The Unique Philosophy of Venture Capital (Part 1 of 2)
99% of all startups fail. This maxim has been repeatedly hammered into our heads. It’s the caveat emptor, the “buyer beware” of the entrepreneurial world.
From this simple dictum springs a journey of extrapolation leading us to discover a truth unique to venture capital. If 99% of startups fail, how in the world do venture capitalists consistently generate great returns relying solely on that tiny 1% sliver of startup success? The answer is in the question.
Relying solely.
Venture Capital is the only asset management class that focuses on return/potential maximization rather than risk management/minimization.
In traditional asset management, you always hear about diversification. Make sure your stock portfolio is well diversified! Don’t put all your eggs in one basket! Minimize your Beta (correlation to the overall stock market)! Aphorisms like these have become dogma, no brainers for intelligent investors. All of this advice is centered around the same guiding principle of managing risk. The return is to be driven by the portfolio as a whole, and the seemingly astute thing to do under these circumstances is to minimize the risk side of the risk/return equation.
VC Mechanics Make Return Maximization the Only Viable Strategy
In venture capital and venture capital alone, the focus is on maximizing the return side of the risk/return equation. We’re all more than familiar with the “99% of startups fail” thing. From this, it’s clear that the startup world is governed by an extreme power law.
The distribution is incredibly right skewed. There is absolutely no point in trying to diversify with a distribution like this — you’ll just end up with a ton of strikeouts and miss out on the very few grand slams. Diversification works best when distributions are close to normal.
So if you’re the VC, you’ve been entrusted with tripling a fund of millions of dollars, and this is what you’re given to work with, how do you make it work?
You have no other option but to enter the business of swinging exclusively for grand slams. Bunts, line drives, and doubles to left field simply don’t cut it. That’s why there’s so much hype around unicorns. Why the size of the market is one of the most important factors for VCs. Why 80% of VC returns come from 20% of investments (A nice instance of the Pareto rule).
Typically, VCs are relying on a small handful of investments that can return the entire fund. If you’re in charge of a $100 million fund, you need to return $300 million in ten years (the goal is to triple in a decade). What does that mean for your investment strategy? Well, let’s say you own on average 10% equity in the companies you invest in. To get $300 million in returns with 10% equity, you need a company to exit for $3 billion at the very least ($300million/10% = $3billion). You’re forced to look for unicorns. Return maximization, not risk mitigation. And to bring the discussion full circle, that’s why VCs have to look for and rely solely on that minuscule sliver.
For more on this: TechCrunch: The Meeting that Taught me the Truth About VCs
In Part 2, we’ll cover the positive implications this philosophy has on society.
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