The Power Law: Identifying Outliers
“We don’t live in a normal world; we live under a Power Law.” These are the words of Peter Thiel, PayPay founder and the first investor in Facebook. But what does this really mean, and how is it relevant to investing in venture capital?
What is the Power Law?
The Power Law is a phenomenon seen throughout life where the majority of the output in any given circumstance comes from the minority of the inputs. 80% of your sales may come from 20% of your clients, or conversely 20% of your wardrobe may be worn 80% of the time.
Searching for the big winners
Venture capital funds know that the majority of their returns will come from a minority of their investments. As such, every company which goes through a fund pipeline is assessed through the lens of whether it can be a “fund returner” (i.e. if a fund has £100m, can this one investment – whether £1m or £10m – return the £100m+ by itself).
Below is a typical example of the returns in a portfolio of 10 investments – There are five failures, and three return 1-2x money, whilst just two provide the majority of the returns. The losses are expected, as long as the risk-reward leads to the big winner.
Building a portfolio
The implication of the Power Law is that investing sporadically, into individual companies is unlikely to lead to success – and if it does, there is a good chance it is luck rather than skill. This is where professional fund managers (particularly the best and most experienced) have a distinct advantage over the individual investor. They have a set thesis and are mandated to build a portfolio – whether 5, 50 or 500 companies – and they have the team and tools in place to support this.
It has been proven that building out a significant portfolio mitigates your risk of losing money. If you make 300 investments, you’re twice as likely to treble your money than if you invest in just five companies.
Why does this matter to you?
Investing in early stage businesses is hard.
To make outsized returns, some companies in your portfolio need to exit for upwards of £100m, £1bn or £10bn+, and there’s only a finite amount of companies that exit for those numbers.
If you’re an angel investor who sees 10-50 investment opportunities a year, the likelihood that one of these opportunities will exit for billions, while not impossible, is low.
Top-tier venture capital funds have the infrastructure, the network, the team, the resources and the time to make sure that they make the best, most well informed decisions, whilst seeing and assessing as much as the market as possible. Despite this, they still see the majority of their returns come from a small number of investments, with the rest falling by the wayside. But with these big winners come outsized returns overall.
Knowing this, if you’ve invested directly in a startup, don’t be shocked or upset if the startup doesn’t make you any returns – it also happens to the best.
If you’ve invested in a venture capital fund via Sprout, and you see an update that one of their companies has gone into administration, and not returned much or any money to the fund, that’s ok, it’s all part of the Power Law.