Some of functionality may not work while you disabled JavaScript. Enable JavaScript for better User Exprience.
Access here alternative investment news about Trusted Insight's 4 Laws Of Venture Capital
Venture Capital

Trusted Insight's 4 Laws Of Venture Capital

by trusted insight posted 8months ago 2152 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.
Please contact if you have any questions or would like to discuss this piece further.

Important Disclosures
This blog is for informational and educational purposes only. Nothing in this blog constitutes investment, legal or tax advice. This blog is not intended to constitute any offer or solicitation to buy or sell securities. Offers of securities or investment advisory services may be made only pursuant to appropriate offering or other disclosure documents, and only after prospective investors have had the opportunity to discuss all matters concerning the prospective investment or engagement with their adviser and the issuers of the securities. In addition, neither TI Platform Fund I GP, LLC nor any of its affiliated entities (collectively, “Trusted Insight”) may offer interests in any of its unregistered funds or accept subscriptions from any potential investors with whom it has no prior or existing relationship until the expiration of a 30-day “cooling off” period with each potential investor, respectively.

This blog is not an offer to sell, or solicitation of offers to buy, securities. Investments in a private fund can be made only pursuant to such fund’s subscription documents and private placement memorandum and only after careful consideration of the risk factors set forth therein. Non-private fund investment advice shall be provided in accordance with the investment management agreement. Investments entail significant risks and are suitable only for certain investors as part of an overall diversified investment strategy and only for investors able to withstand a total loss of investment. Investment advice offered by Trusted Insight is typically available only to investors who meet statutory qualifications as promulgated under the Investment Advisers Act of 1940 and the Securities Act. In addition, there can be no assurance that current investments will be realized as projected. Actual realized returns will depend on, among other factors, future operating results, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing and manner of sale, all of which may differ from the assumptions on which the information contained herein is based. It should not be assumed that any issuers described herein were or will be profitable. Forward-looking statements involve known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples and should bear in mind that past performance is not necessarily indicative of future results. Neither Trusted Insight nor any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were originally made. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Information included herein does not constitute investment advice and should not be viewed as a current or past recommendation to buy or sell any securities or to adopt any investment strategy.

This blog is not to be distributed or disseminated without the prior written consent of Trusted Insight. This blog and any of the content therein is the sole and exclusive property of Trusted Insight. Nothing in this communication nor the contents of this blog are intended to imply that such investments may be considered “conservative”, “safe”, “risk-free” or “risk averse.” It should be noted that past performance is not indicative of future results.

In this article