Vilfredo Pareto was an Italian polymath who when studying land records of Italy in the late 19th century found that 20% of individuals owned 80% of the land. It was a fascinating insight because it quantified the concentration of wealth. Economists call this unequal distribution of wealth the Pareto Principle or 80/20 rule in honour of Vilfredo.
The Pareto Principle explains the distribution in areas where randomness dominates results. Venture Capital, we call it Power Law. Power Law dictates that most of the returns come from a few investments. Thus, VCs are always chasing that 100x return or home run.
Suppose you decide to invest $1M in 100 early-stage startups. Since you don't know which bet will become 100x, you spread your investments equally. You decide to invest $10K in each company.
You strike gold and make a 10x return in 10 years. Your $1M is now worth $10M. This is an excellent return (26% IRR). It puts you in the top 5% of the VC universe.
But let's assume your returns follow this 80/20 distribution. Thus, $8M of your $10M came from 20 investments. The remaining 80 investments give you just $2M.
Is this $8M equally distributed amongst your top 20 investments?
Your 20 successful bets resulted in $8M. But this doesn't mean each investment was equally successful and made $400K ($8M/20) on a $10K original investment or a 40x return.
These 20 successful investments also follow this 80/20 rule. 20% (4 out of 20) of investments gave you 80% ($6.4M out of $8M) of money.
100 investments = $10M
20 investments = $8M
4 investments = $6.4M
0.8 investment = $5.12M
Since we can't have a 0.8 investment, let's round it to 1. So, 50% of returns came from just one investment. One $10K bet led to a $5M payoff (500x return). If we remove this one home run from your sample, your 99 investments ($990K) become $5M in 10 years.
Your IRR drops from 26% to 17.6%, and your performance becomes merely good from exceptional. This is why one Google or Facebook can make or break the career of any fund manager.
We know power law dictates venture capital returns. But we don't know the coefficient of this power law.
Are venture capital distributions 80/20 or 70/30 or 90/10?
If we assume a 70/30 distribution, we get the following results.
100 investments = $10M
30 = $7M
9 = $4.9M
2.7 = $3.43M
0.81 = $2.4M
One (0.81) investment accounts for 24% ($2.4M out of $10M) of total returns. The inequality becomes lower. If we remove this outstanding bet from our sample, $990K (99 investments of $10K each) yield $7.6M in 10 years making our IRR 22.6%. This is a less extreme form of power law.
Our results will be much more skewed in a 90/10 distribution. One investment of $10K will fetch us a massive $8.1M return while the remaining 99 will give us just $1.9M and a tiny IRR of 6.7%.
How does Power Law affect Angel Syndicates?
Angel Syndicates are a group of individuals who invest in the early stages by pooling capital. The syndicate managers are called GPs, while the members who invest capital are known as LPs. You will be an LP if you join a syndicate. Angel Syndicates are different from VC funds because LPs don't commit capital in syndicates as they do in VC funds. Syndicate LPs invest money in individual deals while VC fund LPs invest in a fund that in turn invests in different deals.
The best GPs are experienced investors who get the best deals because of their network and track record. Most syndicates invest between $100-500K in Seed or Pre-Series A rounds in India.
Because GPs spend a lot of time evaluating startups and negotiating terms, they take a share in profit from all successful investments. This profit share is called Carry and varies between 10 and 20%.
How do LPs make money when they invest through syndicates?
Suppose you are an LP who wants to invest $100K in startups. You decide to invest $5K in 20 deals.
After four years,
A) Ten busts (Capital lost, Zero return)
Total return = 0
Profit = 0
GP's share =0
LP's share = 0
B) Three break-evens (1x – Returned capital)
Total return = $5K x 3 x 1x = $15K
Profit = Total return – Initial investment = $15K–$15K = 0
GP's share =0
LP's share = Total return – GP's share = $15K + 0 – 0 = $15K
C) Three moderate returns (3x)
Total return = $5K x 3 x 3x = $45K
Profit = Total return – Initial investment = $45K–$15K = $30K
GP's share = 20% of Profit = 20% x $30K = $6K
LP's share = Total return – GP's share = $45K – $6K = $39K
D) Three good returns (5x)
Total return = $5K x 3 x 5x = $75K
Profit = Total return – Initial investment = $75K–$1
5K = $60K
GP's share = 20% of Profit = 20% x $60K = $12K
LP's share = Total return – GP's share = $75K – $12K = $63K
E) One outstanding success (25x)
Total return = $5K x 1 x 25x = $125K
Profit = Total return – Initial investment = $125K–$5K = $120K
GP's share = 20% of Profit = 20% x $120K = $24K
LP's share = Total return – GP's share = $125K – $24K = $101K
In VC power law, a lion's share of return comes from a small number of deals while most investments fail to return capital.
What is the LP's final return on his $100K investment?
0 + $15K + $39K + $63K + $101K = $218K
The LP made a 118% return on his $100K investment in 4 years. This translates to a 2.18x Multiple on Invested Capital (MOIC) which is the common metric investors use to calculate returns in the Venture Capital industry.
How much money did the GP make in fees? 0 + 0 + $6k + $12K + $24K = $42K
This is quite a tidy sum for his efforts. But remember, GPs make money only if the LPs make money. Their incentives are aligned with that of LPs.
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