Venture capital is a power law business: most of the underlying investments fail¹ while a tiny fraction generate the bulk of returns. This is in contrast to normal distributions where most outcomes cluster around some central value.²
The chart below — which roughly follows a power law distribution — shows that most investments (65% of companies) don’t work out but a few (4% of companies) can generate 10 to 50 times your money or more.
Moreover when you look at fund-level performance, you find that it’s that very small number of investments that drive aggregate fund returns. This can be seen in data from Horsley Bridge — a limited partner in A16Z and other funds — which found that 6% of investments generated 60% of fund returns.
But why exactly do venture capital fund returns (and the underlying entrepreneurial ventures) follow a power law distribution? What leads a tiny minority to significantly outperform the overwhelming majority? And when you understand power law drivers, can you tilt the odds in your favour?
To answer these questions I spent a few evenings and weekends scouring academic literature on power laws. Admittedly some of the maths involved is beyond me, but I did pick up on 3 possible power law drivers that are worth internalising when starting a business or investing in startups.
Power Law Drivers in Entrepreneurship and Venture Capital
(1) Preferential Attachment
This power law mechanism is commonly expressed in the maxim ‘the rich get richer’. Or if you’re religiously inclined, the Bible says ‘for whoever has, more will be given to them.’
Academics call this phenomenon preferential attachment (or cumulative advantage). It’s when an initial endowment makes subsequent gains more likely. This leads to a privileged position where early wins lead to further benefits that cumulatively add up to an outsized advantage.
I’ve seen this privilege play out in my life in a small way. Getting my first book deal was a low probability event but once that door was open, getting the second, third, and fourth book contracts became more likely.
Preferential attachment isn’t always fair and it contributes to inequalities in the world that I won’t go into here. However, understanding it in the context of entrepreneurship and venture capital can inform strategy.
We see preferential attachment in entrepreneurship when an ex-Google engineer finds it easier to raise money and recruit talent for their startup because of their pedigree. We also see it in network effects, where each user added to a platform increases the likelihood that other users will flock to it.
Meanwhile in venture capital the best startups preferentially attach to funds which already have success in their portfolio. In other words, success begets more success and as Samir Kaji puts it: “One massive hit is often all it takes to “mint” an investor, regardless of how serendipitous the investment was.”
To benefit from preferential attachment, identify positive feedback loops in your field then look for ways to engineer them to your advantage.
(2) Self-organized Criticality
Despite the unusual name this power law driver is something you’re already familiar with. We see it in ‘overnight success’, which is actually an inaccurate description of something that’s so common in nature that theoretical physicists gave it a technical label 30+ years ago: ‘self-organized criticality’.
This power law mechanism is expressed in snow avalanches, neural networks in the brain, earth quakes, financial market crashes, and even social upheavals. It’s a process where lots of seemingly benign interactions in a complex system can ‘self-organise’ that system to a ‘critical’ state3 such that even the tiniest subsequent input can unexpectedly lead to dramatic change.
A useful analogy here is a pile of rice. If you build one by adding a few grains at a time, most of the grains don’t have much impact. But after a while, adding just one grain of rice can lead to an avalanche.
This is similar to overnight success. Except that even though the description suggests instant success from nowhere, most successful people make it only after years of metaphorically adding small grains of rice to a pile of effort.
In startups, getting to product-market-fit is a similar affair. Companies have to iterate continuously until something clicks so that the business can start to scale. Even in later years, those same businesses have to persevere before they can benefit from a step-change in growth.
One example I really like here is that of Microsoft when it was still a startup. In 1980 it secured a landmark contract to supply IBM with an operating system — an event that arguably changed the course of tech history.
However, this event didn’t pop into existence on its own. Lots of prior events had already placed Microsoft at a point of “criticality”. To name but a few:
- Bill Gates and Paul Allen had been writing and selling software for almost 10 years already and were well-suited to getting the job done.
- Among other reasons IBM had attracted decades of anti-trust investigations against it and to avoid further regulatory scrutiny, it accepted a non-exclusive contract with Microsoft.
The latter point meant that Microsoft was free to sell its software to other computer manufacturers and as PC hardware become commoditised, the business grew without restriction and saw its revenues balloon almost 10x, from $16m in 1981 to $140m in 1985.
Uneventful steps taken frequently can also lead to outsized outcomes in venture capital. Fred Wilson was writing and thinking about bitcoin for years before he met and invested in Coinbase. In fact he met the company because he was willing to persevere through a lengthy office hours session at Y Combinator with 16 startups across 4 hours of back-to-back pitches.
To benefit from self-organized criticality, play the long game and take heed of Seneca’s observation that “luck is what happens when preparation meets opportunity”. Or putting things more poetically:
“Chance can be on our side if we but stir it up with our energies, stay receptive to the glint of opportunity on even a single hair above the underbrush, and continually provoke it by individuality in our attitudes and approach to life.” — James H. Austin in Chase, Chance, and Creativity.
(3) Multiplicative Processes
Power laws also emerge when events are multiplicative instead of additive. One example is word-of-mouth. If you have a fantastic restaurant experience you don’t just tell one other person about it (which would be an additive process). You tell lots of friends who then go on to tell many others too.
Other examples of this process include population growth, the spread of viruses, and rapid wealth accumulation (getting rich through investing is a multiplicative process while building wealth through a salary is additive.)
Multiplicative processes are perhaps the simplest power law generator: a value is multiplied by some variable and the result is further multiplied by another variable. Repeat this process and you get exponential growth.
In startups, hiring a ‘10x employee’ is a multiplicative process. An elite performer can substantially change the trajectory of a business while most hires tend to be additive.⁴ For VCs, blogging is multiplicative networking. Ideas can spread faster online compared to offline 1–2–1 conversations.
To benefit from multiplicative processes, you have to identify and seek out multiplicative factors — much like preferential attachment — then look for ways to engineer them to your advantage.5
Engineering a Power Law Mindset
Outsized success is rare and takes just as much (if not more) in luck as it does effort to hit a home run. However, if we internalise how power laws work, we become better placed to tilt the odds in our favour by working not just harder, but also smarter.
Notes
[1] Businesses fail for a variety of reasons (e.g. team issues, lack of funding, creating products that people don’t need, competition and market timing.) But while building for the future is inherently unpredictable and hard, it’s worth remembering that..
“In any natural system, failure is the engine that causes growth, that causes new birth, that causes anything to happen. One of the truly big differences between growing economies and economies that stagnate is the acceptance of failure. If you don’t let forests burn, if you don’t let the old trees die out and the new trees grow, you don’t get a healthy forest. The ability to manage failure so that enterprises fail but people can still succeed becomes one of the tricks of how you build a society that can reinvent itself as the world changes.” — Shikhar Ghosh in the Harvard Business Review.
[2] In normal distributions most outcomes cluster around a central value. Human height is one example of this. Over two thirds of the population are close to average height while a minority are really short or really tall.
[3] A ‘critical state’ is typically a hypersensitive state between order and disorder (or vice-versa).
[4] Data from 5 studies covering 600,000+ professionals shows that performance in many domains isn’t normally distributed. A small portion of talent outperforms the majority by a significant margin. See examples below from this paper.
[5] eBay leveraged the Beanie Baby collectibles mania that run from 1996 to 1999 in order to grow faster. Brian McCullough provides a good historical account of this in his book.