{"id":10526,"date":"2020-07-04T22:33:00","date_gmt":"2020-07-05T02:33:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=10526"},"modified":"2020-07-10T21:59:04","modified_gmt":"2020-07-11T01:59:04","slug":"how-does-venture-capital-work","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/how-does-venture-capital-work\/","title":{"rendered":"How Does Venture Capital Work? Peter Thiel’s Secrets"},"content":{"rendered":"\n

How does venture capital work, and what does the Pareto law have to do with it?<\/p>\n\n\n\n

When you ask, “How does venture capital work?”, the answer is complicated. But one element of venture capitalism<\/a> is using the Pareto law, or power law. <\/p>\n\n\n\n\n\n\n\n

How Does Venture Capital Work?<\/strong><\/h2>\n\n\n\n

How does venture capital work? Venture capitalists search out promising tech startups to invest in for a share of the profits. While many of them don\u2019t fully understand it, the power law<\/a> greatly influences their results.<\/p>\n\n\n\n

If companies in a venture fund portfolio gain value and go public or are sold to larger companies, the venture fund makes money. However, a venture fund typically loses money at first because most of the companies in its portfolio fail soon after starting. The investors hope the fund\u2019s value will shoot up in a few years when the most successful startups experience exponential growth and scale up.<\/p>\n\n\n\n

They try to identify companies that will excel, while hedging their bets\u2014which is a mistake. They expect portfolio returns to be normally distributed, with good companies returning two to four times value, average ones remaining flat and some failing. So they aim for a diverse portfolio, which usually fails. <\/p>\n\n\n\n

This approach fails because, in reality,<\/strong> venture returns follow a power law: a very small number of companies far surpass all others combined. <\/strong>For your portfolio to succeed, you need to focus on finding those few companies that will be standout performers rather than focusing on diversification. For example, Facebook, the most successful company in Thiel\u2019s Founders Fund, returned more than everything else in the portfolio combined. Palantir, the second-most successful investment in the fund, was set in 2005 to return more than all of the others combined excluding Facebook. You need to understand the secrets of funding to know how venture capital works. <\/p>\n\n\n\n

The secret in venture funding is that the top investment equals or exceeds the rest of the fund combined. This means you should invest only<\/em> in startups with the potential to return the value of the whole fund<\/strong>\u2014which of course eliminates most potential investments.<\/p>\n\n\n\n

You still need a portfolio because there are no guarantees. But every company in your portfolio should have extraordinary potential. Find a very small number of companies likely to go from 0 to 1\u2014and back them to the hilt.<\/p>\n\n\n\n

When you stop looking for substance and focus on whether a company fits your diversification strategy, your process is akin to buying lottery tickets and you\u2019re setting yourself up to lose.<\/p>\n\n\n\n

Missing the Pattern<\/strong><\/h3>\n\n\n\n

Venture capitalists often don\u2019t see the power law pattern because they fixate on the present, while the pattern develops over time. Knowing how venture capital works can help you successfully find patterns. <\/p>\n\n\n\n

For example, if you invest in ten startups (too many) with monopoly potential, their early returns will look similar. Their values will start to vary from each other over a few years but overall fund growth will still look linear. However, after about 10 years, one investment will shoot up, far exceeding everything else. Power law distributions<\/a> were there all along, unnoticed.<\/p>\n\n\n\n

Investors aren\u2019t alone in not seeing the power law when it comes to startups\u2014everyone else does too. This is part of how venture capital works. <\/p>\n\n\n\n

For example, when most people think of venture capital, they imagine small, off-beat companies like those on ABC TV\u2019s Shark Tank. But they miss seeing the huge overall impact venture capital has on the economy. While less than 1% of the new businesses starting annually get venture funding and venture funding accounts for less than 0.2% of GDP, this funding has a disproportionate impact. Venture fund companies create 11% of private-sector jobs; their combined annual revenue is equivalent to 21% of GDP.<\/p>\n\n\n\n

The Power Law in Life<\/strong><\/h3>\n\n\n\n

Everyone should be aware of the power law\u2014a minority of effort leads to a majority of results\u2014because we\u2019re all investors.<\/strong><\/p>\n\n\n\n