The Power Law Phenomenon in Venture Capital
By charlie
The Power Law phenomenon was first discovered in the late 19th century, thanks to the work of the Italian economist Vilfredo Pareto.
He stumbled upon the concept when he realized that 20% of the pea pods in his garden produced 80% of the peas. Soon after this discovery, he began to recognize this phenomenon in Italian society’s wealth distribution structure (where just 20% of the population owned 80% of the land).
This 80-20 principle, also known as the Pareto Principle, soon became an important element of countless fields, laying out the foundation for the Power Law. The Power Law Phenomenon occurs when one element dominates the rest. From physics to sociology – it manifests itself in most fields, including venture capital.
Power Law Distribution shapes the high-risk, high-reward world of venture capital – right from the way investments are made to the way portfolios are crafted. It guides VCs to hunt their next potential investment and make sound decisions to maximize their returns.
What is the Power Law Distribution?
What is a power law distribution, exactly?
Simply put, Power Law in venture capital states a handful of investments made in a venture capital portfolio will help extract the vast majority of returns. To simplify the law further, most companies in a VC portfolio will fail and only a few of them will generate a massive chunk of profits.
In his book, “The Power Law: Venture Capital and the Making of the New Future,” Pulitzer Prize finalist Sebastian Mallaby reveals that power law is “the most pervasive rule in venture capital.”
With the phenomena dominating practically every arena of human life, the Power Law Distribution becomes a major foundation of the way any VC investment unfolds. Think about it: out of 333.34 million companies operating in our world today, only a handful of them have truly redefined markets, overshadowing their peers along the way.
Now that you know the answer to “What is power law?”, it’s time to understand the implications and strategies that surround this phenomenon from the lens of VC investments.
Power Law Distribution’s Impact on Equity Allocations
Venture Capitalist firms often emerge in the form of limited Partnerships (LPs). Each partner invests a sizeable amount of capital to create a well-rounded VC fund. A general partner (GP) operates at the forefront of all investment decisions.
A VC portfolio may contain a wide range of startups. Based on their performance, each one of these startups journeys through a range of funding rounds. As these portfolio companies begin to reveal their performances, the star startups are what progress into the final funding rounds. A majority of the fund’s capital then gets distributed among top-performing startups until they reach a liquidity event. Each funding round enables an investor to gain a certain amount of equity ownership based on the capital they’ve invested in it.
Can Power Law Effects Shape the Outcome of Different Funding Round Stages?
The Power Law takes effect across all stages of funding rounds.
The initial funding rounds (especially the Seed and Series A stages) come with high risks and high rewards. Early-stage investors must be selective in which portfolio companies they invest in by focusing on the company’s potential to generate returns and creating a diversified portfolio. This can help them succeed in today’s dynamic world of investments.
The industry has continued to mature, and the data extracted from it clearly shows the presence of the power law phenomenon. A small minority of investments have the potential to generate a majority of results even if a small amount of capital is poured into them.
How Does the Power Law Phenomenon Influence Pro Rata Rights?
Pro rata right is the right that an investor exercises to make investments in a portfolio company during the later stages of funding rounds. While this right is legally binding, the investor is not always obligated to exercise it.
Let’s say an investor gains a 10% stake in a startup after its seed round. If this portfolio company continues to perform well, it can progress into a Series A round by issuing more stock. The result dilutes the rights of the investor. This investor can then exercise their pro rata right to participate in Series A with the aim to continue maintaining their stake at its previous level.
The arrangement brings substantial benefits to both parties. The portfolio company stands to gain further capital to scale and the investor ends up having a guaranteed stake based on the company’s previous performance.
The power law phenomenon often impacts whether an investor is willing to exercise their pro rata right. But if an investor does exercise it, they will prioritize portfolio companies that bring the most results.
Implications of Power Law for Venture Capital Investments
The Power Law Distribution in venture capital comes with important implications. It is critical for early-stage investors in particular to understand how the phenomenon could unfold over the course of the fund’s lifecycle.
With the amount of risks early-stage investments involve, investing in a diversified portfolio is not enough. According to data, the top 100 VC-backed startups generated about 72% of returns in 2012 and a maximum of over 100% across a long timeline since its value creation. This period lasted for almost two decades (from 1995-2012).
This only proves the need to be highly selective when making early-stage investments. More than diversifying your portfolio, it is critical to focus on finding startups with the capacity to generate enormous results. While it can be difficult to spot successful startups in the early stages, certain factors can prove to be helpful during the process. These include analyzing the size of market opportunity, understanding the quality of the team, and determining the uniqueness (and demand) of the product or service that is being presented.
In many cases, funding rounds have been known to experience what is called a flywheel effect, where success attracts more success. About 40% of VC firms, according to JP Morgan’s research, for instance, are sure to repeat their fund’s first quartile performance. By understanding the potential of startups and decoding the power law, investors can make sound decisions to multiply their dividends.
Building a High-Performance VC Portfolio with Power Law in Mind 200
A high-performing VC portfolio is often a result of comprehensive analyses of portfolio companies, the unparalleled skills of a general partner (GP), and the decisions that are made by keeping the power law distribution in mind. Understand how each one of the companies in your VC portfolio performs, find out which startups stand out the most, and which companies will drive the most results. Direct your capital towards these companies to ensure the future results are fruitful.