3.1 - The Power Law in VC - VC Lab (2024)

The Power Law in venture capital (VC) is a principle where one single investment yields returns larger than all other investments combined, often by orders of magnitude. The entire global venture capital industry’s success often hinges on a few companies that rise to prominence, overshadowing their peers and redefining markets. This article delves deep into the origins, implications, and strategies surrounding the Power Law in venture capital.

The Power Law

The Power Law concept originated in the late 19th century with the work of Vilfredo Pareto, an Italian economist and sociologist. Pareto noticed that 20% of the pea pods in his garden produced 80% of the peas. He extended this observation to wealth distribution in society, noting that 80% of the land in Italy was owned by 20% of the population. This 80-20 rule, later termed the Pareto Principle, laid the foundation for the Power Law.

Over the years, the Pareto Principle evolved into the Power Law through its application in various fields. While Pareto initially observed the 80-20 rule in economic disparities, this principle soon found relevance in other areas. It was noted that in many creative endeavors, a small number of works or individuals often overshadowed the rest. For instance, a few bestselling authors sell more books than all other writers combined, or a handful of artists have more listeners than the rest of the musicians. This pattern, where one element dominates all others, became known as the Power Law. It is now recognized as a fundamental principle in fields ranging from economics and sociology to physics and venture capital, shaping our understanding of how success and influence are distributed.

Today, the Power Law is a fundamental principle in venture capital, shaping the way investments are made and portfolios are constructed. It has become an accepted truth that a small number of investments will yield returns far greater than the rest, often exceeding them combined. This understanding of the Power Law guides VCs in their search for the next breakout success, the one investment that will validate and overshadow all others. The Power Law, thus, continues to be a driving force in the high-stakes, high-reward world of venture capital.

Example

Consider a VC fund that has invested in 10 startups. According to the Power Law, if one startup, say Startup A, becomes a unicorn (valued over $1 billion), the returns from this single investment will exceed the combined returns of the remaining nine startups. Even if the other startups perform well, the success of Startup A, as dictated by the Power Law, would dominate the fund’s overall returns.

The Power Law in Action

The Power Law is clearly visible in the world of startups, particularly in the tech industry. Companies like eBay and Google are prime examples. Both started as small ventures but rapidly grew to dominate their respective markets.

eBay, founded in 1995, revolutionized the online marketplace, becoming a platform where anyone could buy or sell goods. Its growth was exponential, and it quickly overshadowed other online marketplaces. Similarly, Google, launched in 1998, rose to dominate the search engine market, outperforming competitors and becoming a household name.

The success stories of companies like eBay and Google have significant implications for venture capital. For VCs, these companies represent the ideal manifestation of the Power Law. An early investment in such startups can yield returns that far exceed the combined returns of all other investments in a portfolio.

This potential for outsized returns from a single investment is what makes the Power Law so influential in venture capital. It encourages VCs to seek out and invest in high-risk, high-reward startups that have the potential to become the next eBay or Google.

A VC making smart investments is likely to witness the Power Law in action within a single fund. The success of one or two startups can significantly skew the fund’s return distribution, leading to outsized returns. The Power Law also holds across multiple funds. A VC firm with several funds may see a single investment from one fund outperforming all investments across its portfolio.

How to Seek the Power Law

Venture capitalists and investors are always on the hunt for opportunities that embody the Power Law. To identify such opportunities, it’s essential to understand the typical characteristics of startups and markets that align with the Power Law:

• Blue Ocean Deals: Seek opportunities in untapped markets where competition is minimal or non existent, allowing for rapid growth and dominance.
• Enormous Potential Markets: Focus on ventures that, if successful, could tap into vast markets that are yet to be proven but have the potential to be massive.
• Avoid Established Incumbents: Steer clear of markets where established players are already experiencing massive growth. The Power Law is less likely to manifest here.
• Novelty and Uniqueness: Look for companies that seem out of the ordinary or operate without any apparent past or present competition. Their uniqueness can be a sign of untapped potential.
• Strong Early Adoption: Companies that show robust growth in their early stages, even without a clear market, often have the makings of a Power Law success.
• Leap of Faith: Sometimes, the best opportunities require investors to suspend their disbelief and take a leap of faith, trusting in the vision of the founders.

Remember, sometimes the most unconventional ideas turn out to be the most lucrative. The world didn’t know it wanted cars; they wanted faster horses. Yet today, the automobile industry is worth trillions, while horses, though cherished, are mostly a pastime. Seeking the Power Law means being open to such paradigm shifts and recognizing potential where others might not.

Implications of the Power Law

Modern venture capital operates with the Power Law at its core. The entire industry’s foundation is built around the idea that a few standout companies can drive the success of the entire venture capital sector worldwide. Funds meticulously craft their portfolio strategies, all in pursuit of that one startup that embodies the Power Law. However, it’s worth noting that not all venture capital firms strike gold. Those that don’t experience a Power Law success in their portfolio might be grappling with a flawed strategy, subpar management, or sheer misfortune.

The Power Law’s influence in venture capital is undeniable, and it brings with it both opportunities and challenges. Recognizing these can be pivotal for venture capitalists as they navigate the high-stakes world of startup investments.

Pros

• Massive Returns from One Company: A single breakout success can deliver returns that overshadow the combined performance of all other investments.
• Early Signals of Success: The Power Law often provides early indicators of success in traction, recruiting, customer engagement, helping VCs make good investment decisions.
• Winner Takes All: This phenomenon leads to industry consolidation, presenting opportunities for smaller players to be bought or acquired.

Cons

• Market Dominance: Once a company establishes itself as the leader, it becomes challenging for others to compete.
• High Capital Requirements: The leading company, while successful, often demands significant capital to scale and maintain its position.
• Fierce Competition: The race to invest in potential breakout startups can be intense, with multiple VCs vying for a piece of the pie.

The Power Law is responsible for the failure of many startups, as well as the success of a small few, so understanding its intricacies offers venture investors a distinct advantage. This knowledge becomes a competitive edge, especially when sourcing and finalizing deals.

Conclusion

The Power Law, with its promise of outsized returns, has become the North Star for venture capitalists worldwide. It underscores the essence of venture capital: the pursuit of that one breakout success amidst a sea of potential. While it presents challenges and necessitates a high-risk appetite, the rewards it offers are unparalleled. As the world of startups continues to evolve, the Power Law remains a testament to the transformative power of innovation and the relentless quest for the next big thing.

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