POWER LAW
“Power and the money, money and the power
Minute after minute, hour after hour”
Gangsters Paradise - Coolio
The Power Law distribution is a mathematical relationship between two magnitudes. Returns on Venture Capital investments behave more as a mathematical relationship between two magnitudes rather than as an average of a company’s performance.
Here’s a bit of context:
We live in a world of normal distributions. We believe and trust that the majority of the phenomenons we know, and face, follow this distribution.
Most likely, if you are reading this blog, you’re familiar with the Gaussian Bell. If it is not because you studied statistics at some point of life, it is because that’s the way your teacher graded - grading on a curve. Most values tend to fall in the center, and there might be some atypical values that fall outside the mean, outliers. In the classroom example, your classmates who broke the curve.
If you are Mexican, it is most likely that you measure around 1 meter with 65 centimeters and weigh almost 70 kilos. My friend Hector is 1 meter 90 centimeters tall and weighs around 90 kilos. He´s an outlier within the sample.
A normal distribution is something that we understand well and is called normal because it represents a large number of events in our lives, both physical and social.
When we talk about money and investments, people generally think and aim at having a good average. In fact, almost all financial advisors recommend that you have a diversified portfolio to achieve a positive average. However, this type of investment leaves out outliers. You don’t lose everything, nor does it make you a billionaire. The risk is moderate and the return is moderate.
Power Law vs Normal Distribution
“Venture Capital is all about the outliers” – Carlos Ochoa
Now, there are other processes and events that follow different distributions. For example, earthquakes do not have an average intensity nor does the frequency of names obey a normal distribution. The craters on the moon, for instance, follow a potential distribution.
When the probabilities that a certain event might occur, decline at a certain magnitude, they follow a potential distribution. That is, there are few super results, some decent results, and a high number of bad results.
Venture Capital behaves like this.
And because of this, Venture Capital is the investment that allows extraordinary results.
Here are some real-life numbers. The companies that paid-out the most to investors from 2009 to 2014 curiously behaved like a potential graph. Our outlier was Facebook, followed by WhatsApp and a bunch of others that got nowhere near Facebook's 104 billion.
Power Law startups graph - Top 100 V.C.-backed exits
Let's talk about Facebook (like!)
Peter Thiel was Facebook’s first external investor. In 2004, he invested 500 thousand dollars in the company and, 8 years later, he had profits of 400 million. Thanks to his first and subsequent investments, he obtained a little more than 1.2 billion dollars.
Although Facebook is the undisputed winner of investments before 2010, since then we have had several examples of exponential growth. In 2014, WhatsApp, with only a team of 19 people, was acquired for the outrageous amount of 22 billion. And so, as with many other Silicon Valley success stories, early investors also generated outrageous returns.
In 2011, Sequoia Capital invested 7 million dollars when WhatsApp was probably valued at 30 or 40 million. In 2013, they invested 50 million more, valuing WhatsApp at 1.2 billion. At that time, half the world thought it was a bad investment. Two years later, in 2014, the company was acquired for 22 billion.
In three years, Sequoia probably received a 733 multiple (rule of three) from their 2011 WhatsApp investment. Meaning that, if in 2011, Sequoia had asked you for a 100 thousand dollars and had invested it in WhatsApp, 3 years later they would have returned 73.3 million. Not bad at all!
That is what we aim for with a venture capital investment. Yes, the risk is high, but the returns are spectacular.
Venture Capital is all about outliers. Companies that can grow at a speed that ordinary companies can't, teams that build high-quality technology at a pace that's off the charts, and founders who understand the target market like few people do.
Of course, most companies don’t make it. Many die and many become zombies (companies that continue to exist, but do not grow and are not sold). And so, we invest in the companies that we think can generate these extraordinary returns. We do not seek to improve the average; we seek returns of at least 160 times over and when those returns are nowhere to be seen, we simply pass. Sometimes, these companies we let go will do well, they will generate profits, they will pay some dividend, but they most likely will not belong to the club of mythical unicorns.
The power law will strike again, which of these unicorns do you believe will be on the left side of the graph? Place your bets. My picks are: Palantir (the unfulfilled future of Sm4rt Predictive), Twillio (where my heart is), and Uber (for helping me understand what Venture Capital is all about).
What curve are you on?
Carlos - @CarlosOchoaVC
All the best from the bay,
Alpha Impact 8 - @AlphaImpact8
www.alphaimpact8.com
Sources:
VentureBeat, Wikipedia, Crunchbase & CBinsights