Truly Feeling the Power Law
Act “as if” you’ve already experienced the common trait across all successful VCs.
Given the maturity of venture capital as an asset class, its now become common knowledge that the power law rules positive returns, in particular at the early stages. A small number of companies invested will create a disproportionate amount of the value. When you google “power law curve venture capital,” the familiar graph appears:
Early in your venture career, you know and understand this distribution theoretically. As you gain more experience, however, you begin to feel the power law in action. I mean, really FEEL it. What starts as a theoretical concept translates into powerful reality.
When I talk to younger VCs and they ask me what's the one thing that I've learned over my career, this is the answer. I already "knew" it all along, but now I feel it. And because of that recognition, my perspective has indeed changed. Today I act differently in company selection process, as swinging for doubles just doesn't make sense. I attempt to make non-consensus bets and hope that they're right. I also focus a lot more on the quality of the founding team, ensuring that they have the drive, desire, and capability to build something truly remarkable.
The power law is of course a phenomenon which applies not just to each fund's portfolio, but one's professional career. Most likely, and hopefully(!), there will be a few outsized winners in your own career which overshadow absolutely everything else. As a fun exercise, I recently mapped out my own track record over the past dozen+ years investing in dozens and dozens of seed stage startups at NextView, and sure enough a familiar image appeared:
While the strong positive returns aren’t the result of solely one company, it does turn out (so far) in my case that 10% of the investments have yielded 90% of the value. And when that aforementioned 90% of value is a lot, then the system works remarkably well.
However, the nature of the power law creates a lot of challenges, too... often outliers happen early in one’s career (great!), but you don't actually capture a lot of value from it (not so great). This situation is why after a big win, many VCs switch or start their own firm, as they didn't reap the rewards of their given that firms’ economics often accrue lopsidedly to the most senior members of the team. Alternatively, the really big wins can happen later on or even at the end of one's career, which necessitates focus on surviving in the role until they do occur.
Of course the big wins cannot be absolutely predicted or engineered, or you would manufacture them to happen all the time. So what can you do? How do you act differently knowing this fact?
First and foremost, as frequent readers have heard me repeat: don't lose your seat.
However, there are potential strategies which you could employ earlier in your VC career to become associated with success sooner rather than later, which then naturally compounds. Keeping in mind that there is no "safer" bet at any given stage and the goal is to find an outlier, you can either push the boundaries on investment stage or make more bets to increase your chances. Two example strategies include:
Running seed programs within larger platform. Often multi-stage/-sector/-geo aircraft carrier firms delegate a scout/pre-seed/seed program to an up-and-coming investor. This role provides broad exposure to numerous startups, thereby increasing likelihood of catching some halo of success given the larger number of chances.
Pushing to one-step later than typical. In a low-volume shop where the investment pace isn’t prolific, pushing a firm to go towards the edge of its comfort zone in terms of stage can be fruitful. Not only is a later-stage company ostensibly further de-risked than the firm’s usual profile, but the feedback cycle timing is likely shorter.
All of that being said, you can't tweak your way to success. The real solution to the power law phenomenon is to become a genuinely better investor, which is easier said than done.
And the process can be disheartening. By definition, most the time you're making investments into startups which will not become the selective winners, and certainly most of the time you're spending with portfolio companies which will not create the most value. Both because the challenged companies require the most help and attention, while the best performing companies don’t really benefit from meddling VCs. But also due to the fact that the definitional number of companies which will succeed is in the minority.
This experience can lead to the trough of disillusionment. In a lonely job, lots of things can and do go wrong. It's normal. Actually, more than normal, it's expected. Something is off if that's not the case.
Yet almost all venture capitalists are optimists. Climbing out of the trough of disillusionment is truly feeling the power law curve in all of its glory. In the meantime, apply some of the lessons with the corresponding knowledge before you experience it yourself.