Overpaying versus getting a great deal

At the start of my career, an experienced VC told me that, in most of his great investments, he felt like he was overpaying at the time of the investment. The rationale behind this thinking is that most of the great companies have a lot of investors looking to fund them and this drives up their price. So you feel like you’re overpaying for the company, and it’s better to overpay for a great company than underpay for a bad one. This is especially true in an industry like VC where returns are distributed according to a power law.

At the time, I didn’t have the experience to know whether the VC was right. But now that I do, I don’t agree with the assessment.

Looking at our investments, there have been times when we felt like we were overpaying at the time of the investment and, now that we look back with the benefit of hindsight, we see that we actually ended up getting a great deal. But there are also times when we felt like we were overpaying at the time of the investment and, it turns out, we actually were. And there are enough instances of both that I can’t draw a confident conclusion between the feeling of overpaying and the quality of the investment decision.

The reason why I don’t believe that a feeling of overpaying is correlated with a high quality investment decision is because, when you’re overpaying, you’re betting together with the crowd. You’re overpaying because many other investors also think that the company is attractive, and so you’re making a consensus bet. And when you make a consensus bet, a lot of the potential future returns of a company are arbitraged away by other investors who bid up the company’s valuation. So even if you’re right and the company does perform well, you’re unlikely to achieve a great return.

To achieve great returns, you need to not only be right, but also be non-consensus. And if you’re non-consensus, that means that there aren’t many investors willing to take the same bet. As a result, the price won’t be bid up and, relative to the value that you believe the company will create in the future, you’re unlikely to feel like you’re overpaying. You may be overpaying relative to what other investors are willing to pay, but you won’t be overpaying relative to what you believe the future value of the company will be. You’ll feel like you’re getting a great deal.