We continue this series of blog posts outlining the ten lessons we’ve learned since launching our first fund in late 2020.
Last week we discussed the fact that to get truly outsized returns, an investor has to not only be right but run counter to the herd.
This week, we discuss the “Power Law,” and why the math dictates that funds like ours need to underwrite every individual investment to (potentially) achieve a 50x+ return.
Power Law
In any portfolio, it’s very typical that only a few companies will yield the majority of returns. Refer back to Economics 101 and the Pareto Principle (also known as the “80/20 Rule”). This effect is even more pronounced in venture capital.
This “Power Law” codifies this: a handful of investments in a portfolio (or fund) will deliver substantially all of a fund’s overall return. The implication is that most investments result in little or no profit.
This concept shapes how VCs operate, from their investment strategies to their risk tolerance and decision-making processes.
The Power Law drives the need to invest in companies that are addressing huge, painful problems, have a large total addressable market (TAM), and have business models with the potential to grow exponentially, not just incrementally.
Read on to understand why the power law is so important to VCs.
What business are we in?
A VC invests their Limited Partners’ (the investors) capital into a portfolio of companies through a 10-year investment vehicle called a “Fund.” The overarching goal is to deliver Alpha (above-average returns).
VCs measure many different KPIs, but the one goal is (and should be) to return a multiple of an investor’s capital back to them over the 10 year life of the fund (Pro Tip: if you’re able to return 4x “cash-on-cash” returns, you typically rank in top 25% of all fund managers, and you earn the right to raise your next fund).
Let’s say a typical fund invests in 25 companies. Experience shows that about 30% of these companies fail.
Extreme Outcomes Drive Returns
One or two companies in a VC fund's portfolio need to generate 50x returns to compensate for the many companies that fail or simply break even. The success of a VC fund largely depends on identifying and backing these rare "home-run" companies.
Risk Tolerance
The power law explains why VCs are willing to (and have to) take significant risks. The majority of startups in their portfolios will not generate meaningful returns, but VCs are comfortable with this because they expect that a few exceptional winners will make up for the losses. As a result, they embrace high-risk, high-reward opportunities, knowing that the potential upside justifies the risk. It's not about being right every time but about finding the few exceptional companies that will drive returns for the whole fund.
Focus on Scale
The power law encourages VCs to focus on investing in startups with the potential for massive scale, because only companies with outsized growth potential can provide the exponential returns needed to satisfy the power law's distribution. This is why VCs prioritize industries and business models with very large addressable markets, where there is the potential for rapid growth, network effects, and winner-take-all dynamics.
Portfolio Strategy
Given the Power Law, VCs need to build large, diversified portfolios to maximize their chances of hitting on one or more of these outsized winners. Each individual investment should have the potential to return the amount of the whole fund. Even though the majority of their investments may not succeed, having a broader portfolio increases the probability that one of their bets will follow the Power Law's long-tail distribution and deliver huge returns.
Valuation Discipline
The Power Law also influences how VCs approach valuations. Since they are seeking outsized returns, they must ensure that they invest at valuations that allow for significant upside. Overpaying for an investment can reduce the potential for a massive return even if the company succeeds. Therefore, VCs try to avoid overpaying for opportunities, no matter how attractive the company.
Implications for Automotive Ventures
For each fund we’re really looking for 3 deals that return 50x+ on each deal. Since our funds are each around $15 million in size, this equates to returning 2–4x the fund. The remaining 22 deals will likely return less than 20% of all returns. Early-stage venture capital is about extreme winners. To find the right 3 deals you need a lot of shots on goal.
Side note: we feel very fortunate to have several emerging companies in our portfolio that are on track to be home runs.
Conclusion
The power law is important to VCs because it defines the nature of venture capital returns, where a small number of big winners generate almost all the profits, while most investments fail or provide minimal returns. VCs structure their entire approach—risk tolerance, portfolio construction, focus on scale, and valuation discipline—around this reality, aiming to identify and support the rare companies that can achieve exponential success and dominate their markets.
Join us on the journey,
Steve Greenfield
