The Power Law: A Few Investments Drive a Fund’s Returns

The previous post mentioned four principles of venture investing: 1. Prefer to invest earlier. 2. Invest in people. 3. Invest in a sector. 4. The value of an investment is more than money. Next is another basic law that affects venture investing: #PowerLaw. Investment returns do not follow the commonly discussed normal distribution. Instead, they are highly concentrated in a small number of cases. If a venture capital firm invests in 100 companies, one or two must perform extraordinarily—for example, eventually becoming Facebook or Google. Another seven to 10 may do reasonably well and eventually complete an IPO or be acquired by a technology giant. The remaining 90 may die, or return only a small portion of the principal. The key to venture returns is therefore investing in those one or two best companies. I remember that Y Combinator, the world’s best-known accelerator, conducted an internal analysis very early on, when it had invested in around 200 startups. Unsurprisingly, the top performer returned more than the second through the 200th combined. Just as unsurprisingly, the second returned more than the third through the 200th combined. If early Y Combinator had missed the first and second companies, it is far from certain that it could have developed into what it is today. For venture investors, therefore, the fear is not losing money on the wrong company, but missing a good one. There is an English phrase, “fear of miss out,” abbreviated FOMO. It means being afraid of missing out. Put plainly: better to back a hundred wrong companies than let one get away, because the one you let go may determine the success or failure of your investing. Sometimes you see venture funds investing in founders or ventures that look particularly eccentric. Have those investors lost their minds? In 1978, you probably would not have invested in Steve Jobs. In 2004, you might not have invested in Mark Zuckerberg, a geek who had not even finished college. Or in 2003, you might not have invested in Elon Musk, a technology eccentric dreaming of going to Mars. Each of these people may have single-handedly changed an entire generation.