Co-Founder & General Partner l SucSEED Indovation l SucSEED Angels Network l Early-stage VC l TiE Charter Member I Empaneled Independent Director I Transaction Lawyer l Angel Investor
Power Law in Venture Capital When Vilfredo Pareto conceived “the Power Law” concept in the late 19th century, little did he realise that over the years it will become the fundamental principle in venture capital industry, shaping the way investments are made and portfolios are constructed. Mr. 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. For a VC, the Power Law means that only a few of its portfolio companies (say 20%) will generate vast majority of returns and most of the portfolio companies will fail. The Power Law continues to be a driving force for the VCs worldwide in their search for the one investment that will validate and overshadow all others. For example, in a VC portfolio of says 25 companies with total investment of ₹100 Crore, if the targeted return is say 3X, which means that the Fund has to generate ₹300 Crore, a bulk of that ₹300 Crore would come from 5-6 companies (20% of 25 portfolio companies), 8-10 companies will fetch only a decent return and rest all companies will fail. I was looking at a report of PitchBook which evaluated the DPI performance of 1500 VC Funds globally (vintages 1976-2014) (see the picture attached) and it reports: 💰 For $0- $100Mn funds, 12% of their portfolio gave >3X return, 10% of the portfolio gave 2X-3X return and 47% of the portfolio gave <1X return 💰 For $101Mn- $250Mn funds, 12% of their portfolio gave >3X return and 12% gave 2X-3X return. 💰 For $251Mn- $500Mn funds, only 6% of the portfolio gave >3X return and 12% gave 2X-3X return. 💰 However, for funds >$500Mn, only 2% of the portfolio gave >3X return and 14% gave 2X-3X return. For those VCs who did not have a Power Law success in their portfolio might have a flawed strategy or it's a sheer misfortune. 💡 However, Power Law assumes that the Fund has almost equal distribution of fund corpus among portfolio companies, otherwise it becomes inadequate and unequal distribution which does not fetch these returns! That is why it is important for the VCs to meticulously craft their portfolio strategies, all in pursuit of that one startup that embodies the Power Law! Will write about how a VC should structure its ideal portfolio next time 😎 ------------------------------------------------------------------ ♻️ If you found this post helpful, please repost it so your network can also learn from it. #venturecapital #investing #powerlaw #funds #investment #VC #startup #portfolio