Understanding the VC Power Law: Why Fund Size Matters in Venture Capital Returns
I’ve had the privilege of navigating the investment waters since 2004, amassing nearly two decades of experience as an Angel investor, syndicate lead, and notably, as the Managing General Partner at Moonshots Capital — a venture firm I founded alongside Craig Cummings. Our portfolio boasts 110+ investments, with notable winners like LinkedIn, Pandora, TrueCar, and Scopely.
Despite the ebb and flow of markets, venture capital remains a beacon for returns; however, the returns in VC are ruled by a key principle: the Power Law. Here’s how it shapes the fate of micro and mega funds — and how it impacts portfolio companies and fund investors (LPs).
Diving into the Power Law of VC Returns
At its core, the VC power law dictates that a handful of investments typically drive the bulk of returns. A few successful investments can recoup the losses of many unsuccessful ones. This isn’t restricted by sector or geography; it’s universal. A study by AngelList covering 1,808 investments cemented the importance of the power law in VC.
The takeaway? Identifying, assisting, and protecting their ownership positions in unicorns is essential for VC funds.
Micro vs. Mega Funds: The Power Law in Action
Success in venture capital is partly about getting the ownership math right.
Typically, a lead VC’s stake in early-stage start-ups ranges between 10% and 25%.
And here’s where fund size plays a role:
- Micro Funds (<$250 million): They have fewer times at bat, but a single successful unicorn exit can provide stellar returns for the entire fund.
Consider this: a $50 million micro fund invests an average of $2M in 12–20 companies for 20% of equity. Even if the fund’s stake drops to 15% through dilution from follow-on rounds, a single billion-dollar exit will yield a $150M return. That’s a whopping 300% of its entire fund from a single deal!
- Larger Funds (>$250 million): They spread their bets across more start-ups, but they need multiple unicorns in the stable just to break even. Let’s say a $500 million fund invests $50M in a winning company over several rounds and can maintain a 20% ownership after dilution. Even assuming they maintain that ownership position, at least one start-up needs to hit a valuation of $2.5 billion and the VC needs to exit at that valuation just to return initial fund capital.
Both start-up founders and venture fund investors (LPs) should understand the effects of power law on the VCs they partner with.
Founders Need to Align Goals with Fund Size
Recognizing the power law dynamics helps founders select ideal investors and secure favorable term sheets.
Micro funds can support founders looking at exits between $50 — $250M and still make a strong return on investment. These VCs will work hard to help you even if you’re not going for an IPO or M&A exit with a multi-billion-dollar valuation.
Large VCs prioritize potential billion-dollar companies: they are the only ones that have a real impact on their returns. If you’re not tracking to become a unicorn, they cannot spend their time helping you. And let’s face it: the number of $2.5B companies is exceedingly small.
Patience Is Profit for LPs
Quick cash feels good, but ultimately weakens the bottom line. In our experience, M&A activity typically occurs 5–7 years into a start-up’s lifecycle and IPOs happen in the 10–12-year range.
Data supports this observation. According to PitchBook data, the older the vintage year of a high-performing emerging fund — which means more time for portfolio companies to grow — the more capital gets distributed to investors.
Remember: larger funds can swing more often but need to back their top performers heavily. Micro funds should prioritize securing sizable early stakes and defending them through subsequent funding rounds. When selecting a fund to invest in, research the fund’s post-investment practices and make sure they do just that.
Conclusion
The VC power law isn’t just a theoretical concept; it’s the bedrock of venture capital returns. Both fund size and the power law dynamic are instrumental in shaping the investment landscape. Whether you’re an investor, founder, or an LP, navigating these waters requires a strong grasp of the power law dynamics and their impact on micro and larger funds.
Sources:
Moonshots Capital is a veteran-founded venture capital firm that invests in early-stage startups with extraordinary leaders.
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