By Joel Balbien
Economists use game theory to model interactions among firms, customers, regulators and other market participants where there is strategic behavior by these agents who understand that their actions affect the actions of others.
It is assumed that each agent has a best response to the actions of all other players, and that this can lead to predictable outcome in the marketplace, often referred to as a Nash equilibrium.
In contrast, in a perfectly competitive industry, there is no strategic behavior between firms, or firms and their customers. Market participants just maximize profits or utility in response to exogenous market prices.
Game theory also is used by economists to study industries containing only a few firms, cartels such as OPEC, externalities like pollution, public goods such as fisheries, and contractual negotiations between two economic agents such as a union and employer. In this context, a game consists of a set of utility — or profit — maximizing agents, a set of strategies for each agent and payoffs to each agent for every possible list of strategy choices by the other agents.
So, what can game theory teach us about the financing of startups? One important aspect of many, but not all, games is an assumption of asymmetric Information between the agents and how this affects market outcomes.
For example, startups may know more about their likelihood of success than prospective investors. However, given the challenges of raising capital and the competitive nature of financings, startups are likely to present highly optimistic views of their potential success and financial outlooks.
Providing investors a more conservative outlook will likely negatively affect a company in the competition for funding. Most investors are likely to respond to a prevalence of excessive optimism among applicants for financing by heavily discounting all projections from submitted business plans and financial models.
In addition, financing term sheets that emerge from the startup financing game, particularly where there is significant asymmetric information and/or uncertainty, are likely to provide milestone-based funding for companies whereby valuation for both the prior round and future funding levels respond over time to commercialization outcomes rather than initial projections.
Finally, investor decisions may rely more on verifiable signaling on the quality and experience of the startup management team as opposed to any assessment of technology and business plans.
So, for a startup in this landscape, what is the appropriate degree of optimism in a pitch deck and financial projections, and best strategy for assembling its management team?
First, be optimistic because all presentations are being discounted by investors and successful entrepreneurs are by nature optimistic people.
However, entrepreneurs must also recognize the limits of physical laws and engineering with respect to technology performance and the common economic constraints that tend to limit the growth rate of any business.
In regard to a management team, there is no better way to improve the odds of closing a financing than to assemble the strongest possible one with roots in the targeted industry and a verifiable track record of success. This will provide the most favorable signaling to venture capitalists irrespective of how optimistic a startup’s marketing collateral may be.
Another area where game theory can be helpful to entrepreneurs and startups is in providing guidance on the market structure of targeted industries.
For example, is it better for a new entrant to confront and potentially disrupt a monopoly, a duopoly, or an oligopoly of three or more dominant firms?
Here, it may turn out that the number of firms in the industry is less important than whether the leader practices price as opposed to output leadership in response to either a threat of entry or actual entry by a new firm. A startup facing output leadership will likely be crushed as occurred in the thin film photovoltaics- and biomass-related industries, whereas under price leadership a startup may have a fighting chance at disrupting cybersecurity, health care and financial services.
Applied well, game theory can give entrepreneurs the competitive edge they need to land financing.
• Joel Balbien is an adjunct professor in the California Lutheran University School of Management.