Originating from Vilfredo Pareto’s observation in the late 19th century, The Power Law is a statistical principle that states that a small number of events will have a disproportionately large impact. In the VC industry, this is reflected in the fact that a small number of startups generate the majority of returns for a fund.
Venture capital is a high-risk, high-reward investment asset that involves funding early-stage businesses. This means that venture capitalists must be very selective in their investments, trying to focus on finding the small number of startups that have the potential to be unicorns.
The Power Law has been around for centuries, but it was not until the advent of Venture Capital that its significance in the startup world was fully appreciated as it reflects why the majority of venture capital investments will fail.
Despite the challenges, the Power Law also creates opportunities for venture capitalists. By investing in the right startups, they can generate significant returns.
Here are some actions that a venture capitalist can take to maximize the upsides and minimize the downsides of the Power Law:
- Focus on finding the best deals: VCs should focus their efforts on finding the startups with the highest potential, even if it means investing in fewer startups (move away from spray and pray ‼️).
- Be patient: It can take many years for a startup to achieve unicorn status. VCs should be patient and not expect to see returns overnight. it includes building relationships with founders and not skipping Due Diligence stages (you’ll bump on some SBFs ⚠️).
- Diversify the portfolio: Investing in a variety of startups can help to reduce the risk of failures.
- Have a clear exit strategy: A clear exit strategy for each investment will help to maximize returns when the time comes to sell the stake in the company.
The power law is a complex and essential concept in Venture Capital. By understanding it, venture capitalists can improve their chances of success.