“Power Laws Rule Everything Around Me:” Distribution of Venture Capital Returns
reactionwheel.net/2015/06/power-laws-in-venture.html
(With a quote from a16z.com/2014/07/21/a-dozen-things-ive-learned-from-marc-andreessen/)
In this article, Jerry Neumann looks at one of the reasons why venture capital (VC) is such a challenging industry to succeed in. Many prominent entrepreneurs and venture capitalists assert that VC returns are distributed according to a power law. As Marc Andreessen of Andreessen Horowitz points out, each year, of the 4,000 technology startups seeking VC funding, only 200 are seriously fundable, with “15 of those generating 95% of all economic returns…even the top VCs write off half their deals.” Similarly, notable entrepreneur and investor Peter Thiel remarks that, “Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal…In reality you get a power law distribution.” Neumann addresses whether this is really the case, and what the implications of a power law distribution might be for venture capital?
As discussed in class, a major feature of power law distributions is that small outcomes are very likely while larger ones are less likely. Power laws also exhibit “fat tails,” while the area under the curve for a normal distribution falls off much quicker the farther right you go on the x-axis. As Andreessen mentioned earlier, VCs often write off as many as half of their investments. This is because historically, most investments will return very little or even lose money. Many still return some multiple on initial investment, but it is the very small handful that return an outcome well outside what could be expected in a normal distribution that compensate for losses and also generate most of a portfolio’s returns. This final point exhibits the idea of “fat tails.” Portfolios are constructed around the idea that these unlikely, but high value, outcomes will drive the returns of the portfolio even in light of small-to-negative returns being the highest probability outcome of companies within the portfolio.