Narrative and Numbers: The Value of Stories in Business (Columbia Business School Publishing)

by Aswath Damodaran

Let’s now add the twist that causes the deviation from rationality and makes both the entrepreneurs and VCs overconfident, the former in the superiority of their products over the competition and the latter in their capacity to pick winners. This is neither an original assumption nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and VCs) attract overconfident individuals. The game now changes, since each business cluster (the entrepreneur and the VCs that back his or her business) will now overestimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses targeting the big market will be collectively overvalued. Second, the marketplace will become more crowded and competitive over time, especially with new entrants being drawn in because of the overvaluations. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at individual firms will fall below expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, and those entrepreneurs and VCs will be well rewarded for their investments.