Why the Power Law is not that powerful in VC?
Strategies of today for investing in early-stage tech companies are largely dominated by “power law” of returns — it is the backbone and architecture of the entire game with many known — and often positive — examples.
Much has been said already on the topic with a variety of explanations (e.g., here; here; here; here; and here). However, it is the overwhelming consensus that returns in venture capital are distributed according to a “power law” of some description with the major share of returns earned from a few successful investments out of tenths or hundreds attempts. Now, whilst the data , as shown below, demonstrates this distribution to be true across the industry and even within firms , we believe the answer is slightly more nuanced..
A bit more data on this:
“a small number of startups — 6% — end up driving 60% of the returns” — link
“A normal early-stage VC portfolio has about 80% failures (mainly flops), about 19% are deemed successes (mainly flips), and about 1% are home runs (mainly unicorns)” — link
“For the best performing funds, 90% of their returns come from less than 20% of their investments” — link
…and same views from earlier vintage
“VCs pick winners only 2.5% of the time. More than a decade of data reveals that out of more than 4,000 VC investment rounds annually, the top 100 generate between 70 and 100 percent of industry profits” — link
“Among the very top performing VCs, 4.5% of invested capital generates 60% of their funds’ returns” — link
So, what does that mean for investors? Often the answer is
“VCs need at least one outlier in the portfolio to be successful”.
Then, depending on the angle, assumptions and data chosen for the analysis, authors would give more practical recommendations on the ways to build an ‘optimal portfolio’ leveraging the power law, such as ensuring diversification (“If unicorns happen only 1–2% of the time, it logically follows that portfolio size should include a minimum of 50–100+ companies in order to have a reasonable shot in investing in 1B+ business”); ensure sufficient follow-on reserve to double-down on best-performers and increase returns from home runs and more (e.g., here or here).
There is no doubt that this approach works when you do a large enough portfolio set. If however you are in a “smaller” manager category, as we are, this all comes down to 1 of 2 options: invest at earlier stage (and, basically, flip the coin) or …well…invest more focused (or less diversified, whatever you prefer).
Diversification is a basis of any sustainable strategy, and it clearly works well for larger funds, and although it is hard to disagree with this, is this the only way? Do we really need to invest in 100s of startups knowing that, 2 out of 3 investments (in best case!) will be written-off? How does this effect selection and decision-making process and, not least, the motivation of investors and founders?
To answer this we need to our best friends — numbers.
Let’s look at it on a simplified real-life example of a small VC with $40m capital available for allocation. Let’s also assume that our virtual firm has:
- (a) $40m are net of all fees;
- (b) lifetime of 8 years*
*Although larger funds would normally have a lifetime of 10 +1 +1 years, emerging managers (like we ourselves) would try to look competitive and be aiming to ensure shorter investment cycle raising 7+2 years, for traction of quicker turn around.
Earlier in Blueprint series [link], I've described an approach to Fund’s returns modeling, which can be used for detailed evaluation of each of the exemplary scenarios described herein.
Now when we have main things lets create 3 different presets for strategies:
Strategy 1. Highly-diversified (“Spray and Pray”).
With small (15% of AUM) reserve for follow-ons, we provide small (€500k) tickets to create super-diversified portfolio of 51 companies. At next stage, we will follow-on just 9 best-performers (18% of portfolio) with additional €0.5m tickets.
Strategy 2. Diversified (“Spray, Pray and Double down on winners”).
Similar to Strategy 1 we will provide €500k tickets, but to 36 companies. This strategy maintains high level diversification and utilizes remaining capital to support more companies with higher tickets at next stage — 12 follow-ons (33% of portfolio) with €1m tickets.
Strategy 3. Focused ("Less diversification — less write offs")
Third strategy assumes a different approach — comparably higher concentration of portfolio due to larger initial tickets of €1m invested in 18 companies and significant follow-on reserve — 8 follow-ons (44% of portfolio) with even larger €1.5m tickets. Key of this strategy is to target as low write off rate as possible.
All 3 strategies invest in similar companies as follows:
(i) Initial tickets invested as part of €2m Seed Round at €7m pre-money valuation.
Strategies 1 and 2 will hold c.5.6%, and Strategy 3–11% post-investment
(ii) Follow-ons are made at Series A (Early-Stage VC) — €4.5m with €15m pre-money valuation
Post-investment shareholding will increase to: Strategy 1 — c. 6.5%; Str.2 — c. 9%; Str.3 — c. 15%.
Parameters are based on the average Seed and Early-Stage VC rounds in Europe in 2023 according to Pitchbook data. Thus, median deal valuation can be even lower, providing all 3 strategies with additional upside potential.
Now let’s assume few scenarios of how invested companies could develop:
Write-off [<1x Gross ROI]
Business wasn’t successful and didn’t grew as planned. As a result, went into administration / was sold with massive discount:
- 0.1x ROI return for Strategies 1 and 2;
- 0.2x ROI for Strategy 3, which, due to larger investment ticket will have better economical protection & control powers, allowing to partially mitigate the losses.
Moderate Exit [2–3x Gross ROI]
Business raised 1–2 more investment rounds (27% dilution), but couldn’t lead the segment and was acquired by a PE / Competitor for €35m.
Good Exit [8–10x Gross ROI]
Business raised Series of subsequent rounds (43% dilution post Series A) and Investor exited at later stage — either via secondary sale, mid-cap M&A or PE acquisition — at valuation of €200m — average pre-money valuation of a venture-growth in Europe in 2023 according to Pitchbook data.
Excellent Exit (Homerun) [44x Gross ROI]
IPO or another exit from a unicorn-company at €1bn valuation, 70% dilution from Series A to exit.
According to market stats (Pitchbook; Dealroom; here; here; etc.) exit with c.100x gross-ROI has far less then 0.1% chance of happening.
Accounting for dilution, these scenarios will result in the following Net ROIs for the strategies:
Finally, we will also assume that in 3 strategies the manager does a tremendously great job on follow-ons — pick right follow-on targets almost always.
So, what does it takes to achieve very moderate 2x return with these parameters?
Composition of portfolios by-strategy will look as follows:
Surely easier is to visualise distribution on a graph, and it will look as follows:
Experts are not wrong — if the write-off ratio is at industry-average levels — at least 1 unicorn in portfolio is required to achieve 2x on a portfolio, but, without the homerun (=unicorn), outcome will not exceed 1.5x in best case.
But what if we can achieve at least a slightly lower write-off ratio? Well, it changes the picture completely: Strategy 3, without any homeruns at all, it can achieve the same 2x with just 2 “Good Exits” by decreasing write-off by just c.10% — to significant 56%.
Just 10% decrease in write-off lowers the target from 3–5 good exits AND unicorn from a portfolio of 40–50 to 2 ‘good’ exits from a portfolio of 18.
If we would look at higher target — 3.5x ROI — the difference is even more significant. Considering similar write-offs levels:
(i) Strategy 1 (65% write-off) will require to have 5 ‘good exits’ + 3 unicorns in portfolio. A very high target that can be met by just a few Funds.
Or
(ii) Strategy 3 (56% write-off) will need same 2 ‘good exits’ with just 1 unicorn.
Or
(iii) Same 3,5x return can be achieved by Strategy 3 without unicorns at all, by decreasing write-off ratio by 10% — to 44% (8 out of 18 companies) and completing 5 ‘good exits’.
So summing up:
Again visualising it — it will look like:
Of course, these calculations are simplified, and, in practice, portfolios are more dispersed, significantly different for each industry, etc. However, in the majority of segments this correlation will be correct: less write-offs allow to achieve high returns at much more realistic assumption, without need for the portfolio outliers. And the difference can be quite significant: 3 unicorns in a single €30m portfolio is a VERY ambitious target, especially comparing to 20% decrease of write-off ratio.
We’re not done yet, there is more!
When we remove the burden of ‘finding a unicorn to deliver returns’, the investment strategy can be further tailored and focused towards minimizing write-offs (via thoughtful specialized investments) rather than flipping the coin in search of unicorns.
(1) The above examples are based on realistic ‘average’ parameters of Seed rounds of early-stage companies. At this stage, startups would typically have traction, proven product-market fit, and a tested business model, making thorough investment analysis feasible and enabling fully informed investment decisions.
Furthermore, if a VC is focused on ensuring a lower number of write-offs, parameters affecting investment decisions should also change. While still considering the size of the market and opportunity, more attention would be paid to the sustainability of the business model, unit economics, margins, etc.
(2) A more relaxed investment schedule and a concentrated portfolio (18 vs 51 investments in the above examples) further unlock VCs’ resources for more detailed pre-investment analysis and post-investment portfolio development.
(3) Larger investment tickets will allow the Fund to negotiate comfortable investment terms and all necessary controls to create almost a symbiotic relationship with the the portfolio company, becoming not only a "board member" but actually team member who is working with the entrepreneur and helping them to achieve goals.
No less important is the fact that a VC that is not going after 100x+ returns can rethink the investment approach and become a true partner to an entrepreneur. Instead of pushing a startup to achieve 3x YoY growth at any cost, investor could be comfortable with lower growth rates as long as they are sustainable, profitability is achievable, economics are healthy, etc. This kind of flexibility allows a company to consider a wider spectrum of factors and implement a more applicable strategy to ensure sustainable development.
All these factors combined make a write-off ratio of 40% an absolutely achievable target. Of course, there are multiple business risks associated with early-stage investments, but a focus on sustainably growing early-stage companies and tailored investment strategies can allow for 3–5x returns at much more realistic exit targets, even without a single exit above €300m busines valuation.
The market is changing, and perhaps the paradigm of VC investments will shift as well. Instead of hunting for mega-rounds and unicorns (with hundreds of trials and expectations of >65% of businesses failing), investors will focus on building and supporting sustainable, growing businesses — startups achieving the same leadership position in their markets, but at a different pace. Time will tell, but I have little doubt that we’ll see the emergence of flexible VC strategies, helping entrepreneurs to grow businesses without compromising on business sustainability and providing steady growth of value to its investors.
And to finish this — as they always say:
If you read it and thought that was interesting feel free to get in touch with me at ac@verb.ventures!
