Power Law in Venture Capital: Why Portfolios Matter
Many individual investors and family offices say that they don’t like the venture capital asset class because they have tried it before and it did not go well. However, when you go deeper into the conversation, they say that they’ve done direct investments in one or two startups and that those particular companies failed. I do not believe that this argument is either fair or correct.
There are many sources of information out there with different numbers, but I am comfortable assuming that approximately 90% of startups fail. When startups raise capital from institutional investors, after going through a deep due diligence process, receiving capital and becoming institutional, that number is reduced to approximately 50%. Half of the companies that receive venture capital fail! Given this risk, the potential upside must compensate the potential losses. Startup investing follows a power law curve:
This graph represents a ten company portfolio, where five companies fail and return zero, three companies return 10% of the total returns, one company returns 30% and the other company returns 40% of the total returns. In a portfolio of startups we know that we will have losers, but our winners have to be so big that they compensate for the losses. In DILA, we believe the winners should give us at least 10 times our capital invested.
So, we know that the distribution of returns when investing in startups is not normal, but rather skewed, where very few of our investments will return a large percentage of the fund’s returns. But, a priori, we do not know which companies will be successful and which wont. We believe they will all be successful. With this said, all of our investments have to have the capacity and probability of being the winners. All of our investments have to have the potential of giving us 10X the capital we invested, all of our investments have to be able to return the entire fund.
But, as I have explained, only some of the companies in a portfolio will be the winners, the bulk will be losers. So, what happens if you only invest in one or two startups? Well, you could be very lucky and have chosen one of the winners, but the odds are not on your side. The probability of randomly investing in one of the losers is high, it’s a flip of a coin. It doesn’t matter how much you believe in the team or the size of the market or the tremendous technology the company is developing, it does not matter how much you diligence the opportunity and it does not matter how much you will help the company out: venture capital firms do this for all their portfolio companies (at least good VCs do) and still 50% of the companies we invest in will lose some or all of the capital we invested.
To sum all of this up, investing in startups is extremely risky, but only when we analyze the risk from a deal by deal perspective. When we analyze the risk from a portfolio standpoint, it becomes more balanced and fair. So, here is my advice to all of you interested in investing in startups:
1) If you are investing in one particular startup, understand the risk you are taking. This company is likely to fail, but if it succeeds it could give you extraordinary returns. It is not fair to criticize startup investing because one of your investments did not work out.
2) If you are an angel investor, make sure to invest in a portfolio of companies and study portfolio theory and capital contribution within your portfolio. Remember that when investing in a portfolio of companies, the particular returns of companies (high or low) do not matter, it is the sum of the returns that make a difference.
3) If you are interested in investing in startups but do not have the time to source deals, analyze investment opportunities and create a strategy around the power law distribution in this asset class, then become an investor in a venture capital firm. We get paid to do that job for you!
If you are reading this and are interested in investing in startups, please comment below, contact me via Twitter @adiezbarroso or email me: firstname.lastname@example.org