The Power Law in Venture Capital

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We’ve touched on it briefly before but felt this particular topic deserved its own post. We’re talking about the Power Law (insert dramatic intro music). The Power Law is a principle where a single investment will yield greater returns than all other investments combined, and often by a LOT. This phenomenon is a well known and defining characteristic of VC, where success is expected from only a few breakout companies that completely eclipse their peers to redefine, or even create, entire markets.

The concept originated back in the late 19th century with a man named Vilfredo Pareto. Pareto, an economist and sociologist, noticed that 20% of the pea pods in his garden produced 80% of the peas. He eventually 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 was later termed the Pareto Principle and it laid the foundation for what we now know in VC as “the Power Law”.

The Pareto Principle can be observed in a large number of fields. For example: a small number of bestselling authors sell more books than all other writers combined, a handful of Spotify artists have more listeners than all other Spotify artists, or only a small number of movies produced will dominate box office earnings.

The Power Law dictates that a small number of investments will yield returns far greater than the rest. The one investment that will validate and overshadow all others. For better or worse, this principle guides VCs in their quest to find the next breakout successes and it’s often a career defining moment for the VC who underwrote the deal.

To illustrate just how the Power Law in VC works, here’s an example:

Let’s imagine a VC firm invests €10 million across 10 startups, with €1 million invested in each.

• Startups 1-6: Fail and return nothing.

• Startups 7-9: Perform modestly, returning €2 million each.

• Startup 10: Becomes a unicorn, valued at €1 billion. The VC’s share is worth €100 million.

Investment Breakdown:

• Total Initial Investment: €10 million

• Returns from Startups 1-6: €0

• Returns from Startups 7-9: €6 million (€2 million x 3)

• Return from Startup 10: €100 million

Total Returns: €106 million.

This is a simple example but it perfectly illustrates how VC works. Startup 10 was responsible for more than 90% of the fund's overall returns. Remove that outlier from the portfolio and the fund managers are making a very different phone call to their Limited Partners.

We’ve said it in many of our previous posts but diversification is critical to achieving returns in VC and the Power Law reinforces this. You want as many “shots on goal” as possible to increase your odds of hitting one of these outlier companies. Sure, you might get lucky and hit one without diversifying but if that’s your strategy, you might be better off just buying lottery tickets…

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The Unsophisticated Investor is brought to you by Scott & Rob, the founders of PitchedIt. We’re both sick of private markets being a playground exclusive to the ultra-wealthy so we started a company to challenge the status-quo. PitchedIt’s singular focus is to unlock private markets for Millennial and Gen Z retail investors and help them build wealth through the highest performing private market opportunities.

Scott & Rob
PitchedIt Co-Founders