If you want to become a venture capitalist, there’s a good chance that the skills and abilities that propelled your success in your corporate career will turn out to be a liability. There are two distinct types of venture capitalists: financial venture capitalists, who are known as VCs, and corporate venture capitalists, or CVCs, who, as their name makes clear, are part of mostly large corporations. The VCs and CVCs, who I will refer to as VC in this article for the sake of simplicity, play by a very different set of rules than those that govern corporations where you spent the formative years of your career. Since success and failure are determined and predicted by different factors, the entire decision-making process that paves the way for those successes and failures is quite different as well.
If you’re new to the world of venture capital, it’s important to understand these differences. It’s equally important to recognize that the good habits that kept you on a steady trajectory to the top of the corporate ladder are no longer applicable. In fact, they’re a problem.
In my experience, successfully acclimating to a VC environment requires you to unlearn much of what you already know about many things. After a deep dive into distribution law, on which the best practices for corporate investing are based, this article will introduce you to power law, which could not be more different from distribution law and that guides how VCs decide whether to pursue or decline an opportunity to invest in a startup. I believe it’s important to understand both. I then want to explain, for those of you interested in corporate venture capital, why it’s important to remain connected to your corporation, but loosely so. Avoiding the obvious when making investment decisions and reimagining your own role as a leader are yet other parts of the unlearning process on which I share my experience. Finally, I detail the financial realities that will be part of your daily life if you pursue a career in VC. Please keep in mind that this article is by no means comprehensive but is, rather, intended as a starting point for your unlearning process. My goal is to help demystify the VC world for you, so if there are topics in this piece you’d like to learn more about in future articles, please let me know.
Why corporations invest based on distribution law
I think the biggest unlearning those of us with a corporate background must undergo as we move into VC concerns distribution law, which is what guides corporate investments.
Because you can rarely if ever attempt a grand slam in corporations, what you end up with are outcomes that adhere to a standard distribution law bell curve. That means very few investments will return either a lot or a little; on the bell curve, they’re on the outside edges, on either side, with the majority of the outcomes residing in the swollen middle. They are neither dire nor outstanding. As the bell curve makes clear, the overwhelming majority of the returns are merely good. This truth is so embedded in corporate investment strategy that it’s commonly accepted, as illustrated by Figure 1, that what differentiates a great management team from one that is merely good is the ability to shift outcomes in the direction of better, i.e. “to the right.”
There are good reasons that distribution law is the governing principle: Corporations have finite resources they can invest, namely money and the capabilities of their employees. That’s why their strategy needs to be based on deliberate choices about where to invest and, equally important, where not to. A good corporate strategy is one that efficiently allocates resources with the goal of delivering profits to serve the company’s mission. Not surprisingly, a good management team, especially at a public company, is one that allocates resources in a way that makes profitable returns highly predictable. And a good investment strategy is one that dictates choosing a project to invest in because it offers good-enough profitability at high predictability instead of high profitability potential at low predictability. The latter could be called a “grand slam” when successful, but it would be a dangerous move for the ambitious manager. That appetite for high predictability, or high probability of success, is an example of a filter you’re likely bringing with you from your corporate career that you must unlearn.
Rewards and punishments are handed out based largely on predictability. Shareholders reward corporations that are predictable. If you can predict what your investment is going to earn in a year, and follow that up by showing good numbers year over year, you’re on your way. An investment growing 20 percent annually is not what you are looking for if you are a venture capitalist, but it’s not going to get you fired from a corporation. What might get you into difficulties in the corporate world is trying to hit a home run. Think about Google, Uber, and Square. Investment decisions based on high predictability would have promptly removed all three companies from the list of investments a corporation would consider. Before they became part of the global vocabulary, none of the companies could be considered predictable; accordingly, a recommendation to invest in them would have been dismissed if not penalized inside a corporation.
Power law, the governing principle of venture capital
The world of VCs, on the other hand, is governed by power law. It’s a world of high risk and high reward, one in which there is no place for predictability on a single investment basis. As the blue line in Figure 2 makes clear, power law dictates that the overwhelming majority of investments will not deliver good returns, but that a few of them — very few of them, such as recent investments in Kuaishou and Coinbase — will generate returns that are truly phenomenal.
Venture capital revolves around the disproportionate valuation increase that will be returned by a very small percentage of total investments. In direct opposition to distribution law, under power law, the distribution of returns is heavily skewed. Exceptional financial performance is delivered by a VC for a given fund as a result of very few exceptional investments, and in many cases just one.
When it comes to venture capital, the reality of disproportionate ratios holds true even at the industry level: A large percentage of VC returns are captured by a small percentage of VCs. Put another way, very few VCs take home the lion’s share of the prize. That’s why VCs are constantly trying to position themselves in the “winning” part of the curve, where there’s not much extra room and the entrances are hard to find. It’s important to remember that power law applies equally to traditional financial VCs and to CVCs, such as TDK Ventures.
Applying power law
Once you’ve entered the VC field, it’s imperative that you structure your internal processes to find, surface, and invest in deals that have the best chance of delivering a high return under the reality of power law. This is an important topic to anyone exploring a VC career, one I plan to write about in the near future. But for now, the rest of this article will focus on what I learned on my ‘unlearning’ journey.
The importance of the contrarian view
Rather than investing based on a high probability of success, our focus is on startups launched by entrepreneurs who believe with all their heart that what they’re doing is going to change the world. Once we believe they are capable of doing just that, we invest. Ideally, we look for startups that don’t yet have many (if any) investors. That sounds counter intuitive, but our goal is to invest in an entrepreneurial vision that has not yet convinced large numbers of investors because it is not yet obvious. Remember, success in the world of VC is driven by being able to discern the opposite of obvious, and to build a contrarian view of the future based on unique insights. If lots of people believed in the vision that inspired the founders to launch the startup under consideration — if there was consensus, in other words — there would already have been plenty of investors. Once there are large numbers of investors, the valuation increases, the investment returns diminish accordingly, and we’re back to the distribution law that governs corporate investing and prioritizes probability.
A VC must be capable of taking a contrarian view in order to see the potential of the founders’ vision long before others do. While corporations cannot afford to invest in a vision nobody yet believes in, for a VC to be good, it cannot afford to invest in the obvious choice.
Avoiding the obvious was my mission when I hired the investment directors for TDK Ventures. I looked for — and found — people who came to their role without filters through which they make decisions because they were not from the VC or CVC fields, or from TDK. Importantly, I took great care to hire investment directors who thought differently from me, and from each other. Because we invest in startups that will ultimately help drive TDK’s overall strategy, I didn’t want or need a point of view regarding what TDK could not become to serve as a filter for what we should and should not invest in. I didn’t want anything to be considered impossible until it was proven to be just that. I think it was a good call: When we proposed investing in a startup working on delivery robots, some at TDK didn’t think it was a good idea to even propose the investment and believed it would surely be declined. But our investment committee thought it was a compelling idea, and approved the proposal, and I give them full credit for this approval decision so early in TDK Ventures story.
Another manifestation of the unlearning process I went through during the design of TDK Ventures is that I stripped myself of veto power. In most CVCs, the president has the power to veto investment proposals before they reach the investment committee, a practice that makes sense intuitively. The head of a CVC is, after all, still the head of a corporation, so that mindset remains ingrained. But what became obvious to me in developing and designing TDK Ventures was the importance of being able to invest in the non-obvious. And to do that I needed to be able to trust my team and its investor’s instincts. Rather than having the right to veto, I insist that our investment directors are passionate about the topic, that they’ve researched the topic extensively during their due diligence, and that they bring conviction to their belief that we should make the investment. If those three conditions have been met, there should be no reason to ever have a veto. The investors at TDK Ventures were hired because they can believe in — and articulate a vision for — a future most people don’t yet see. That negates the need for agreement or consensus.
Why financial returns matter even more
As we’ve seen, the financial realities in the world of venture capital put a tremendous amount of pressure on a very small number of investments.
To illustrate in greater detail the brutality of the math that dictates success and failure in the world of venture, let’s consider a $100 million fund that will invest in 20 early-stage startups over a 10-year investment period. From the very beginning, the fund will typically charge a 2 percent annual management fee that, over 10 years, will add up to $20 million. So, we’re effectively down to $80 million to invest in these 20 startups.
To add more pressure, let’s also assume that the limited partners, or LPs, expect a 3X ($300 million) return on their investment after 10 years. This 3X return over 10 years is essentially a 12 percent annual return, probably low considering the fact that the money is committed for 10 years, let alone the risk that many VCs don’t return 1X to their LPs.
There’s also a 20 percent carry on the fund’s profits, so the $80 million will need to return $350 million on these investments to reach the 3X return to LPs: LPs will receive the principal of $100M plus 80 percent of the $250 million profit (or $200 million), totaling $300 million return, while the VC will receive 20 percent of the $250 million profit, or $50 million of carry.
Let’s now assume all 20 start-ups receive equal investments from the $80 million, or $4 million each. Those investments would likely be made across multiple rounds of financing, but let’s simplify and assume the best case of a single investment at the lowest valuation. To return $350 million, each startup would need to return $17.5 million from that $4 million investment. Achieving returns greater than 4X on each of the 20 investments is something that simply never occurs, particularly under the dictates of power law. Even if 19 of the investments doubled their money, the 20th investment would still need to return $198 million ($350 million minus 19 x $4 million x 2), or about a 50X return on the $4M investment.
Moving away from abstract examples and into the real world of VCs, the importance of grand slams becomes abundantly clear when we take a look at a top-tier financial VC that might make 200 investments over a 20-year period. It’s likely that a whopping 90 percent of the returns will come from just 20 to 30 of the 200 investments. I am familiar with one top-tier VC for which 40 percent of the returns came from just one of its more than 200 investments. The fund’s next five best investments returned 30 percent, with the rest of the top 25 investments bringing the total of returns to 90 percent. Most of the remaining investments either returned barely anything or lost all of their value. Said another way, 10 to 15 percent of the investments returned 90 percent of the returns in the history of the fund. This reinforces why you need a portfolio robust enough to give you enough ‘shots on goal’ in order to find the one or two dozen investments that will deliver the vast majority of the returns.
Rolling the dice on a portfolio in which more than half the investments don’t succeed is risky. But because they adhere to power law rather than distribution law, venture capitalists take much bigger risks when making investment decisions. If you’re considering going into venture capital, this is one of the most important facts to understand. This is why you will hear venture capitalists asking themselves if a new investment “can return the fund.” This is an important question because they can’t really afford to invest in a company that doesn’t have that potential in the first place.
According to the logic that drives corporate investment decision making, VCs will never outperform the market. But they do. A return of 50 times the initial investment is amazing; at the same time, in the world of VC, it’s what you’re going to need to achieve for some of their investments. How? By knowing how to pick the winners.
The importance of loose connections
Technically speaking, CVCs are part of a corporation. TDK Ventures, for example, is an affiliate company of TDK. It’s important that we maintain our connection to the corporation, but it’s equally important that the connection be a loose one. The looseness of the connection gives us the freedom to develop the discipline of a financial VC. It’s the key to our flexibility, nimbleness, and responsiveness, each of which I believe is an important factor in our promising start. At the same time, maintaining a loose connection to TDK keeps us aligned with the company’s strategy and long-term vision. Our goal is to contribute to that strategy with innovations from the startup ecosystem with which we’re engaged. As you can see, it’s all connected, but loosely enough that we can invest with a high degree of independence. TDK has a long-term strategy that we use for guidance, but it’s only guidance. This loose connection enabled our investment in health tech, for example. TDK did not spell out that sector in its long-term strategy, but we think it should be considered as it’s well aligned with our capabilities and our mission to contribute to society.
Beginning your journey
As you begin to transition from a corporate setting into a career in VC, I hope this article leaves you with an understanding of some of the more important differences between the two. Success and failure are indeed defined very differently, and the investment strategies differ accordingly, as do the financial realities. If there are other aspects of venture capital you’d like to learn more about in future articles, please leave a comment.
For now, I want to reiterate that I shared the numerical scenario not to intimidate or scare anyone away, but to offer an honest view of the odds we work against every day. At the same time, I want to be equally clear that when you enter the world of VC, the challenges you must overcome on your journey to success are indeed greater than they were in the corporate world, but so are the rewards. It’s both liberating and empowering to step beyond a corporate mindset and know that the investment decisions you make are going to have a much greater and wider impact. The opportunity to contribute to society, after all, to support entrepreneurial innovation that will make the world a better place, is not something that will ever reside comfortably within the confines of a bell curve.