In recent years, the press and the VC community have latched on to the idea of a Unicorn, which is a start-up that is valued at a billion dollars or more. While still somewhat rare, Unicorns are becoming increasingly common. According to CB Insights and VentureBeat there are 350 Unicorns in the world today and, in 2018, they represented on the order of 1.2% of all venture deals funded.
But Unicorns aren’t the only creature inhabiting the venture capital bestiary. Since the term Unicorn entered the VC lexicon in 2013 several sub-species have emerged as well. We now have decacorns (which are start-ups that have achieved a valuation >$10B) and hectocorns (aka Super Unicorns at >$100B). There are some more fancifully named ones such as Centaurs (>$100M but <$1B), Ponies (<$100M) and even Cockroaches (which are sort of the opposite of a Unicorn in that they are built to survive any condition and are steady and unremarkable except for their ability to eke out a profit as they slowly grow. Legend has it that Unicorns and Centaurs have a habit of stomping on Cockroaches).
However sexy the idea of a Unicorn has become over the last few years, the description isn’t that useful in helping to distinguish the best investors or funds from everyone else. With several hundred Unicorns currently available to choose from, most of whom are losing money and are not public, it is relatively easy for a VC firm to put lots of them in their stable. This fact has caused many a VC fund to chase Unicorns for their portfolio.
Unfortunately, this has not led to the hoped-for uptick in monetized returns because “Unicorn” is an almost useless rubric if what you are interested in is finding the best investments. Instead, the rare species that most distinguishes the best venture capital investors is what is called a Dragon. A Dragon is hatched when a company that a VC has invested in returns their entire fund. Dragons are more than just something VCs watch on Game of Thrones or hope one day to be lucky enough to encounter in the real world. Instead, finding a Dragon is the trademark which distinguishes the elite club of the very best VC managers.
The importance of Dragons can be seen by looking at the data on venture firms with Unicorns in their portfolio. John Backus (@jcbackus) and Hemant Bhardwaj from NAV.VC ran these numbers and published them on TechCrunch. They found having Unicorns in a venture portfolio did not necessarily correlate with better returns because holding a unicorn in a portfolio does not necessarily mean that it was acquired at a significantly lower valuation. In fact, the correlation was minimal with only 7% of VC investments in Unicorns over the 10 years to 2015 becoming Dragons.
Top Funds Have Bigger Wins, Not Fewer Misses
The Horsley Bridge data bears out the importance of having big winners for overall fund returns as well. They performed a review of the 7,000 investments made by funds in which they had invested from 1985 to 2014 and they reached some noteworthy conclusions of relevance to the importance of finding Dragons. The best VC funds, contrary to what one might think, don’t have fewer losers and they don’t have more winners as compared to average VC funds. In other words, they’re no better than average at choosing winners and avoiding losers. Instead, the money is made by the best funds having bigger ‘big wins’. In other words, they’re just better at finding Dragons.
Looking at the chart below, and ignoring the lowest performing funds on the leftmost bar, you can see that the best funds have a roughly similar number (40–50%) of failed and moderate-performing deals (denoted by the yellow line on the chart below) as compared to the average funds. Again, ignoring the “<1x” funds on the left, all VC managers allocated about half their funds to (and had about half their deals in) money-losing businesses. What differs as you move to the funds exhibiting more and more superior returns is that they have more 10x or greater deals (the grey areas).
This difference is dramatized when the data is reorganized to show the distribution of deals by the share of fund returns.
Again, the grey bar represents the deals that delivered >10x return. (If a VC fund invests an average of 10% of the fund in each of say 10 deals, we can use 10x return as a proxy for a Dragon). This brings us to the so-called “VC Power Law Curve.”
The “VC Power Law Curve”
In the venture capital industry, the rule of thumb that gives rise to the term Dragon is that for the funds that returned over 5x, 90% of the return came from 20% of the investments. The Horsley Bridge data supports this rule directionally in what they call the “VC power law curve”, which they state more narrowly as 60% of the returns for all VCs come from just 6% of their investments (see chart below).
The Horsley Bridge data show that if you want to be in the 3x fund club, you have to have at least one 10x investment. In fact, there are no exceptions to this rule: 100% of funds in their data set that at least tripled the fund had a minimum of one ‘10-bagger’.
The Horsley Bridge data also show that if you want to be in the elite club of the best VCs, 10x might not be enough unless it is also a Dragon: 87% of >3x funds had at least one Dragon. This why you often see what is referred to in the VC business as the Babe Ruth Effect. Like the famed baseballer, the best VCs swing hard on every good pitch, even though it means they are going to strike out a lot. Base hits don’t do the job, so every pitch has to be a homer, or it isn’t worth swinging.
There is another elusive species lurking in the Horsley Bridge data that is worth uncovering. According to their number-crunching, 93% of >3x funds had at least one 25x deal so, even though this creature is the rarest of the rare, it is a near-essential member of the best VC’s portfolios. So, perhaps we need a new term for the 25x-ers? Unicorns are uncommon in the venture business (just over 1% of all deals funded in any given year), and Dragons (which are often in the 10x category) are even scarcer. What about the 25x-ers? What mythical creature might best represent this almost impossible to achieve investment outcome of 25x or greater return? My vote is for Chimera, the fire-breathing three-animal monster from Homer’s Iliad whose name has also come to mean “A thing which is hoped for but is illusory or impossible to achieve.”
Source for Horsley Bridge data:
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* sadly, public data on the frequency of “dragons” is very limited, and the studies cited here (referencing data through 2014–15) do not include returns from the last several years, which have seen numerous multi-billion dollar exits. Still, I believe that the overall point that they make is still relevant — it is typically a smaller number of the biggest “big wins” that make the best funds, not better performance across the entirety of their portfolios