"The Power Law of Venture Capital is the theory that an exceedingly small number – as little as 5-10% of an investor's venture capital investments – will yield the vast majority (90-100%) of returns from venture investing. But the Power Law, as practiced by most venture capitalists today, is BS. The best venture capital firms consistently see higher return attribution from a much higher percentage of investments. Sadly, the deteriorating definition of the Power Law of Venture Capital has been used, particularly by institutional investors, to justify continued investment into inferior funds." (Mark Buffington)
Venture Capital is considered the highest risk/reward asset class among private market investment alternatives. Without question, the Deal Failure Rate – the percentage of investments in a fund that fails to return at least the invested amount of capital (a 1x Multiple of Invested Capital) – is much higher when investing in VC deals than it is with investments in other private market asset classes. That is true even with the best fund managers. That said, investors have no rational reason to accept deal failure rates of 90-95% in pursuit of outstanding venture returns.
Empirical evidence reveals that the best proxy for future venture returns is Deal Batting Average – the percentage of deals (in a fund or series of funds) that produce at least 1x Multiple of Invested Capital (MOIC). Deal Batting Average is the corollary of Deal Failure Rate (1 minus Deal Failure Rate = Deal Batting Average). Fund managers that consistently show up in the top quartile (top 25%) of venture investors produce Deal Batting Averages of 30-35%, not 5-10%. The best VC fund managers consistently produce deal batting averages of 40% or greater.
From a statistical standpoint, a VC firm that absorbs a 90% loss rate and generates its returns from 10% of its wins is not that different from a firm that has a 40% or 50% loss rate. Even funds that consistently produce deal batting averages of 40-60% still have an element of the Power Law. Being an econometrician and a statistician, I tend to think about wins and losses in terms of distributions. Unlike the traditional bell curve, investments in venture deals yield exponentially distributed outcomes. In other words, with the Power Law, there's a greater loss ratio (Deal Failure Rate), but when you get your wins at a smaller percentage, those wins tend to be much larger.
The rate parameter, which governs the shape of an exponential distribution, has grown too high. Current discussions about the Power Law of Venture Capital suggest that investors and founders should accept playing a game where 10% of investments generate a 25x, and everything else is basically a write-off. That's despite the mounds of evidence showing there are more great startups that might generate a 3x, a 5x, or even a 10x return. They don't quite meet the Power Law Magnitude of Return definition, even though they are more likely to yield exceptional outcomes for founders and investors.
Casino construction offers an excellent metaphor for the Power Law risk/return tradeoff. If you go into a casino, you'll get the best odds at the Blackjack table and the worst at Keno. It's not coincidental that in almost every casino in the U.S., the first machine when you walk onto the gambling floor is Keno. Picture a Keno machine (it's the one with a bunch of flashing lights and giant payouts advertised). The construction and placement tell you everything you need to know – humans are thrill seekers. Many of us like the excitement of rolling the dice on wild, low-odds bets for the prospect of hitting it big. It's the same reason so many people play the lottery week after week, even though they lose week after week. Investors are no different. They're willing to take their chances on putting capital into VCs that play the Power Law for one of those investments to hit it big, and they'll get the chance to say, "I have a stake in X."
In many ways, Silicon Valley packaged up lottery-like emotional and psychological dynamics and sold it to institutions. They justified it and gave it an aura of credibility by using the term "Power Law." The fact is there's a better way to invest in venture. There's a better version of the Power Law – they're not all created equal. There's a more consistent and predictable way to generate outsized returns.
We're seeing more venture funds (particularly those not drinking the Silicon Valley Kool-Aid) recognizing this economic reality. By taking an incremental approach to portfolio investments, they are generating more consistent returns and outcomes and higher batting averages across multiple fund vintages. These VCs know that vying for a higher batting average means being willing to miss the possible 25x return to land a lot more 5-10x returns. That's because they know it's only 10% that might yield that return. They put capital and efforts toward generating closer to 5-10x returns on most of their investments. And they see that this more measured strategy usually comes out ahead more often than it doesn't.
Most founders and investors go into venture because they want to solve big problems. These are people who (generally speaking) are psychologically geared to accept the risks necessary to pursue big wins. Doing so doesn't require that they ignore statistics and expected returns. Instead of the steep exponential but suboptimal outcomes from a Power Law approach, a more measured approach builds a larger portfolio of successful companies. Many will have a slightly lower magnitude of returns than the 10% in a Power Law VC firm, but overall, the firm will generate a higher batting average and fatter tails across the board over time.
The Power Law approach can create a skewed dynamic between investors and founders. In a bid to win deals and secure their place in the next big success story, investors may cater to founder egos and prioritize their needs over sound investment decisions. This approach can lead to a lack of due diligence and critical analysis. Investors may be more concerned with impressing founders than ensuring the company's long-term success.
Most founders (even serial entrepreneurs) take venture to bolster the only company they'll ever start. Accepting a binary chance of hitting it big is more than a risky tradeoff. It could mean losing everything. Even still, some founders go all in to say they got a check from a "top" VC (no matter what the fund's historical returns show). Silicon Valley funds are notorious for flooding visionary startups with capital that doesn't align with their valuation (case in point – Quibi). The big bets reflect belief in a hot market and a founder's ability to capture it. When a company fails, the fund reloads and starts again. Many of these firms have enough brand cache to get away with it.
It's worth considering why founders might take a check from a VC firm that takes binary bets (name recognition aside). Why don't more founders seek a capital partner that is more practical and focused on taking care of their best interest and producing consistent returns? Ego has a lot to do with it. The big Silicon Valley firms don't get enough credit for their ability to sell. They woo and razzle-dazzle founders into deals. We talk to founders who have taken money from big brand-name firms and found themselves on the losing side of that bet. They always say, "I learned some valuable lessons. I wouldn't do it the same way."
I'm proud that we approach investing in a way that results in at least 60% of our founders getting an equity check. All our portfolio companies get much more than that: they get a capital partner willing to work with them over the long haul, even through downswings. They get experienced, aligned advisors who help them know how and when to take an investment, the right size and type of funding, and how to use the money wisely.
At the end of the day, founders who take on a VC partner are giving that partner the ability to impact their big idea – maybe their life's work. Many serial founders who have built enduring businesses in our portfolio say, "Let's do it again." Many times, if they've had a great outcome, they put their money in alongside ours, deepening the partnership and outcomes.
The extreme Power Law model is in for a reckoning. Capital eventually finds its way to the most efficient home. Despite Silicon Valley's marketing prowess, first-mover advantage, and the few amazing companies that have grown there, a sea change is happening. Institutions might tolerate the model for now, but fewer individual investors and advisors will. As more advisors enter the private markets and compete for clients, they'll seek to optimize the probability of returns. It follows that institutions will change, too.
It is a venture planet now. Innovation is coming from everywhere. It's getting funded in different places. That will change how funds deploy capital to the most innovative ideas. The Power Law is not an effective tool when it can only offer a 10% chance of an idea winning. The time has come for a more probabilistic strategy to manage risk and generate outcomes.
Anyone who has sat in on a webinar with BIP Ventures has seen our outcomes across vintages since 2007. If you have, you see that we are striving to build probabilistically optimized portfolios. We invite you to contact us for a list of upcoming webinars to learn more.
In VC, the "Power Law" indicates that roughly 80-90% of returns come from just 10-20% of investments, with the top 1% of investments often accounting for the majority of a firm's overall returns.
Batting average in VC measures the proportion of a venture capital firm's investments that have successfully exited or achieved significant growth, reflecting the firm's ability to identify and support high-potential startups.
Exponential distribution in venture capital is the statistical pattern where the time between successive investment successes follows an exponential decay. Graphically represented, it is a bell-style curve showing that while some investments yield returns quickly, most take much longer to realize returns.
A vintage in venture capital refers to the year in which a fund makes its first investment, marking the beginning of its investment period and serving as a reference point for evaluating its performance.
Deal Failure Rate is the percentage of investments in a fund that fail to return at least the invested amount of capital (a 1x Multiple of Invested Capital/MOIC).
Deal Batting Average is the percentage of deals (in a fund or series of funds) that produce at least 1x Multiple of Invested Capital (MOIC).
