST WILL
STILL PAY ATTENTION TO THE VALUE
PROPOSITION OF EACH DEAL EVEN IF
BLUEWAVE CORPORATIONS AND BIG IDEA LTD.
STRIVE TO PREDICT ONE ANOTHER'S MOVES
AND COMPETE WITH ONE ANOTHER.
BECAUSE OF HOW CAPITAL MARKETS ARE SET
UP AND HOW THEY OPERATE, VENTURE CAPITAL
HAS A NICHE. THE FIRM'S GENERAL TRACK
RECORD, THE FUND'S "STORY," AND ATOMIC
VENTURES' CONFIDENCE IN THE PARTNERS
THEMSELVES, RATHER THAN ANY INDIVIDUAL
DEALS, ARE WHAT CONVINCE THEM TO INVEST
IN A FUND.
ATOMIC VENTURES FREQUENTLY MAKES
INVESTMENTS IN PROFITABLE SECTORS OF THE
INDUSTRY, OR SECTORS THAT ARE MORE
TOLERANT OF COMPETITION THAN THE WHOLE
MARKET.
LET'S IMAGINE THAT BLUEWAVE
CORPORATIONS AND BIG IDEA LTD MISTAKENLY
BELIEVE THAT VENTURE CAPITAL IS A ZERO-
SUM GAME. IN A ZERO-SUM GAME, NEITHER
WEALTH IS CREATED NOR LOST. FUTURES AND
OPTIONS ARE SEEN AS ZERO-SUM GAMES IN THE
FINANCIAL MARKETS SINCE THEY ARE
AGREEMENTS BETWEEN TWO PARTIES, AND IF
ONE LOSES, MONEY IS TRANSFERRED TO THE
OTHER.
THE FOLLOWING SITUATIONS ARE
CONCEIVABLE IN THIS SITUATION: THE VC FIRM
INVESTS IN BOTH BLUEWAVE CORPORATIONS
AND BIG IDEA LTD. BECAUSE THEY BOTH PLACE
A LOWER VALUE ON THEMSELVES THAN THEY
SHOULD. BIG IDEA LTD. RATES ITSELF ABOVE
TRUE VALUE WHILE BLUEWAVE CORPORATIONS
VALUES ITSELF BELOW TRUE VALUE. BLUEWAVE
CORPORATIONS ARE INVESTMENTS FOR VC
FIRMS.
BLUEWAVE CORPORATIONS RATES ITSELF
ABOVE GENUINE VALUE, WHILE BIG IDEA LTD
VALUES ITSELF BELOW TRUE VALUE. BIG IDEA
LTD. IS INVESTED IN BY VC FIRMS. THE
CORPORATIONS PUT THEMSELVES AT RISK BY
ATTEMPTING TO PREDICT THE MOVES OF THE
COMPETING COMPANY. A ZERO-SUM GAME
INDICATES THAT THERE CAN ONLY BE ONE
"WINNER" AT THE EXPENSE OF THE OTHER
PERSON OR INDIVIDUALS IN THE CONTEXT OF
INTERPERSONAL INTERACTIONS.
WHEN BOTH ORGANIZATIONS UNDERVALUE
THEMSELVES, THE NASH EQUILIBRIUM FOR THE
CIRCUMSTANCE TAKES PLACE. STARTING
BUSINESSES AND VENTURE CAPITALISTS
WORKING TOGETHER IS A WIN-WIN STRATEGY
THAT IS MORE POPULAR. INVESTORS AND
STARTUP FOUNDERS DEPEND ON ONE ANOTHER
AND SHARE THE RISKS OF RUNNING A BUSINESS.
INVESTORS HAVE AN ADVANTAGE OVER OTHER
PLAYERS BECAUSE THEY HAVE HAD HUNDREDS
OF OPPORTUNITIES TO LEARN, DEVELOP, AND
MASTER THE GAME. ENTREPRENEURS
OCCASIONALLY PLAY A BRAND-NEW,
UNCHARTED GAME. THEY MUST CONDUCT
THOROUGH STUDY AND GAIN ADDITIONAL
MARKET KNOWLEDGE BEFORE MOVING
FORWARD WITH THEIR PLAN TO PITCH THEIR
COMPANY TO VENTURE INVESTORS.
VENTURE INVESTORS WORK WITH START-UPS
AS PARTNERS, CONTRIBUTING VENTURE CASH,
MANAGEMENT EXPERTISE, AND OTHER VALUE-
ADDED SERVICES. ENTREPRENEURS AND
INVESTORS LEARN MORE ABOUT ONE ANOTHER
IN EACH CONVERSATION, WHICH ALLOWS THEM
TO MODIFY THEIR TACTICS. THE SELECTION
AND NEGOTIATING PHASE IS CRUCIAL FOR THE
PARTNERSHIP BECAUSE IT WILL AFFECT HOW
SMOOTHLY LATER STAGES MOVE FORWARD.
WE PRESUME THAT THE SUCCESS RATE IS WHEN
BOTH PARTIES DETERMINE THAT THEY ARE
LIKELY TO WORK TOGETHER THROUGH
PROPERTY COOPERATION. CONSIDER TWO
SOFTWARE BUSINESSES MAKING FUNDING
PITCHES TO THE SAME VENTURE CAPITAL FIRM.
THE MOST CRUCIAL QUALITY A BUSINESS
ENTREPRENEUR CAN DEMONSTRATE TO
INVESTORS IS THEIR CAPACITY TO ASSEMBLE
AND RETAIN A STRONG TEAM.
EVERY PITCH NEEDS TO INCLUDE A COMPETITIVE
ANALYSIS. BOTH STARTUPS HAVE NO INTENTION OF
WORKING TOGETHER BECAUSE DOING SO WOULD
GUARANTEE THAT JUST ONE WOULD RECEIVE
FUNDING. A BRIEF, THOROUGH, AND
STRATEGICALLY PLACED VC PRESENTATION DECK
CAN PIQUE CURIOSITY, START A DIALOGUE, AND
SECURE THE FUNDING—AND FUTURE—FOR THE
FOUNDER'S BUSINESS, EVEN THOUGH THERE MAY
BE A VERY SMALL WINDOW TO CREATE AN
IMPRESSION. THE RIVAL STARTUP WILL RESPOND
SIMILARLY IF ONE ATTEMPTS TO ANTICIPATE THE
OTHER AND SETS A LOW VALUATION.
REFERENCES:

HOW VENTURE CAPITAL WORKS, VENTURE CAPITAL MAGAZINE ARTICLE

WIN-WIN: THE GAME THEORY BEHIND VENTURE CAPITAL, COURSE BLOG

LUIS ALMANZA, OCT 3, 2021, IGNORE THE BLOND: GAME THEORY AND
STARTUP INVESTMENTS: HTTPS://MEDIUM.COM/@LMALMANZA/IGNORE-
THE-BLOND-GAME-THEORY-AND-STARTUP-INVESTMENTS-95495BE33879