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Paradox of the Power Law in Venture Capital

January 13, 2016

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The most experienced and successful venture capitalists grok the concept of the power law and how it describes the outcomes of startup investments. Simply put, 80% of the returns come from 20% of the deals.

The 80-20 rule can be seen in both natural and man-made phenomena such as the size of earthquakes, the size of solar flares, the distribution of wealth and movie ticket sales.

The power law is so common that Peter Thiel, the billionaire tech investor and entrepreneur, declared, “we don’t live in a normal world, we live under a power law.” According to Thiel, it’s like the law of gravity—you can’t escape it.

Paradoxically, if this power law phenomenon is so simple and so common, why does Thiel declare that 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?”

Humans have a hard time grasping exponential curves and the implications of the power law. For example, if you apply the 80-20 rule to the top 20% of venture capital deals, then 4% of the deals produce 64% of all returns. Apply the 80-20 rule again to the top 4% of deals and you get 0.8% of deals producing 51.2% of all returns.

The implication is that 1 in 20 deals may produce two thirds of all returns and 1 in 100 deals may return more than all other deals combined. Such skewing of outcomes is hard to fathom when VCs are hunting for those elusive home runs every time they make a new investment.

The Rise of Unicorns

The VC world’s quest for those rare, home-run deals has led to the rise of “unicorns,” a term coined by Aileen Lee, which describes startups whose valuations have grown to reach $1 billion or more. As of June, 2015, the top 14 VCs listed in this study were investors in 93 unicorns which collectively represented 2.6% of their deals. Aileen’s first blog post about unicorns estimated that only 1 in 1,538 tech startups reach unicorn status. Comparing the rates, a startup funded by one of the top VCs is 40x more likely to be a unicorn compared to a random startup.

Even so, the reality is that unicorns are rare even among top portfolios. Sequoia Capital, which had by far the highest number of unicorns (total of 17), saw only 1 in 20 companies reach unicorn status. Peter Thiel’s Founders Fund had five unicorns which represented less than 1 in 30 companies.

Paradox for VCs

Peter Thiel criticizes the VC industry by making the observation that most VCs spend 80% of their time on “the losers.” His advice would be to spend much more time on the small handful of big winners.

Thiel’s advice rings true when you observe the boards of some successful VC-backed companies. The boards tend to get larger and larger as each round is bid up and led by new investors. Furthermore, not only do all board members attend every meeting, all official and sometimes non-official board “observers” start to show up (some VC firms may bring more than one person to meetings, even if they are not on the board).

Conversely, at companies that are not successful, board attendance may shrink. Some VCs may stop showing up—by dialing in or finding a replacement (usually a junior partner or an industry executive). If things start to look really bad, some VCs may resign from the board and walk away. As the saying goes, “success has many fathers and failure is an orphan.”

In contrast, Fred Wilson of Union Square Ventures (USV), takes a different approach. He also has a better term to describe “losers.” In a blog post last November, Fred claimed that he spends most of his time with the “long tail of investments that don’t move the needle for the VC fund.”

Why would he do that? Because the “long tail is comprised of entrepreneurs and their teams. People who have given years of their lives to a dream that was ultimately not realized.” Some VCs not only understand but also empathize with the human costs of startups.

This is perhaps irrational behavior from a fund economics perspective. However, for a VC firm’s reputation, it makes sense if you consider the fact that VCs touch the lives of many entrepreneurs, most of whom will not achieve great success. It is incumbent upon VCs to treat the “long tail” with respect, not as losers. Ironically, USV’s hit rate of investing in unicorns is among the highest in the industry (8.1% vs. 2.5% average of other top VC firms).

There are also two pragmatic reasons that many VCs spend most of their time with long-tail companies. First, it is impossible to know a priori which companies will become huge winners. Even top VCs who swing for the fences every time get it right less than 1 in 30 times.

The second reality is that most winners need less help compared to most. As they gain momentum, they are able to attract even better talent and have plenty of funding and resources to accomplish their missions.

According to Roelof Botha of Sequoia Capital, “the problem companies can actually take up more of your time than the successful one.” Thus, the paradox of VCs is that although they may want to spend most of their time on winners, they often wind up spending more time on the long tail.

Implications for Entrepreneurs

The track record of VCs is overwhelmingly skewed by a tiny handful of winners. However, as an entrepreneur, if you try to assess the reputation of VCs by only looking at home runs, you may get a skewed view.

In good times, investors will be supportive. However, how will they behave during bad times? Even great companies go through ups and downs. If your startup is not one of the big winners (which is likely, based on probabilities), how will your VCs behave? Will they abandon ship, or worse, will they turn negative or downright hostile?

VCs check references before making investments. Entrepreneurs should do the same and check references before taking VC funding. It is critical to talk not only to winners but also to the long tail companies—you will have plenty to choose from.

Thiel made the comment, “the unspoken truth is that the best way to make money might be to promise everyone help but then actually help the ones who are going to provide the best returns.” So as you do reference checks or browse sites such as TheFunded.com that rate and review VCs, try to figure out who is making false promises and who is not.

For every winner, there will be many more losers. There will be skeletons in every VC closet (disgruntled entrepreneurs) so be realistic in how you assess VCs and what they can do for you.

At the end of the day, entrepreneurs build companies, not VCs. All VCs claim to help (“add value”), but they won’t do your job. Furthermore, even the most supportive VC won’t keep investing in your company at increasing valuations if your company is not performing. Even if more investment is not offered, some VCs will work with companies to the end, treating people fairly and with respect. Some VCs will not. You’ll get a much better sense for this when you talk to the long tail.

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