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Past Performance Is Not An Indicator Of The Future

August 15, 2022 | Micky Tesfaye

VCs love investing in past founders. That’s not just making them bad at picking tomorrow’s winners – it’s also a barrier to diversity.

Venture capital is an exercise in controlled failure. As many as 80% of all funded startups fold before exiting. In this high risk, high reward game of chance the most important signal investors use to predict a startup’s fate is a surprisingly simple heuristic. Has the founder had a previous exit?

A startup’s fate is determined by a series of unknowns. Does the product have a market fit? How will the founding team manage the challenges and pressures of scaling a business? Is the time right for this product? Founders with previous exits offer an antidote to this uncertainty. After all, if you’ve done it once, you’re more likely to do it again!

But…what if you’re not?

Because as logical as this line of thinking sounds, often it actually ends up distorting our ability to calculate the odds of something happening.

This focus on the past isn’t just a problem for VCs’ bottom line – it’s a dangerous cognitive bias that perpetuates inequality.

Stupid decisions, brilliant hindsights

When we try to distill success, we look at those that did it. We fixate on “The 7 Habits of Highly Effective People” or ask “What Did Billion Dollar Companies Look Like at the Series A.”

This way of interpreting data to predict outcomes is called survivor bias and it’s everywhere we look. Case in point: Think of the cultural phenomena of hoodie-wearing, college dropouts turned industry titans. Gates, Jobs, and the Zuck all became fantastically successful after quitting school. If you look at these founders, you might think to reach their level of success you need to drop out of school and run with your idea.

Yet, how many have followed the Jobs model and failed? Who knows? We don’t get front-page write-ups about, and extensive interviews with, brilliant-yet-unknown entrepreneurs and their failed businesses. And that’s precisely the problem with survivor bias.

When we look at those that have made it to determine why, we ignore those that didn’t make it. We attribute success to something they did or had. But this removes those that failed from our view, because for every Jobs or Gates, there are thousands of college dropouts who didn’t go on to start a trillion dollar company. Focusing on founders’ with previous exits is much like thinking what made Jobs, Gates and the Zuck successful is dropping out of college.

Of course an experienced founder is likely to be better versed to deal with many challenges that come with running a startup. Still, the fact is that almost all startups are trying to figure out what they’re doing and how they do it. It’s through trial and error, and a fair share of luck along the way, not by following a meticulous step-by-step guide.

Survivor bias makes us ignore everything that failed – the founders whose second venture and third venture went on to fail – and instead focus only on those that won. College-dropout billionaires are both rarer and less illustrative than popular culture might make us believe. Likewise, more startups led by founders with previous exits fail than succeed.

With survival bias in the driving seat though, “a stupid decision that works out well becomes a brilliant decision in hindsight.” And a college-dropout’s lucky punt becomes unwavering foresight.

Paul Graham, investor and founder of the famed startup incubator Y Combinator, said it best when he quipped, “I can be tricked by anyone who looks like Mark Zuckerberg”.

When stupid becomes dangerous

Unchecked survival bias doesn't just make us bad at predicting outcomes – it’s also dangerous.

How? Because it mistakes correlation with causation.

Consider the fact that in 2021, of the total venture capital funding raised in the US, only 2% went to women.

With everything else being equal, that means of every 1000 startups funded in the US last year, only 20 of them had female founders. If 80% of funded startups fail, that means only 4 startups with female founders will exit, compared to 196 startups with male founders.

A VC’s survival bias will tell them that only a tiny portion of future winners will be startups founded by women.

In reality only a fraction of female founders have the opportunity to exit.

So VCs, what makes for a successful startup?

“Not women or people of color.”

At least, until your survival bias is addressed.

About the Author

Micky Tesfaye

Fintech Journalist

Money20/20