What is Venture Capital?

The quest for long-tail risk profiles

I have a passion for questions that seem very simple on the surface, until you try to actually answer them thoroughly. This is a decent example. The standard answer here typically digs into a description of disruptive technologies, business model maturity, investment check sizes, and the esoteric differences between angel investors, mid-market private equity, growth capital, and how venture sits between, encroaches on, or encompasses them. But all of this is far too complicated.

Fundamentally, venture capital is the funding of long-tail outcomes. Put even more simply, venture capital is the funding of endeavors that have:

• a relatively high probability of low returns,
• a moderate probability of modest returns, and
• a very small, but still possible, chance to be wildly successful and deliver an outsized return

You can compare this to the types of investments that typical debt investors seek to underwrite (having a low probability of low returns, high probability of moderate returns, and no probability of an outsized return).

While this might seem like a very specific and highly theoretical definition, I believe that everything else we know about venture investing (like venture firms often investing in disruptive technologies, funding in startups, creating venture portfolios, and doing mostly minority investments) follows from this.

Investments in disruptive technologies

Say we were tasked with betting on companies that exhibit a the long-tail return profile. Where would we find them today?

We are likely to look for companies that are trying to change the status quo, to do things not just marginally better, but in a whole new way. We might want to look for products that face a challenging path to widespread adoption (legacy incumbents, user sophistication, existing processes and relationships), but that, if adopted, would become a large and dominant player in their space. That sure sounds like many of the disruptive technology startups of the past few decades. Or, we might think about how developing a successful new therapy or treatment has a low chance of success (and requires a lot of R&D), but if successful can affect the lives of millions and be protected by lucrative patents.

If we were further pressed to optimize for the “best” possible enterprises in with a long-tail return profile, we would likely start look at products that have a lower cost to build and operate (software companies!) or that are able to capture more value if successful (challengers in large legacy markets!).

This is to say, venture capital did not set out to specifically finance search engines (Google) and synthetic hormones (Genentech), but rather, Google and Genentech had a risk profile that was suitable for venture capital. Some industries will have more opportunities with a venture profile, and some will have less. Most industries will evolve and cycle through being more or less attractive to venture funding (semiconductors, agriculture, education, insurance are all sectors which have, at various points in time, been wildly attractive, and wildly unattractive, as venture funding candidates). So venture capital is not, and will likely never be, locked to a specific industry — at least not for a long time.

Investment in young-ish companies

Similar to the industry question, we might ask — how mature are the companies we are looking to fund?

There are a few easy, instinctive observations. The younger and smaller the company is, the more obstacles it has in its way and the more likely it is to go out of business (the probability of a low to average return is higher). At the same time, in this early stage the business has not yet experienced its (potentally) exponential growth phase which can bestow upon prescient (or lucky) investors an outsized return. Then again, the more mature and bigger the company is, the more difficult it is to be “wildly” successful — growing 100x from $1 million in revenue to $100 million in revenue is generally more achievable than growing from $100 million to $10 billion. These differences that the company’s matury level contribute to risk and return profiles help us begin to see the continuum from angel investing to venture capital to growth equity.

Venture capital depends on the long tail and the ability to drive some big returns. Those outsized outcomes are most often made through a major change in market dynamics — the creation of new market leaders and, frequently, the coinciding destruction of existing ones. As such, it only makes sense that venture capital tries to fund companies that are earlier on in their journey and can be innovative and nimble in carving a new niche for themselves or taking down some large incumbents.

Construction of portfolios

Given that investment opportunities in with a long-tail return profile are inherently high-risk situations, investing all available capital in one such opportunity — putting all your eggs in one proverbial basket — is not advisable. Doing so most certainly would not (and should not) feel comfortable.

To navigate around it, we might want to spread the money around several different opportunities. For the “mature” companies we described earlier, we might not need that many to feel comfortable with our portfolio — maybe even 5–10 opportunities will do. If we are, however, targeting “younger” companies we want to make sure we have a chance of hitting at least one big winner to compensate for the likely losses from everyone else. Either way, it becomes rapidly evident why most of venture capital investing is done through funds which invest in numerous opportunities, rather than as individual one-off bets.

At the end of the day, this is some simple hedging. Just by increasing the portfolio size we are able to dampen the effects of idiosyncratic risks. This is generally effective for risks like team dynamics (no two companies in our portfolio will have the same team) or product quality (no two companies should have the same product). There are, however, risks that might be attenuated through a concerted portfolio construction and diversification effort. An easy example here is geography (a portfolio of Silicon Valley companies has a correlated risk exposure to “The Big One”), but the same can be true of market dynamics (if our portfolio is industry specific), business model (if we primarily fund SaaS businesses), and any other criteria that all investments in our portfolio might have in common. One curious example that I can’t help but bring up is the topic of diversity. From a purely statistical standpoint, consistently funding predominantly young, white, male teams has to carry an unhedged risk (I don’t know — leaked frat party pictures?). A deliberate effort to diversify the portfolio across these dimensions (or at a minimum to acknowledge where correlated risk exposure within a portfolio exists) can help reduce the riskiness of the portfolio as a whole, despite each individual investment having a long-tail risk profile.

Minority investments

Ok, last one! The preference for minority investments follows almost naturally from the construction of portfolios. If diversification makes sense and our overall returns are likely to improve by placing a larger number of uncorrelated bets, when we have limited capital to invest then we should always choose two minority deals over one majority deal. We can kind of see this play out empirically in that seed-stage funds (where diversification helps a lot) do only minority deals, whereas later-stage funds (where the diversification is less critical) start dabbling in control deals.

There is also a more subtle nuance that by taking a majority position we might be affecting the underlying return curve of the asset. Just a speculation, but when the management team starts feeling less like daring visionaries with some venture capital to back them and more like employees of the majority owner, they may not be as excited to push for those outsized returns.

The whole point here is that when we talk about venture capital, we often default to discussing industries, stages, and themes, but those are just corollaries of the type of risk that venture capital sets out to underwrite.

Sometimes, tied up in the higher-order concepts of the industry, venture investors might start imagining interesting notions — like doing seed-stage buyouts, or launching a fund with a lot of portfolio companies but a very narrow mandate. Not saying that those are irrational decisions, or even real examples, but it might make sense to check in with the fundamentals.