The VC power law decoded

STARTUPS, ON SATURDAY 

A small VC fund typically invests into twenty portfolio companies. The venture capital math tends to be different from math and success rate of each of those portfolio companies. If you ask the investor, informally, how many of those he expects to work – he or she will probably say one or two.

One success is expected to pay for the whole fund and make up for the rest of the nineteen. It is what is expected from a venture capital portfolio. It is the design. This is the most ruthlessly capitalistic of all arithmetic in business, the VC Power Law.

Many people including entrepreneurs sometimes wonder why clever investors chase wild, unlikely bets and pass opportunities to invest in solid, profitable businesses. The answer is in a single idea, the Power Law. It is like the law of the thirds in photography, once you see it you will never forget it and the picture becomes much clearer (pun intended). You stop seeing venture capitalists as mavericks with inexplicable behavior. The Power Law traces its origins to a popular economic principle which has its origin in Italy.

Vilfredo Pareto realized that a fifth of his pea pods gave four-fifths of his peas. This led to the pareto principle or the 80-20 rule. This type of lopsidedness generally exists in most aspects of the world. The VC Power law is simply a more extreme version of this principle. In a typical venture fund, one or two investments hit it out of the park and dwarf every other investment. The VCs typically refer to this prize investment as the “fund-returner” i.e. a single company that pays back the entire fund to its limited partners (or investors).

Here is the arithmetic and it is worth decoding. Let’s say there is a 1,000 crore venture fund. For the fund to return the basic expectation of 8% to its 8-10 years, it must return at least 2000 crores. As fund typically takes a 10%-20% ownership when it invests in a company.

Let’s work with 16% to get round numbers. For a 16% stake in a fund-returner to be worth 2000 crores, the value of that company needs to be a whopping 12,500 crores. There you go, so even a profitable business valued at 1,000 crores won’t make the cut. So, when a VC passes on a solid profitable business, they are not blind.

At the time of making the investment, he or she needs to see a chance that this investment becomes a fund-returner. The limited partners (pension funds, family offices) who gave them the money are expecting them to chase a rare occurrence i.e. the fund-returner.  For Startup Founders chasing venture capital, this math is everything.

For others who are already running businesses that are solid and compounding a “No” from a VC is not a verdict on your business in general, it is an assessment on the fit with their investment thesis. For those participating in the startup ecosystem in any other capacity, or observing it from the sidelines, the Power Law is core to how this world plays out. Attention, money and success do not have an even spread, they concentrate, at the top.  Why it matters: The Power Law explains why venture capitalists chase only large billion-dollar dreams. Not all their bets will make it. It is this arithmetic that should determine if a business needs venture capital.  

- Ravi Ravulaparthi

CEO & Cofounder, Qapita