The Power Law Blog: #1 About the Power Law

About the Power Law

The Power Law distribution (also called the Pareto distribution or 80–20 rule) was first discovered by the Italian civil engineer, economist, and sociologist Vilfredo Pareto. Originally Pareto applied this law to describe the distribution of wealth in a society, fitting the trend that a large portion of wealth is held by a small fraction of the population.

The “Pareto Principle” or “80–20 rule” stated that 80% of outcomes are due to 20% of causes. Empirical observation has shown that this kind of distribution fits a wide range of cases, including natural phenomena and human activities. It applies to the size of the cities, the mass of the stars, peas in a pod, trees in the amazon rainforest, wealth distribution in society, success in any field of work and many other spectacles. For society, the Pareto Distribution indicates that in any creative domain, there is going to be a small number of people that generate the majority of the output. The power law pulls the mean towards the right, away from the median.

The Power Law is highly prevalent in Venture Capital (VC) investing. In the investing world, the power law starkly distinguishes VC from other forms of funding.

In VC, the power law indicates that a small number of investments are responsible for generating a significantly large portion of the overall returns.

This does not necessarily mean that the other investments fail (they could well fail). Still, a select few investments generate such significant returns that a normal or nominal return generated from the other investments is often overshadowed.

Given below is a highly optimistic example that may help visualise the power of this law:
Fund manager ‘X’ invests $10 million in 10 companies. Assuming that capital was deployed and divested in a similar time frame, two investments generate 40x return each, four investments generate 4x each, and the remaining four investments generate 1x each. The two investments, or 20% of the invested capital, generated a whopping 40x return each, accounting for 80% of the fund’s gross returns.

A 4x gross return is not poor by any means; the capital quadruples. However, when the manager generates 40x returns, a quadruple return on capital tends to get overshadowed.

The Power Law exists in reality. Companies like Facebook, Yahoo, Alibaba, Uber, Google, Apple, DropBox, Zoom, AirBnB, and many others have generated extremely high multiples for their investors. For example -

• Peter Thiel — a renowned tech entrepreneur and investor, invested $500,000 in Facebook as one of its first outside investors. This $500,000 investment alone has generated $1.1 BILLION. Peter is one of the most vocal proponents of the Power Law in VC-led technology investing.
• Accel, Facebook’s Series A investor, invested ~$13 million and within four years sold a partial stake for $500 million; in six years when the company went public, Accel’s stake was worth $9 BILLION. Scoring a multi-bagger like Facebook made Accel’s IX fund one of the best-performing Accel funds in its history.
• Softbank — a Japanese multinational conglomerate, invested approximately $20 million in Alibaba in 1999. In 2022, Softbank sold a partial stake in Alibaba, generating an estimated $34 BILLION pre-tax gain from the sale.

Astonishing as it is, these multi-baggers do occur in the venture world more often than one could imagine. That said, investors can and do lose millions of dollars in pursuing many such multi-baggers.

According to a study by Cambridge Associates, out of more than 4,000 yearly investment rounds over a decade, the top 100 investment rounds have generated well over 70% of all returns. Investors who can identify and invest in these outliers across multiple economic cycles are highly sought after by entrepreneurs and capital providers.

Top venture investors crave technological disruption through different kinds of people. The mindset of most VCs is to identify and deploy capital in companies that have the potential to be “THE OUTLIER”.

Disruptive Innovation and Venture Capital:

Disruptive innovation is the process by which a smaller company — usually with fewer resources — moves upmarket and challenges established businesses. Disruptive innovation creates new markets and reshapes existing ones. Disruption is a long-drawn process that takes time. The term disruptive innovation is often misleading when it refers to a product or service at one fixed point rather than to the evolution of that product or service over time.

The VC provides a form of capital designed for companies to build fast and think big. While this may be a vast generalisation, most investors scout for disruptive companies — “The Next Big Thing”.

Throughout the history of disruptive innovation led by technology, venture dollars have helped to accelerate the mass adoption of differentiated products and services. In some cases, it helps create large markets that never existed before. In my opinion, disruption is not accomplished by the first company to develop the idea. Disruption happens when an offering scales to such a level where it becomes impossible to imagine a world without that product or service offering.

Path-changing breakthroughs have often come from those people and companies which may not necessarily be established in that sector. As Vinod Khosla likes to say —

“Could Hilton or Hyatt do AirBnB? Could Hertz or Avis do Uber? Could Walmart or Target do Amazon? Could Boeing and Lockheed do space? Media became the people who didn’t know they were in media — Facebook, Twitter, Youtube, Netflix and so on…”

Managers at large corporations do not want to fail. Hence they do not tend to experiment or dare to change the pathway of established businesses, and fairly so. Mavericks who are new to the industry may not necessarily know the accepted practice and therefore see things from a fresh perspective. The fresh perspective allows these newcomers to shake things up and revolutionise the path of certain sectors. It is also normal for experts in a field to continue innovating incrementally with the help of technology to continue to take their offerings to the next level.

Every innovation, disruptive or not, starts as a small experiment. VC funding enables this set of experiments which have the potential to become path-changing breakthroughs eventually. VC helps companies sustain themselves in a highly competitive environment while achieving mass disruption. By identifying, financially supporting, and cultivating these young companies with entrepreneurial tenacity, VCs promote the development of small businesses, daring them to become large ones.

The role of a venture investor is not just to provide capital. The VC tries to be a “Jack of all trades” while trying to support their portfolio companies in every way possible. VCs often become guides to these companies and help charter their path to disruption and glory.

Not to take any credit from the founders, they are the mavericks who dream, create, manage and enable this disruptive innovation. But VCs do not simply show up when companies are disrupting; they are a vital cog of what allows this disruptive innovation.

Not all technologies work. But those that do, particularly disruptive innovations, seem obvious in retrospect — it is easy to say that “this had to work”. However, it may not be clear where these companies are headed or whether the industry can be disrupted in real time.

People, in general, didn’t believe in the mass adoption of many products or offerings during its initial phases, this includes — the internet, web browsers, search engines, personal computers, e-commerce, electronic payments, aggregator services, mobile phones, drones, robotics, blockchain technology, and so on. Sceptics always exist; however, it is a VCs job to identify the diamond in the rough and polish it. This exercise is one of the main reasons why the Power Law exists in VC.

Valuations, Unicorns and Dragons:

In the financial ecosystem, value is the monetary worth of a company. A valuation is a price an investor is willing to pay for a certain asset. Valuations work differently in venture capital in comparison to the rest of the financial ecosystem, especially for early-stage technology companies.

Young companies may not have a definitive way to derive a substantial fundamental value, and some may not even know how and when the company shapes up. At the early stage, VCs value a company primarily based on the conviction that they have built for investing in the company — which is built on multiple factors such as the core team and founders’ pedigree, business model, product or solution, market size, and many other macro and micro factors.

In private markets, investors compete for top-notch deals. Once identified, investors may be willing to pay a premium on the accepted fair market value in order to get on the cap table. Valuation methodologies exist but can tend to be severely flawed. An essential aspect of portfolio construction relates to the fund managers’ ownership stakes in each portfolio company, which is determined at the entry price (or valuation). This will ultimately be key to the impact each outlier will have on the fund’s returns.

Unicorns and Dragons are imaginary animals that are highly sought after in the venture ecosystem. First, let’s get the terminology straight: a Unicorn is a company valued at $1 Billion or more. A dragon company generates returns that are sufficient to return the ENTIRE fund by itself.

Fund managers are often mesmerised by the idea of investing in Unicorns. However, the true secret to outsized fund returns lies in the pursuit of Dragons. There is nothing wrong in chasing either, and for an early-stage investor, it is likely that the Unicorn they have is also their Dragon company. However, this may not always be the case.

A Dragon company could generate 50–100x return and not be a Unicorn, while a company can generate 2x return and still be a Unicorn. While these are examples of extreme outliers, the power law is determined by a few of these extreme fat-tailed outliers, which eventually define the performance of VC fund managers.

Spray and Pray Model. Is it flawed?

The opportunity cost of missing out on a multi-bagger is theoretically infinite.

AngelList is a strong advocate of indexing the early-stage venture market. Investors can potentially increase their expected return by following a “spray and pray” model. According to AngelList, broadly creating an index for every credible deal can outperform roughly three-quarters of early-stage venture capital funds. While this may sound lucrative, it may not be so apparent that this strategy works, especially when top VCs are looking to invest in outliers only. Rodrigo Ferreira explains the limits to spray and pray in his blog, and he goes on to highlight that:

AngelList’s average return outcome is approximately 2.7x. If we add just a few outcomes that were not part of the set — e.g., a 2,200x, a 5,000x, and a 10,000x (Facebook, Uber, and Google’s seed multiples, respectively) — the average of the same distribution increases to more than 27.7x. Even if we only added Peter Thiel’s famed Facebook investment, the average outcome would more than double to 5.9x. This shows just how significant an effect the extremely unlikely tail of the venture capital Power Law distribution can have on its mean.

The mean of any sample does not represent the average of the total Power Law distribution, as the contribution of the tail of the distribution — unlikely though it may be — is theoretically infinite.

The spray and pray model may have the potential to work. However, for it to work effectively (to capture one or multiple outliers), the investor still has to identify a large pool of lucrative investment opportunities. Data in Rodrigo’s blog suggests that the chance of outperforming any given benchmark increases with portfolio size, but only marginally.

Capital is not infinite; therefore, investors must choose wisely before spraying; praying will not help capture the outlier. Young companies require guidance and additional support from their VCs. If VCs cannot add value because of restricted bandwidth, start-ups would be less likely to become an outlier and create significant wealth for investors.

While the opportunity cost of missing out on an investment may be significantly high — VCs pride themselves on the reputation they build across multiple economic cycles. A series of poor decisions decrease credibility and hamper a VCs ability to raise and deploy capital effectively. The risk of losing reputation in the market is extremely high, and this prompts some investors to go out of their way to ensure the reputation remains intact.

Power Law: Luck or Skill? What separates the good from the great?

All forms of investing bet on an uncertain future, but VC investing is incredibly uncertain.

It is extremely difficult to continue to pick outliers all the time; it just does not happen. Sceptics often attribute LUCK to being one of the most significant drivers of a VC’s success. This may be true to a certain degree.

Multi-baggers are created by investing in the right team that is operating in a ripe market with the right offering at the most opportune time. Even with all the right ingredients, the start-up may fail; therefore, the element of luck comes into play. I believe that top VCs create their own luck. Time and again, top VCs find their way to arrive at the right place at the right moment to score one of the best deals history has witnessed. The sheer hunger for creating and driving disruptive innovation helps these VCs generate significant returns on their capital.

While picking winners might be reliant on luck, having the right investor can definitely skew the scale and play a significant role in building a winner.

Any investor’s success can be measured by the returns they generate across multiple economic cycles. History suggests that very few investors have been able to generate consistently large returns over a long period of time. The investors that have managed to do so have something in common — Culture. Top VCs have built strong cultural support systems (which continue to evolve) within their networks. Specifically, in Silicon Valley, the culture allows entrepreneurs to make mistakes and fail, encouraging them to continue to innovate and daring them to think larger than their imagination. The culture of an investment team is often reflected in the style of interactions, investments, network and the overall portfolio. I will elaborate more on these cultures and the evolution of VC-led technology investing in my upcoming blogs.

In essence, most attempts at discovery fail, but a few succeed at such a scale that they more than make up for everything else. This extreme ratio of success and failure is the power law that drives Venture Capital and the technology investing ecosystem.

I am starting a series of blogs that will try to describe the prevalence, importance and evolution of VC-led technology investing. This series will also try to give insights into some of the most action-packed power law outcomes the venture industry has seen!

Do share your thoughts. Feedback and suggestions are more than welcome!