The Secret Reason Venture Capitalists Are Bad at Picking Winners

Why do so many startups that seemed destined to take over the world end up fading away, despite being backed by the world’s brightest venture capitalists (VCs)? New research from the National Bureau of Economic Research (NBER) and the Wharton School reveals a culprit that can’t be blamed on market timing or bad luck: VCs are cutting corners on due diligence, and it could be costing them big.

Using cellphone data to track 22,000 VC deals over five years, researchers Jack Fu and Lucian Taylor discovered that venture capitalists spend dramatically less time evaluating startups when markets get hot or competitive. The results were startling—a 15% to 34% increase in volatile investment outcomes when due diligence gets rushed.

But cognitive biases—the ways that we’re not always rational market actors—also play a role. Thus, VCs often have built-in reasons for missing “the next big thing.”

Why Rushing Kills VC Investment Returns

New research has an eye-opening answer for why so many VCs fail: They’re often not doing the homework before they invest, and it’s costing them millions.

Researchers tracked 22,000 real VC deals from 2018 to 2023. Using cellphone location data to see how much time VCs actually spent meeting with startup founders before writing checks, they found that when markets are more competitive, VCs spend way less time researching companies and their investment results become far less predictable.

“VCs trade off the costs of research with better investment decisions,” the study found. In plain English: When everyone’s moving fast to close deals, thorough research gets thrown out the window.

According to the NBER study, here’s what actually happens when VCs rush their research:

• Geography matters: If a startup was twice as far away, VCs spent 35% less time researching it.
• Competition kills analysis: When more VCs were chasing the same startup, research time dropped 13%.
• Overworked investors cut corners: Busy VCs managing lots of deals spent 22% less time on each one.

In the end, the researchers found, average returns were often about the same, but the wild swings got much bigger—meaning more disasters alongside the occasional jackpot.

How the Power Law Problem Makes Things Worse

Even the most successful funds lose money on about the same percentage of investments as average ones, but their big winners are dramatically more successful.

“Venture capitalists are playing a power law,” Bridger Pennington, co-founder of Fund Launch, told Investopedia, referring to the principle that VCs only need a few winners to stay ahead. “They’re going to do 20 bets and every single one of them needs to have the potential to do, in most funds, a 10-times if not a 20 to 50, even 100-times return. You need only one or two hits to pay back the expected return for the whole fund.”

In practice, this means VCs aren’t aiming for “pretty good”—they’re swinging for home runs with every investment, knowing most will strike out. But this relentless search for outliers means it’s easy to miss steady growers or unconventional winners.

Missed Unicorns

Over time, legendary stories of VCs passing on Airbnb, Inc. (ABNB); Google, later Alphabet Inc. (GOOGL); and WhatsApp came about not because the VCs weren’t smart enough, but because these startups looked too weird, small, or risky. Or, as the NBER research suggests, the VC didn’t take enough time to find out their value.

For example, Fred Wilson, a well-known investor at Union Square Ventures, famously passed on, because he “couldn’t understand how air mattresses on living room floors could be the next hotel room.

But VCs don’t have to accept the chaos. They can “create luck” by plugging startups into their networks, giving founders crucial contacts, hiring help, and early customers. As Pennington put it, “If you’re Sequoia [a major VC fund], 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.”

But even these advantages can’t offset a bad economy or collective bias, meaning even legends in the space have long streaks of duds.

The Bottom Line

Venture capital is not a crystal ball. No matter how exclusive the fund or sharp the partner, the odds are stacked against consistently picking winners. Power laws, timing, and human bias mean luck will always play a role. But that’s also all the more reason VCs need to avoid rushing due diligence that makes their returns far less predictable.