VALUE: After Hours (S07 E18): Jakes Veggies -VC and Startup Lekking Analogy

During their recent episode, Taylor, Carlisle, and Tim Travis discussed VC and Startup Lekking Analogy. Here’s an excerpt from the episode:

Jake: All right. So, this segment’s inspired by Matt Ridley’s new book, Birds, Sex and Beauty. Ridley’s one of my all-time favorite authors. I think I’ve read everything he’s ever written. So, to paint the scene for you, imagine it’s early morning on the grasslands of South America. A dozen male birds gather in this open patch of dirt, each holding down a little postage size stamp basically of territory.

There’s really nothing special about this land, except generations of birds have been coming here for decades. The birds jockey around for the territory. Occasionally, the fighting can get intense. But mostly, they respect each other’s little sovereign areas. When they leave to go find food, they’ll travel together like friends, hanging out. And then, when they come back, they all get back into their little spots that they had previously held.

So, every morning, from roughly March through May, these birds gather in a cluster in these little chosen areas. It would be quite boring to watch most of the time. But then, out of the blue, you’re sitting there watching and they all start dancing. They puff out their chests, they flutter their feathers like they’re sequins. This whole scene looks like a cross between a Vegas floor show and a nature documentary.

They’re definitely not fighting at this point. They’re not trying to show each other up, they’re not feeding. They’re trying to be seen, because somewhere nearby there’s a female who’s watching. What they’re really trying to do is find their way into another F word. So, [chuckles] strangely though, dozens of males will perform, but only one or two do most of the mating with the females who come and watch.

These females are very selective. They’ll watch the males put forth their best show, and then they’ll leave, and then they’ll come back the next day and the next. And then, they’re really in no hurry. The females are definitely in control of deciding like who they want to pick. Eventually, they choose their next baby daddy from this gathering of males. This whole phenomena has a name. It’s called lekking. And like the little area that they go show up is called a lek, L-E-K.

Many species of bird lek, several varieties of grouse, the mannequin, the ruff, but also some mammals, including the fallow deer and a species of fruit bat. So, you may be wondering, why is the mating so skewed to just a few of the males? If you watched, you wouldn’t be able to see much difference between these males that are gathering together. Their behavior is the same. They look the same. Even these alpha males aren’t really healthier than the other ones as far as scientists can tell. They tend to be a little bit older and therefore bigger, but that seems to be mostly a lot of luck and randomness in the female selection.

There’s this interesting evolutionary idea here called the sexy son hypothesis. The females aren’t just picking based on their own personal taste, and they’re certainly not picking with the hope of pairing up with the bird equivalent of Fabio and living happily ever after. In fact, the males contribute almost nothing to the child rearing more than the few seconds it takes to copulate. [chuckles] The females, they’re picking based on what the other females in the cohort are also finding attractive.

So, if all of her female peers think that this one particular male is sexy, chances are maybe the next generation of females will too. So, they’re all choosing the same male in order to increase the odds of having a sexy son. So, even if another male might be slightly more fit, it doesn’t really matter. She’s betting on sex appeal, because that gives her sons the best shot at being chosen in the next round, hence the name the sexy son hypothesis.

So, let’s leave the savannah behind for a minute and let’s head to San Francisco. Startup founders gathering at demo days, investor summits, coffee shops. They puff their chests out with techno jargon. They vibrate their feathers looking for product market fit. They dance forth grand visions in their pitch decks, all within this small three to four square mile patch that’s the heart of San Francisco. It’s really a modern-day lekking environment.

The goal of these founders isn’t necessarily to find natural selection of building an enduring business. It’s the sexual selection game of getting chosen for the next funding round. Most of these entrepreneurs won’t make it despite their fancy displays. A lucky few will get funded by the venture capitalist females in this analogy. So, when a top tier firm picks a startup, it triggers this cascade. Other investors like rival females and lek start to notice, and suddenly term sheets are flying in and piling up, valuations are ballooning.

Being chosen increases the likelihood of being chosen again, just like in nature. And just like in nature, the sexy son isn’t necessarily a business with the best fundamentals. It’s the one with the best odds of attracting more capital down the line. So, you think about the PayPal mafia with Musk and Thiel and Hoffman and others, they didn’t just succeed once they became fundable again and again and they produce new companies, new founders, entire VC theses.

There’s another concept from biology that we’ll hit right now that also you might see from observing bird mating. And it’s called the Fisherian, like Fisher, runaway selection. And so, a small preference, say, a bright tail, snowballs over generations. And these traits get exaggerated, because both the signal and the preference are heritable. This biologist, Ronald Fisher, worked out the mathematical proof in the 1930s of how runaway selection can occur from persistent directional female choice.

So, that’s how you get that iconic example of a peacock with their tail that they can barely fly. But it shows up in other species like the stalk-eyed flies, swordtail fish and lots of other birds. And the females are drawn to something interesting that maybe is slightly bigger, shiny or something. Within a handful of generations, you get some appendage that bumps up against the odds of practical survival for this thing.

So, back into the VC lek, runaway selection gets you these probably these startups with $10 million seed rounds and 100-person engineering teams that only exist for valuation purposes. But why should this lekking analogy matter? Because if you recognize the dynamics, there might be some unknowingly amplification of traits that are creating fragile businesses.

So, what I mean here, like, each investment round isn’t necessarily just about funding the company. It’s setting the standard for what attractive looks like in the next generation of founders and investors. And that feedback loop can then start to unintentionally prioritize showmanship over stewardship. So, we’ll consider like the trope of like Theranos. Elizabeth Holmes had this carefully crafted Persona with the Steve Jobs black turtleneck, high profile board with all these luminaries and dramatic.

Tobias: Deep voice?

Jake: Yeah, the deep voice, exactly. This runaway selection created a character of a founder that Fisher might have anticipated. Similarly, FTX used celebrity endorsements, stadium naming rights, high profile sponsorships to signal credibility, which really was anesthetizing the need for rigorous financial diligence on the company. And then, of course, you got WeWork’s lavish offices with Adam Neumann walking around barefoot with these aspirational narratives of elevating human consciousness and via community adjusted EBIDTA.

All these powerful signals distracted investors from sustainable actual financial models. And really, anyone who is paying attention could see that when you have variable revenue of renting out office space on an hourly basis against very high fixed costs, that’s a troubled business model.

So, anyway, the louder the signal, the bigger the hype, valuation, celebrity backing, whatever, the more investors are piling in and amplifying these small initial advantages into this overwhelming market perception. And this creates environments where irrational evaluations become rational, because everyone anticipates future up rounds as far as the eye can see. But it also creates this vulnerability that if you’re reliant on these signals rather than substance, they can collapse very swiftly once the momentum fades.

I think we see that a lot in all over the place. And so, you get these spectacular implosions of companies like Theranos, FTX and WeWork. They’re not really isolated anomalies. They’re inevitable consequences of runaway signaling. And so, just to wrap this all up with a pithy little take, VCs and others should probably be focusing more on funding actual flight and not just feathers.

Tobias: [chuckles] Tremendous, JT. Sure to be up there with your sperm whale classic given enough time.

Jake: Yeah. Well, history will be the judge of that.

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