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Trusted Insight's 4 Laws Of Venture Capital

by trusted insight posted 4years ago 2769 views
Selecting venture capital managers is a challenging task, even for the most sophisticated institutional investors. The difficulty arises from the misconception that venture capital and private equity have the same market dynamics. In reality, the physics of venture capital are radically different from any other asset class.
In Trusted Insight’s analysis of the venture capital environment, we identified four laws that govern venture capital:
Law 1 - Power Law Distributions
Only a small number of startups generate positive returns. Of these companies, only a few deliver outsized returns. This applies at the company level, industry level, fund portfolio level and the individual track record level. Due to this fact, venture capital returns follow a power law distribution, where returns are disproportionately skewed toward negative values.
Notable exits, such as Facebook, LinkedIn and Snap Inc., generated immense returns for investors. The top five return-generating companies are worth more than the value created by the next 95 companies combined.
Ninety percent of venture capital returns are generated from less than 10 percent of the total capital invested, even when funds have multiple winners. For example, Accel Partners V’s winners were Foundry Networks and Redback Networks, but these companies only represented 8 percent of the total capital invested. In Peter Thiel’s book, Zero to One, Thiel criticizes venture capital managers for spending too much time on portfolio “losers.” He advises spending time on a small handful of potential breakout winners. In order to identify these breakout winners, one must have a large portfolio of early-stage companies.
Law 2 - Type II Errors Kill VC Returns
Generally, in private equity, public equities and real estate, returns are normally distributed. In these asset classes, good managers have a low loss ratio because failed investments severely damage a fund’s total return in a normal distribution. These are Type I errors, or false positives.
Since venture capital returns follow a power law distribution, they are asymmetric. Good venture capital managers aren’t concerned with their win-to-loss ratio. Instead, the managers that excel rely on breakout companies that achieve outsized success, which lead to a positive fund performance. Thus, venture capital managers should be assessed on the number of breakout companies in which they invest, not necessarily the fund’s loss ratio.
The failure to detect and invest in these breakout companies leads to greater damage to fund performance. These are Type II errors, or false negatives.
Brand names and no names alike commit Type II errors. Firms like Bessemer Venture Partners go as far as to highlight its mistake in its “anti-portfolio.” Some of Bessemer’s notable missteps include Facebook, Tesla and PayPal.
While Warren Buffett famously said, “[In Investing] you don’t have to swing at every pitch,” venture capital and its power law distribution challenge this thinking. Type II errors, the failure to invest in a breakout company, can change the fortune of a venture fund.
Law 3 - The Security Picks The Manager
In public markets, asset managers select the security they desire. In venture capital, the desired security (breakout startups and founders) pick the managers they want as investors.
In venture, promising startups and founders have access to a large pool of capital and exceptional veteran advice from managers. This means that startups have leverage at the bargaining table with venture capital managers. Managers are able to invest if the founders chose to let them in. Thus, managers have to provide value-add beyond capital.
Venture capital firms, accelerators and incubator programs rely on reputation to attract top prospect startups. Y Combinator -- which accelerated unicorns such as Airbnb ($31 billion valuation as of March 9, 2017) and Stripe ($9.2 billion valuation as of November 25, 2016), heavily relies on its reputation. The accelerator has access to a massive network of Silicon Valley leaders, VCs and CEOs of alumni portfolio companies. Its network is the value-add to current portfolio companies.
Law 4 - Any Investment Must Return The Entire Fund
The majority of fund portfolio companies will fail or produce meager returns. Thus, the focus should be on breakout companies in a portfolio that will return the entire fund. If a venture capital manager believes that a company does not have the potential to return the entire fund, the investment should not be pursued.
The four laws of venture capital are crucial to a manager’s success.
1. Returns follow a power law distribution
2. Type II errors kill returns
3. Securities pick the manager
4. Any investment must return the entire fund
These laws should be given serious consideration when managers invest in companies or institutional investors invest in funds in the venture capital world. Failure to do so will almost guarantee an unsatisfactory risk/return profile.
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