The Power Law

Venture capital is a unique asset class for many reasons – there are typically minimal to no metrics to evaluate potential investments on, many of the business plans have never been tried before and require a leap of faith, and testing and learning is prioritized over scaling and optimizing (at the earliest stage / pre-product-market fit).

What is also unique is the typical return profile of a basket of startups. VC is unique in that it is the asset class with the highest risk/reward profile. It should come as no surprise that most startups fail, but on the other end there are a handful of startups that produce incredibly high returns. In an asymmetrical risk profile where all you can lose on an investment is the money you put in, and where the most you can make is seemingly uncapped, it starts to make sense that portfolio performance is not about how many of your investments go to zero – it’s about investing in the few companies that end up returning way more capital than originally invested. This understanding is critical for any VC to grasp.

Source: a16z and Horsley Bridge

A study by Horsley Bridge found that during 1985-2014, 6% of total capital invested in startups returned 60%(!!) of total returns. As a VC, if one did not have exposure to any of the companies in that bucket it would be extraordinarily difficult to produce to-tier returns. This is because the failure rate in VC is high – the companies that do survive really need to become outsized outcomes.

Version One VC recently disclosed how their Fund I portfolio is faring after 7 years. As you’ll see, without the first two investments it would be very difficult to return the gold standard 3x+ portfolio return (they are currently tracking toward at least a 4x return).

The key takeaway is that venture is a game of outliers. This is why a lot of the biggest outcomes have been ideas and business models that were probably laughed at constantly before it became obvious that they would become a success. One cannot be afraid of failure – on the contrary, if your failure rate is too low you’re probably not taking enough risk. Only invest in companies that have the potential to return many times the original investment, ones that are either creating a new market or going after a very large market, and are led by founders who have a growth mindset and are intent on dominating their industry.

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