The Power Law

The Power Law

Most data is evenly distributed. That is to say, even though there are points along a range, the number of individual nodes at any segment tends to be the same as any other segment.

But in a lot of markets, that is not true. Venture Capital is one of those. The number of investments that return a fund, or better, is infinitesimally small compared to the set. This creates a power law curve similar to the one in this week's image (MidJourney plus my pencil).

We can see the law in the data. Below is the SignalRank data for all series AA rounds since 2012. The chart shows the value growth and how many of the 38,000 companies funded achieved that growth.

The plot illustrates the heavy reliance of venture capital on outliers. Here's how to interpret the graph:

The blue line represents all the companies in the dataset, ranked by their Multiple on Invested Capital (MOIC).

The red points represent the top 5% of companies, which are the outliers in this dataset. These companies have significantly higher MOIC values compared to the rest.

The X-axis uses simple integers to represent the rank of each company based on its MOIC value.

The Y-axis shows the actual MOIC values, and the red points are annotated with their MOIC values for further emphasis.

A small number of companies (those in the red) contribute significantly to the overall MOIC, reinforcing the venture capital industry's reliance on outliers for substantial returns.

The Power Law is best understood as counting the percentage of high returners in a portfolio. But there is also a power law within the power law.

The best funds take an uneven share of the power law outliers.

For example, 10% of Series B Rounds result in a unicorn (between 2012-2023). But really good investors have much better than 10%. SignalRank's AI-based B investor achieves over 25%.

So there are a small number of successful companies and an even smaller number of successful funds and fund managers.

Allocating capital to venture is, therefore, a hazardous exercise. The odds of losing capital are very high.

This week there are a lot of really good essays covering this. Dan Gray from Equidam, in Crunchbase News, says:

A well understood concept in venture is that the majority of any fund's returns will be driven by a handful of companies. Maybe 1% of investments will be a 100x return, 5% will be 10x returns, and 50% will lose money. Identifying those outliers is the whole ballgame, so even a marginal improvement to selection can have a huge influence on fund performance. This factor has driven significant investment into VC "platform teams" since 2010.

With that in mind, consider that roughly 4.5% of Y Combinator startups have achieved "unicorn" status since 2010, according to analysis by Inside. That's head and shoulders above similar accelerators, which makes it such an appealing target for investors.

Scott Hartley explains that outliers create new markets that others fail to see until the startup owns them. Zero to Billion Dollar Market is an excellent read. here is a snippet:

So be the one just crazy enough to invent the Zero-Billion Dollar Market you see, and then just sane enough to dominate the category you create for yourself.

Really good seed investors excel at finding these outliers. My colleague Rob Hodgkinson's X posts this week make "X of the Week" because they use the data to demonstrate the reality of the power law. He calls out the top ten highest conversions of seed to Series A, where investors made 20+ seed investments since Nov 2021.

This is important because value grows in Venture Capital when an early-stage investment gains value due to a subsequent funding and valuation event.

There are two pieces talking about Y Combinator's numbers and approach. According to an analysis by Inside, 4.5% of YCs investments become unicorns historically. That compares to only 0.099% of all seed rounds in the past ten years (over 80,000 of them).

So the power law is important because it demonstrates that finding good outcomes is super hard. The advent of data intelligence in channeling capital into de-risked investments becomes very important in that context.

No video this week as Andrew is away.

A call out to Nick Bloom, who is mentioned in 2 essays covering hybrid work. He and I are both advisors to Dan Bladen's company, Kadence, building the enterprise operating system for hybrid teams. Congrats on the acknowledgement Nick.

Essays of the Week