The Power Law

Picture of Mark Bühler

Mark Bühler

President Investment Club ZH

“Venture Capital is not even a home-run business. It’s a grand slam business.” – Bill Gurley

There is great value in studying the history of companies and industries. It allows you to understand how they evolved. A successful business model does not emerge fully formed at the time of a company’s inception. Instead, it results from countless decisions—both good and bad—made by individuals under unique circumstances. The same applies to industries, where established practices are shaped by historical developments. To truly understand a company or industry, it is essential to examine its history. This is exactly what Sebastian Mallaby’s “The Power Law (2022)” does for the fascinating world of venture capital.

Power Move

The concept of investing in promising but risky startups has been around for a long time. However, the modern venture capital (VC) firm structure originated in 1961 with the private limited partnership “Davis & Rock.” In the U.S., limited partnerships are exempt from taxes, allowing them to avoid double taxation on gains. As General Partners (GPs), Davis & Rock raised funds from outside investors known as Limited Partners (LPs). The LPs had limited liability since they didn’t participate in the firm’s business operations. To avoid regulatory restrictions, the number of LPs was kept below 100.

VC Fund Structure
Source: Author

The GPs contributed their own capital to the fund, and to encourage growth, they took a 20% share of the fund’s profits. Employees of the companies the VC firm invested in were typically granted around 10% of the equity to align their interests with those of the VC fund. The remaining 90% of a portfolio company was divided equally between the founders and the VC GPs.

Investing in low-profile startups is accompanied with its fair share of risks. “Davis & Rock” mitigated the risks by influencing a portfolio company’s strategy through their board seats and by backing only the most ambitious and high-growth companies. The rationale behind this is a central theme of the book: The Power Law, a skewed distribution in which the winners experience exponential growth. Even to this day, about 80% of a VC’s returns typically comes from less than 20% of their investments, with the successful investments themselves following the power law.

In venture capital, the biggest returns come from a small number of investments (blue curve). For late stage companies, the returns typically follow a curve resembling a normal distribution with a positive skew (orange curve). Source: Substack Ryan Shannon – Attempting to untangle the messy math behind the “Power Law”

Predicting whether a company would follow the power law was difficult to do quantitatively, making standard financial metrics like price-to-earnings and book value ineffective. Startups don’t usually generate profits in their first years of existence and their most valuable assets are often their employees. “Davis & Rock” therefore believed strongly in backing the right people, or as they referred to it, the intellectual book value. With their approach, they had tremendous success, closing the partnership in 1968, having multiplied the funds size from $3.4 million to $77 million, a 22.6x return.

Power Moves

Any successful new way of investing will quickly find imitators. Two of the newcomers in the 1970s, Sequoia Capital and Kleiner Perkins, pioneered the concept of hands-on activism and stage-by-stage finance. Sequoia, on one hand, originally part of the Capital Group and led by Don Valentine, was the first to raise capital from universities and endowments. This strategy ensured that Sequoia’s LPs had a long-term investment horizon and escaped regulation and capital gains tax thanks to the LPs’ charitable status.

One of their biggest and most significant investments was Atari, a company with erratic founders – known for holding meetings in a hot tub- believed to be unbackable. Atari’s chaotic culture stood in stark contrast to its impressive and innovative gaming products. Reassessing the company in terms of risks meant that Atari had business, marketing and leadership risks, however their technology risks were negligible. Valentine reduced these risks by actively engaging with the company and investing in stages, with each new phase of the progression dependent on the implementation of his strategic guidance and signs of success.

Atari founder Nolan Bushnell held meetings in a hot tub. Source: The Times

Kleiner Perkins, on the other hand, pioneered in-house startup incubation, essentially creating homegrown startups. They financed startups with daunting technology risks. The advantage of this approach was a path to market dominance if the technology risks were successfully overcome. To achieve this, they focused on identifying the “white-hot” risks within these startups and their projects. They used as little capital as possible to address and overcome these critical “white-hot” risks. Perkin’s Law stated that if technological risks could be overcome, commercial risks were modest.

One of Kleiner-Perkins greatest in-house successes was a recombinant DNA company named Genentech, now part of Roche Holding AG. To minimise the “white-hot” risks, Kleiner Perkins utilized the stage-by-stage financing technique. This strategy allowed the founders to retain more of their equity while also incentivizing the scientists and researchers, who held equity in the startup, to meet ambitious targets. Eventually, Genentech went public without generating profits, setting a precedent in VC history.

Another VC at the time, Sutter Hill Ventures, developed the Qume formula. The idea was to control risks through actively recruiting the CEO. This approach along with the trend of companies going public before reaching profitability, became a staple in the venture capital industry.

Collective Power Trumps The Individual

By the late 1970s, a significant amount of money was flowing into VC investments, spurred on by the success stories and the relaxation of capital gains taxes. What emerged from this influx of capital was an efficient network of Venture Capital firms and new industry dynamics.

At this time, a startup you might have heard of set out to disrupt the computer hardware market by developing the then-overlooked personal computer. What seems like a clear bet on the future today was initially passed over by several VC firms; however, rather than simply declining, these firms often referred the founders to their contacts they thought might be interested in investing or helping out.

This led the PC startup founders to Mike Markkula, who was possibly the first angel investor in Silicon Valley. Angel investors are individuals who use the money made in a previous startup to jumpstart the next generation of promising startups. Markkula invested $91,000 for 26% of Apple. But more importantly, Markkula’s connections brought in Venrock, Don Valentine of Sequoia, and Arthur Rock – who had previously passed over Apple – as investors. The rest is history

This episode highlights that Venture Capital’s combined strength was greater than the sum of its individual parts. Silicon Valley had transformed into a competitive hub of small firms with porous boundaries between each other and the science at universities like Stanford. Part of this phenomenon is explained by non-compete agreements being banned in California, special patent laws, and Stanford’s supportive policies that allowed professors to take sabbaticals to commercialize their research.

The other reason for the rise of the competitive hub was the presence of countless VC firms. They were willing to liberate talent to turn visionary science into meaningful products. This environment minimized the feeling of risk for entrepreneurs considering leaving “safe” jobs to found innovative startups. Additionally, VC firms also had less time to run a due diligence on founders, thanks to the abundance of capital competing for the hottest new ideas.

Powerful Network Dynamics 

Metcalfe’s Law states that the value of a network is proportional to the square of the number of connected users or devices in the network. This became a defining principle of the 1980s VC scene. Bob Metcalfe had quit his job at Xerox PARC, where he had invented Ethernet. Leaving a safe salary on the table before finding a new job might seem risky, but the omnipresent influence of venture capital had lowered the mental barrier to such decisions. Metcalfe intelligently implemented the Qume formula himself, finding an outside CEO before the VC backers could to boost the valuation of his computer networking company, 3Com.

During this period, many VCs started using an investing strategy named the “aircraft carrier model” by Don Valentine of Sequoia. The PC, or the “aircraft carrier,” required a range of compatible network infrastructure, software, drives, etc. to function effectively. Therefore, VCs would target startups that supported the PC ecosystem. Cisco, which built multi-protocol routers, epitomized the attractiveness of implementing this model. Their technology made a network of networks possible.

Cisco’s founders were both working at Stanford University in 1984. The difficulties they encountered when trying to communicate between the two different computer systems prompted them to develop the first multi-protocol router. Source: Yahoo Finance

Deep Thinking Powers

The 1980s brought about a venture partnership called Accel with a new philosophy inspired by the microbiologist Louis Pasteur’s quote: “Chance favours only the prepared mind.” Accel’s unique selling point to founders was their deep understanding of technology. They preferred grounded founders who were comfortable with implementing financial controls at their companies. This focus on technology and realism resulted in a low number of busts, startups that go to zero, for Accel. They could make informed decisions rapidly when they understood the central point of a pitch thanks to their deeper knowledge of technology. Additionally, they could anticipate the next trends in a technology they covered, finding the next startup gems. The downside was that they would miss moonshot challengers who came from unusual backgrounds. Regardless of their more cautious approach, the power law dynamics played a significant role in Accel’s fund returns, with the top 20% of investments amounting to 85% of the profits for their first five funds.

Power Injection

Metcalfe’s law and the power law are compelling in their own right. Successful technology companies do not only grow exponentially, but the technologies they are based on, such as transistors, also advance exponentially over time (Moore’s law). Metcalfe’s law, on the other hand, suggests that progress is not a function of the passage of time but tied to the number of users. When these two laws complement each other, extraordinary value potential manifests itself. In the 1990s, startups emerged that had the potential to amplify the impact of these two powerful laws.

All of a sudden, companies could secure backing even while charging little or nothing, driven by the promise of their traction, momentum, brand, or growing audience. Many of these companies faced minimal technological risk and were therefore subject to market risk. Necessarily, these types of companies were required to keep growing and become larger than their competition.

This opened the door for a new kind of venture investor, personified in Masayoshi Son, also referred to as the Bill Gates of Japan for founding the software distributor Softbank. With Softbank’s substantial balance sheet behind him, he could deploy large amounts of capital, typically reserved for the public markets, into private deals at staggering pace. His wagers, which were typically placed at later fundraising rounds, paid off, realizing unseen gains in record times. Hugely profitable outcomes were possible from riding the winners. A year after winning big with a $100 million later-stage investment in Yahoo, Son started a $1 billion venture fund specialized in growth investing, which we will return to later.

In 1995, a venture capital partnership called Benchmark was established. Not only was it a world apart from Softbank, but it also distinguished itself from the legacy VCs like Kleiner Perkins, Accel, and Sequoia. Their aim was to raise a small fund, which allowed them to carefully analyse every deal and keep the team of partners making the investment decisions small. Importantly, the partnership was equal. They would also work closely with the entrepreneurs. The deal that put them on the map was eBay, an online auctioning platform that captured 100% of the commissions it generated on its auctions and owned the network that was profiting from network effects.

Power Failure

The 90s internet startup bonanza led to the formation of a bubble. Finance itself was causing momentum, and everyone was taking part. The combination of VCs only being able to bet on the upside and public markets going crazy for internet companies meant that discipline was neglected, eventually leading to the famous dotcom bubble peaking in the year 2000.

By the late 90s, it had also become apparent that the power between Venture Capitalists and founders had shifted in favour of the founders. More and more entrepreneurs were staying on as executives or had more influence on the choice of the CEO typically brought in by VCs, defying Qume’s formula. In 2004, Google went public with a dual share class issue: a preferred share class for founders and early investors and a secondary class for public market investors, with the difference being the number of votes per share.

Empowering Founders

In the early 2000s, two notable VC firms emerged with a focus on the founders: Y Combinator (YC for short) and Founders Fund. It was a time when the average age of VC general partners and company founders diverged noticeably. What began in the 90s became more pronounced: startups’ products could be built mostly by coding, which had become more accessible through the open-source movement and required little cash to get started. Paul Graham, the founder of YC, brought the paradigm shift to the point sharply: “What I discovered was that business was no great mystery. Build something users love, and spend less than you make. How hard is that?”

Graham’s conviction led to YC’s unique approach to venture capital and angel investing. It all started as an experimental summer program for software founders. YC would help the founders with business tasks, supply a little cash, provide feedback on their projects, and offer a valuable network for the young founders to get to know each other. For each incorporated startup, YC would take a 6% equity stake. What started as a temporary experiment has minted numerous well-known companies, including Stripe, Airbnb, Dropbox, Reddit, and DoorDash, to name a few.

Founders Fund was launched in 2005 by two PayPal alumni, Peter Thiel and Luke Nosek. They believed that founders of outstanding startups were extraordinarily gifted, so the job of a venture capitalist is to find these extraordinary founders, not to coach average ones. This freed up time to find the next exceptional investment opportunities. Furthermore, radical decentralization was favoured, with the fund’s managers identifying deals independently. As VC is dominated by the power law, the Founders Fund would make a small number of high-conviction, high potential, moonshot bets in a wide variety of fields, such as space travel.

PayPal Mafia – A group of former founders and employees of PayPal who have gone on to found successful startups and/or become successful VCs. Source: Fleximize

Powering Ahead

The 2009 financial meltdown influenced venture capital to the extent that the VC limited partners and VCs themselves were holding back investments. On top of that, public markets were wary too. Successful startups that had delayed going public were encountering difficulties  generating real gains for their employees and venture backers. Before the financial crisis, a startup in need of capital could go public or raise another round of investments. These paths had largely dried up.

At the same time, a new breed of financiers entered the world of venture capital that address the shortfall and give rise to a new stage of venture investing. They had a global perspective on the startups and used quantitative analysis, such as incremental margins, to value a startup’s potential. The managers of these pools of money had often spent their formative years at hedge funds and were not looking for futuristic ideas but searched meticulously for undervalued and effective business models, which they could quantify. Nor were they interested in taking an active role in the startups. This enabled startups to remain private for longer, offering exit opportunities for employees and VCs wishing to sell, all without the regulatory scrutiny of being a public company.

2009 was also the year Andreessen Horowitz (a16z), a VC firm that once again claimed to have invented a novel approach to VC, was formed. Believing that every founder, no matter what, must endure a demanding learning period, they planned on facilitating technical founders’ learning to become CEOs by building a large internal consultancy. a16z focused on early-stage investing as well as growth capital.

A big challenge in venture capital is the passing down of a partnership’s control from one generation to the next. There are countless negative examples of VCs not developing their talent and therefore losing the top spots. Sequoia is a positive example of handing down the reins to the next generation successfully. Also in 2009, they changed their leadership, with the senior partners staying in charge but handing over the day-to-day management to two new partners: Jim Goetz, who introduced the prepared-mind approach at Sequoia, and Roelof Botha, whose aim it was to make the investment process more consistent by applying behavioural science. This systematic effort would allow Sequoia to recognize winners when serendipity led them there. They took preexisting ideas from other venture firms and built up the necessary competencies in-house: international expansion, angel investing, expanded counselling of portfolio companies, growth funds, a hedge fund to capture the gains from later company phases and to use their judgment on technological trends to short the losers, and an endowment-style fund. Sequoia’s continuous innovations allowed them to remain on top of the VC game in the 2010s, making them one of the longest standing VC partnerships to date.

The Misuse Of Power

A record amount of money was flowing into VC during the 2010s. More and more late-stage investors joined the race to fund the hottest startups. Investment banks were investing to get hold of large gains as well as establishing potentially lucrative ties, like a front seat for an IPO deal. Alongside banks, private equity firms and hedge funds entered the game. A record number of unicorns – startup companies valued at $1 billion – emerged. This was partly due to large fundraisings that allowed startups to stay private longer and partly due to the influx of capital into venture capital, which pushed up valuations. The phenomenon occurs because large amounts of capital chase a finite number of investing opportunities and venture capitalist can only bet on the upside.

The relaxed oversight over company responsibilities by the new entrants, founders amassed unprecedented power. They were often granted super-voting rights. Thanks to their hubris, some entrepreneurs acted as if they could get away with anything, while their super-voting rights and influence on the boards had made it more difficult to control them. Some later-stage venture deals introduced liquidation preferences. All of these destructive incentives combined to push unicorn companies to pursue reckless growth. WeWork and Theranos were byproducts of this time.

WeWork founder Adam Neumann Source: FT

Uber looked like it would become a “premature truth” too before Benchmark stepped in to fire the founder-CEO and sober up the company. In 2020, venture-backed IPOs raised a record $38 billion. Meanwhile, the next innovation, SPACs—vehicles that allowed companies to go public without a traditional IPO—was becoming mainstream.

No Definite Answers

The question of luck versus skill is a pertinent one in venture capital. Path dependencies do play a large role, and it is often a matter of being in the right place at the right time to get the opportunity to find and invest in the winners. However, skill is a crucial requirement to enter the VC game, and path dependencies can be disrupted. Overall, new venture capitalists entering the space and challenging incumbents has a positive effect on society and the economy. Venture capital is by no means perfect, though, and it is suitable mainly for one narrow area of finance: backing ambitious startups that want to grow fast.

Lessons I Learned

  • You can start a successful movement in finance by recognizing a transformation in the landscape and innovatively deploying capital to meet the emerging need, either by fusing two fields of finance or by counter-positioning against incumbents. However, bubbles form when more money flows into the new type of finance than can be absorbed by those for whom it was initially intended.
  • Nobody can predict the future. Therefore, build a strong investment thesis and take a stand. To profit from generational investment opportunities, you need a certain amount of luck. However, you can only capitalize on this luck by developing the right skillset and positioning yourself correctly.
  • Be patient. For a long period of a startups life, it can be difficult to see whether a startup will grow exponentially, but when it eventually does, that growth is usually sustained. Venture capital is full of examples where VCs sold their stakes too early, missing out on massive gains. An important aspect of patience is having a prepared mind and knowing what you are doing.

Venture capital isn’t our primary focus at the Investment Club ZH. So why does our inaugural blog post feature a book about it? The simple answer to this question is that insights from other disciplines can broaden our perspectives and enhance our investment decisions. Simply following the crowd offers little value. To gain a competitive edge, we must continuously find new ways of doing things, and one effective method to achieve this is by exploring original ideas and unlocking their potential.