In technology, change tends to be revolutionary not evolutionary. So you need to force yourself to place big bets on the future. -Larry Page
Power Law Curve
There is a tendency among less experienced early stage investors to think that the distribution of venture returns is linear — portfolio companies have an equal opportunity of failing, plateauing or growing. In reality, however, venture returns are incredibly skewed within a fund’s portfolio (as well as across venture funds). As Peter Thiel and others have discussed at length, the actual distribution follows a power law, with a few winners accounting for more returns than all others combined.
Understanding the power law curve is essential to being a good venture investor, a difficult task given that most of us are accustomed to thinking linearly in our daily lives. Thiel attributes this curve to the compounding power of exponential growth that is typical of successful venture investments:
Successful businesses tend to have an exponential arc to them. Maybe they grow at 50% a year and it compounds for a number of years. It could be more or less dramatic than that. But that model — some substantial period of exponential growth — is the core of any successful tech company. And during that exponential period, valuations tend to go up exponentially.
These winners will grow and generate exponentially greater financial returns for investors than companies that don’t achieve a viral growth phase. Moreover, the concentration of returns in a few winners is also reinforced by top-down constraints that limit the number of large exits the market can deliver in a given year. Interestingly, according to Thiel, “there’s a pretty incredible power law all the way up. It’s about as hard to get from $10m to $100m as it is from $100m to $1bn or $1bn to 10bn.” This can be seen when looking at the distribution of the top 100 U.S. VC-backed exists from 2009-early 2014. Even within the top 100 exits, an incredible power law exists (with Facebook driving more returns than all others combined).
According to Horsley Bridge (via Chris Dixon), for the hundreds of vc funds that they have invested in since 1985, about ~6% of investments representing 4.5% of dollars invested generated ~60% of the total returns.
Follow the Babe
The importance of the power law is not theoretical — power law distribution directly impacts how top investors make investment decisions. Let me explain. Even in the best funds, over 40% of investments will go to zero. These failures tend to happen earlier rather than later in a fund’s life cycle, while the investments that succeed are hopefully growing exponentially over an extended period of time. Accordingly, a typical successful fund will follow a J-curve. Once the fund hits bottom, the question becomes, which companies will drag the fund from below the break-even line to some sort of respectable return. As the math works out, this usually requires that the top investment in a fund generate a return that is equal to or greater than the total dollars invested in the fund (alternative formulations could work but would generally require a much lower than average company mortality rate).
Since every fund goes into its investment period knowing that it will follow this J-curve and start out underwater, an investor must have the conviction in each deal that it could return the entirety of the fund in the event it succeeds. According to Tren Griffin, “The task of a venture capitalist is to experiment on a trial and error basis in order to discover success from within a portfolio…Which of these bets will pay off will be apparent only after the fact since success will emerge from the complex adaptive systems.”
The likelihood of a startup’s failure is therefore less relevant to the aggregate performance of a portfolio than the potential magnitude of a successful outcome. In other words, swing for the fences.
However, adopting this mentality is easier said than done given our predisposition to avoid losses. Vinod Khosla puts the fear of failure in perspective by looking at venture investing through the following lens:
“It doesn’t matter what your probability of failure is. If there’s a 90% chance of failure, there’s a 10% chance of changing the world. Most technology startups fail. There’s a winner, and there’s 7 out of 10 that lose. I don’t mind failing, but if I succeed it better be worth succeeding for. I have seen too many startups where they have reduced risk to a point where they have a higher probability of succeeding, but if they succeed it is inconsequential.”
In the aforementioned post by Chris Dixon, he describes this as the Babe Ruth effect of venture capital. In order to swing big, you have to not be afraid to miss big either.
“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.” — Babe Ruth
The data he shares shows that, as expected, successful funds have more “home run” investments (defined as investments that return >10x) than less successful funds:
Also unsurprisingly, the home runs for top-performing funds are larger in magnitude than the home runs of worse performing funds. But what is far less intuitive is that the best funds (>=5x overall return) actually have a greater percentage of their invested dollars go to zero than good funds do. This is indicative of the fact that the best investors possess a deep, underlying appreciation for the power law.
Power laws are not just important for initial investment decisions but for guiding follow on investments as well. This is the underlying reason that Fred Wilson has labeled the pro-rata participation right “the single most important term anyone can negotiate for in a venture capital investment”. The pro-rata right means that you get to participate in all future rounds of financing in the amount that maintains your current ownership percentage in the company. How does this relate to power curves? Fred eloquently points out that you want to own as much as you can of the few winners that produce all of the returns, something that is made possible with pro-rata rights:
“Capturing pro-rata” is sooooo important in early stage venture… Guess what? Early stage VC is a lot like poker. You want to go all in on your best hands.
So, in conclusion, here are some guidelines to keep in mind when evaluating startup investments:
(1) Before you make your first investment in a company, ask yourself if it has the potential of being a big winner that could return the entirety of your invested capital.
(2) When one of your portfolio companies is demonstrating exponential growth and is on its way to reaching escape velocity, invest as much as you can because your winners are critical to your overall returns.
Thanks to Chaim Meir Tessler, Liz Cohen, and Stephane Itzigsohn for reading a draft of this post