Hype: The Enemy of Early Stage Returns

There is an inconvenient truth in early-stage venture: Hyped sectors consistently lead to meager outcomes. Outsized returns on the other hand happen where you least expect them.

A brief history of hype

Let's examine some examples from the past 20 years.

• When Google was raising its seed round in 1999, the prevailing wisdom was that "search is dead" since none of the players could monetize. So uncertain were Google's founders about monetization that they offered to sell the company to Excite@Home for $750K--but the latter backed away. (The hottest technology meanwhile was bringing the internet to the phone using voice recognition with Tellme, my alma mater, raising a whopping $250M in VC capital. The company exited to Microsoft years later for $800M, a tiny fraction to Google’s IPO)

• When Facebook was founded in 2004, the hottest trends were smart fridges and RFID, all of which went haywire. Meanwhile investors were running away from social networks following the blunders of Friendster.

• When Uber and Airbnb raised their seed rounds in 2009, the hottest trends were Social (buoyed by Facebook’s success) and cleantech, a sector that arguably caused the demise of Kleiner Perkins v1. No one believed the "sharing economy" would actually work. In fact, that term didn't gain mainstream adoption until three years later. Investors then dumped money into other sharing economy opportunities, most notably electric scooters, where everyone lost their shirt.

• Perhaps no better case illustrates his trend than the most recent mega-exit, Figma, which was acquired by Adobe for $20B last year. The collaborative design startup raised its seed round in 2013 to leverage websockets, the technology enabling continuous communication between the browser and server.  But, websockets was far from being the hottest technological topic of 2013. That award went to Google Glass. So exciting was the new technology that Andreessen Horowitz and Kleiner Perkins launched a dedicated Google Glass fund in April 2013, certain that “developers will create thousands of ways for millions of people to use Glass and improve their lives and the world.” 

The story continues–just with different technologies reaching peak hype from Internet of things to the Sharing Economy to 3D Printing to Electric Scooters to Autonomous Vehicles to AR/VR to Crypto and now, dare I say, to LLMs! 

The merits of hype

Hype is good for innovation: it attracts capital, draws talent, and raises awareness from prospective customers.  But inevitably expectations get out of touch with reality and the hype bursts. What happens next depends on user adoption or, put differently, the technology finding product market fit.

When it comes to what became "novelty technologies" such as Google Glass, 3D printing, and scooters, the bust signals the end of the story. These technologies fit well into the writer John Thackara's observation: “If you put smart technology into a pointless product, the result will be a stupid product.”  But when the technology has meaningful applications, a bust is only temporary. Examples include the first internet bubble in 2000 and autonomous driving in 2019/2020, both poster children of Amara's law: “We tend to overestimate the effect of a new technology in the short run and underestimate its effect in the long run”

But predicting which way things will go is extremely challenging. Technology alone does not create the future. Instead, the future is the result of an unpredictable mix of technology, business, product design, and culture. Facebook had a poor choice of technology (PHP), yet it succeeded thanks to a brilliant product. Google took off because of its search technology, but its success came from a clever business model innovation with inline ads. All of this seems clear in hindsight, but it is entirely opaque looking forward.

Hype and returns 

Although hype inevitably bursts, chasing hype can be a fine strategy for late stage funds. It enables investors to tell exciting stories of “platform shifts” and “once in a generation opportunities.” and feels safe with infinite promise and abundant capital. And it can generate handsome returns if a manager can successfully pick the winner (or, for investors with enough clout, if they can hype their own company as the winner and orchestrate a timely exit)

For early stage investors, however, investing in hype is extremely challenging. The reason: by the time a sector is hot it’s too late for a new entrant to be successful. As a result seed funds do not get the opportunity to pick a winner in an already hyped sector. Perhaps the best analysis here comes from Andy Rachleff, a co-founder of Benchmark and a mentor to many of us in the venture industry. Analyzing years of early stage venture performance, and adopting a framework from his own idol, Howard Marks, Rachleff deduced that the only way to generate outstanding returns at the early stage is to be right and non-consensus. 

Andy’s insight also presents a challenge for investors: you only know if you're non-consensus when you make the investment, and you don't know if you're right. However, what signal can investors look for? Or, more specifically, what did Google, Facebook, Uber, Airbnb and Figma all have in common? They certainly leveraged an inflection point in technology–albeit one that wasn’t necessarily obvious–like PageRank, GPS in cell phones, and Websockets. They had excellent teams. But, most importantly, they solved a need that people turned out to be desperate for. 

For early stage investors, success isn't about predicting the future of how technology evolves. Rather it’s about finding signs of a clear market need (that may appear nascent or even solved by existing players) and backing teams who can capitalize on these needs. In short, when it comes to returns, product-market-fit eats hype for lunch. 

(Special thanks to Andy Rachleff and Samit Kalra for their invaluable feedback in writing this post)