VCs Cut Corners on Due Diligence, Leading to Volatile Returns

Venture Capital’s “Time Crunch” May Explain Why so Many Promising Startups Are Passed Over

New research suggests venture capitalists’ increasing speed in evaluating startups-driven by competitive pressure-is a key factor in their surprisingly low success rate at identifying future “unicorns.” While frequently enough attributed too inherent risk or simply “bad luck,” a recent working paper from the National Bureau of Economic Research (NBER) indicates that VCs might potentially be missing out on potentially groundbreaking companies due to insufficient due diligence. The findings challenge the conventional wisdom surrounding VC investment strategies and offer a potential description for the numerous high-profile instances of investors passing on now-dominant tech giants.

The study highlights how the competitive landscape of venture capital-where funds are constantly vying for access to the most promising deals-incentivizes rapid decision-making. This “time crunch” can lead VCs to prioritize speed over thorough investigation, ultimately hindering their ability to accurately assess a startup’s long-term potential. The implications are significant for both investors and entrepreneurs, impacting capital allocation and innovation across the tech industry.

The NBER research suggests that across the board, venture capital outcomes are far from guaranteed, even for the most seasoned investors. This isn’t necessarily due to a lack of intelligence, but rather the inherent difficulty in predicting success, compounded by the pressure to deploy capital quickly.Legendary stories abound of VCs passing on companies like Airbnb, Google (Alphabet Inc.),and WhatsApp,not because they lacked foresight,but because the startups initially appeared too unconventional,small,or risky – or,as the NBER research posits,the VC simply didn’t dedicate enough time to fully understand their value.Fred Wilson, a partner at Union Square Ventures, famously declined to invest in Airbnb because he “couldn’t understand how air mattresses on living room floors could be the next hotel room.” This anecdote exemplifies how a seemingly flawed concept, when properly vetted, could become a disruptive force.

However, VCs aren’t powerless to improve their odds. The research points to the value of leveraging existing networks to support portfolio companies, providing crucial introductions to potential partners, customers, and talent. As Pennington, a source within the industry, explained, “If you’re Sequoia you may invest in a startup that needs introductions to government agencies. You probably already have those relationships…This reduces the chance of failure compared to that same business on its own.”

Despite these advantages, even the most well-connected and experienced VCs are susceptible to economic downturns and unconscious biases, resulting in a significant number of unsuccessful investments. Ultimately, the study underscores that venture capital is not a precise science. Luck, timing, and inherent human fallibility will always play a role. This reinforces the need for VCs to resist the urge to rush due diligence, as thorough investigation is critical for maximizing the predictability of returns.