The world of venture capital (VC) investing can be difficult to understand, filled with jargon, complex business models, and industry-specific knowledge. However, one concept that all investors should be aware of is the power law. The power law is a phenomenon that describes the distribution of returns in venture capital investing. Put simply, the power law states that a small number of investments in a venture capital portfolio will generate the vast majority of returns. In other words, the majority of startups in a venture capitalist’s portfolio will fail, but a few will be extremely successful and generate the lion's share of returns. Pulitzer Prize finalist Sebastian Mallaby in his book “The Power Law: Venture Capital and the Making of the New Future” calls the power law “the most pervasive rule in venture capital.”
This phenomenon has been observed globally throughout the history of venture capital investing. Harvard Professor Tom Nicholas opens his book, “VC: An American History” with a look at 19th century whaling missions, noting the similarity between highly lucrative but low probability payoffs from whaling missions and that of modern venture capital. In the early days of the modern venture capital industry, in the 1960s and 1970s, there was very little data on which to base investment decisions. Venture capitalists were often investing in untested technologies and inexperienced founders, and the success rate was low. However, the few companies that did succeed, such as Intel and Apple, generated such enormous returns that they more than made up for the failures.
As the industry matured and became more data-driven, the power law has been highlighted. Data from some sources have indicated that a minority of investments, typically representing a small portion of the capital deployed, can generate a substantial majority of the returns. For example, Horsley Bridge, an investor in many venture capital funds, shared that on average ~6% of their investments representing 4.5% of dollars invested generated ~60% of their total returns from 1985-2015. This has important implications for our strategy at Nicola Wealth. We are focused on gaining access to top quartile performing North American VC funds, and co-investing selectively alongside them. We are well-positioned to gain traction here, as the changing environment has resulted in VC fund managers seeking to diversify and broaden their investor relationship base and as the strength of our network continues to improve.
The power law has particularly important implications for early-stage investors. It means that investing in a diversified portfolio of startups is not enough to guarantee success. In fact, the dispersion of returns in early-stage investing is incredibly high. A report by Cambridge Associates found that the top 100 venture backed companies generated a minimum of 72% in 2012 to a maximum of over 100% across several years of total value creation from the period 1995 through 2012. This means that early-stage investors need to be extremely selective in their investments. They should focus on finding companies with the potential to generate enormous returns, rather than just trying to diversify their portfolio. This can be difficult, as the most successful startups often don't look like sure bets in the early stages. However, by focusing on factors such as the quality of the founding team, the size of the market opportunity, and the uniqueness of the product or service being offered, investors can increase their chances of success. For an early-stage manager to outperform, they not only need to see the best deals, they need to be able to pick them – partnering with groups that have demonstrated this ability repeatedly is our focus at the earliest stages. In many cases we observe a flywheel effect, where success begets success, as entrepreneurs actively seek financing from VCs with track records of backing winning companies. JP Morgan’s research backs up this assertion – analyzing venture capital fund data from the last 30 years, they found that 45% of venture capital firms are likely to repeat their funds’ first quartile performance in a subsequent fund.
In conclusion, the power law is a fundamental concept that all investors in the venture capital industry should be aware of. It describes the distribution of returns in the industry, which is highly skewed towards a small number of extremely successful investments. Early-stage investors should be selective in their investments, focusing on companies with the potential to generate enormous returns, rather than simply trying to diversify their portfolio. By doing so, they can increase their chances of success in this exciting and dynamic industry.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is intended for tax residents of Canada who are accredited investors. Residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.
