The Power Law of Venture Capital

THE POWER LAW OF VENTURE CAPITAL

Venture capitalists aim to identify, fund, and profit from promising early-stage companies. They raise money from institutions and wealthy people, pool it into a fund, and invest in technology companies that they believe will become more valuable. If they turn out to be a fight, they take a cut of the returns—usually 20%.

A venture fund makes money when the companies in its portfolio become more valuable and either go public or buy larger companies. Venture funds usually have a 10-year lifespan since it takes time for successful companies to grow and “exit.”

But most venture-backed companies don’t IPO or get acquired; most fail, usually soon after they start. Due to these early failures, a venture fund typically loses money at first. VCs hope the fund’s value will increase dramatically in a few years, to break-even and beyond when the successful portfolio companies hit their exponential growth spurts and start to scale.

The big question is when this takeoff will happen. For most funds, the answer is never. Most startups fail, and most funds fail with them; every VC knows that his task is to find the companies that will succeed. However, even seasoned investors understand this phenomenon only superficially. They know companies are different, but they underestimate the degree of difference.

The error lies in expecting that venture returns will be normally distributed: bad companies will fail, mediocre ones will stay flat, and good ones will return 2x or even 4x. Assuming this bland pattern, investors assemble a diversified portfolio and hope that winners counterbalance losers.

venture-backed companies

But this “spray and pray” approach usually produces an entire portfolio of flops with no hits at all. This is because venture returns don’t follow a normal distribution overall.

Instead, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of the single-minded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place.

Our Founders Fund results illustrate this skewed Pattern: Facebook, the best investment in our 2005 fund, returned more than all the others combined. Palantir, the second-best investment, is set to produce more than the sum of every other investment aside from Facebook.

This highly uneven pattern is not unusual: we see it in all our other funds as well. The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.

This implies two bizarre rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. This is a scary rule because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more modest scale.) This leads to rule number two: because rule number one is so restrictive, there can’t be any other rules of the entire fund.

This is a scary rule because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more modest scale.) This leads to rule number two: because rule number one is so restrictive, there can’t be any other rules,

Consider what happens when you break the first rule. Andreessen Horowitz invested $250,000 in Instagram in 2010. When Facebook bought Instagram just two years later for $1 billion, Andreessen netted $78 million—a 312x return in less than two years. That’s a phenomenal return, befitting the firm’s reputation as one of the Valley’s best.

But weirdly, it’s not nearly enough because Andreessen Horowitz has a $1.5 billion fund: if they only wrote $250,000 checks, they would need to find 19 Instagrams to break even.

 possible investments

This is why investors typically put a lot more money into any company worth funding. (And to be fair, Andreessen would have invested more in Instagram’s later rounds had it not been conflicted out by previous investment.)

VCs must find the handful of companies that will successfully go from 0 and then back them with every resource.

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