RTC #11: The VC power law - great is not enough

Why today’s issue is valuable to you 💎

1. Headlines: "The Musk Method” to transform your startup into a success, the best AI tools to elevate your pitch deck game, the 9 most famous pitch decks, all about the Reddit IPO, and more!

2. Today’s Deep Dive: The Power Law is a fundamental principle in venture capital, shaping the way VCs make their investments and construct their portfolios, find out about the biggest secret in venture capital according to Peter Thiel, and learn what applying its principles means for you as a founder (or investor)

3. Infographic of the week: founder salaries revealed (across stages and regions)

Happy to meet, discuss, and advise based on your specific needs:
👉 Fundraising Advisor or Startup Consultant? Building a robust investor network, deal negotiations, technology in fundraising, and key market trends
👉 Startup (Early Stage)? Foundation building for funding success, investor engagement strategies, pitch deck, investment case, and growth story
👉 Startup (Series A+)? Advanced techniques for larger raises, preparation for Series A and beyond, how to manage complex negotiations and deal structures

Simply book a call by clicking the button below

Headlines 📢

• “The Musk Method” - Question everything. Eliminate excess. Simplify. Speed. Automate last.

• The best AI tools to elevate your pitch deck game to 10/10

  • Pitch Deck Analyzer (Chat-GPT)

  • Slidebean Pitch Deck Reviewer

  • Pitchleague.ai

  • Pitch Deck Co-Pilot (Chat-GPT)

• The equity story you need for the long-term investors you want to have on your cap table.

• Learn from the most prominent pitch decks: Snapchat, Facebook, Uber, LinkedIn, Coinbase, etc.

• Mistral AI takes on OpenAI and releases a new model to rival GPT-4 and its chat assistant (“Le chat”).

• Reddit IPO: The CEO’s total comp was $193 million and adjusted EBITDA was negative $69.3 million in 2023. In the risk disclosure of the IPO prospectus, they mention how important it is that moderators continue to work for free. All about the Reddit IPO!

• The best fundraisers share the same skills as comedians. 🤡

🤿 Deep Dive: The “Power Law” in venture capital

Last week we revealed some of THE unspoken truths in venture capital.

Do you remember Jason M. Lemkin (aka SaaStr)?

“Do not use the fundraising process as an “excuse” for less growth or any other operational (not-)achievements.”

What was his main reasoning?

He told us:

• VCs can only invest in outliers

• So any signal a company might only do great but is NOT an outlier is a NO

👉 Wait! Why is doing great not enough??

It’s the Power Law in action…

Historically it evolved from the Pareto Principle (80/20, remember?) that states that for many outcomes, roughly 80% of consequences come from 20% of causes (the "vital few"). Pareto initially observed the 80-20 rule in economic disparities, but soon its principle found relevance in other areas ranging from economics and sociology to physics, shaping the understanding of how success and influence are distributed.

➡️ This pattern, where one element dominates all others, became known as the Power Law.

Today, the Power Law is a fundamental principle in venture capital, shaping the way VCs make their investments and construct their portfolios. It has become an accepted (industry) truth that a small number of investments will yield returns far greater than the rest, often exceeding them combined.

This is why VCs look for “fund returners” (the “outliers”).

Let’s say a VC invests in 20-25 companies. The reality is that a large number of them, around 13-16, will fail. Another 7-9 might do okay, bringing back a 2x-5x return. But that’s not enough to return a fund (and the expected profit).

They need "fund returners”: usually one or two of the portfolio companies that bring around 50-100x returns, or even more. This fund returner needs to cover the losses from the failed companies and the modest returns from the rest.

BUT: This can also lead to conflicts between entrepreneurs/founders and VC firms along the journey.

Imagine the following situation:

• Most entrepreneurs would consider selling their startup for $50 million sometime after a venture round that valued that startup at $30 million post-money

  👉 Total game changer for the founder 🤑

   

• But most venture capital investors would not agree and would push the founders and urge them to aspire for much bigger exits instead

  👉 EXIT at $50 million rather not helpful 😕

Implications for VC investors and startup founders

VC investors

They have the following goals:

• Discover the outlier and earn massive returns from one company (fund returner) - the winner takes it all

• Understand which to put full focus on and where to invest further capital (“double down”)

• Successfully compete against other VCs for the best investments

These are typical characteristics of startups and markets aligning with the Power Law to look out for 👇

• Blue Ocean Deals: Opportunities in untapped markets where competition is minimal or non-existent, allowing for rapid growth and dominance.

• Enormous Potential Markets: If successful, ventures could tap into vast markets that are yet to be proven but have the potential to be massive.

• Avoid Established Incumbents: Steer away from markets where established players are already experiencing massive growth. The Power Law is less likely to manifest here.

• Strong Early Adoption: Companies that show robust growth in their early stages, even without a clear market, often have the makings of a Power Law success.

• Leap of Faith: Sometimes, the best opportunities require investors to jump and trust in the vision of the founders.

Startup founders

They have the following goals:

• Receive maximum (capital) support from their investors

• Stay in the “driver-seat” along their journey

• Maximize their outcome in terms of their own financial success and the operational success of the company

…first and foremost: be aware of the logic of the Power Law and the resulting consequences behind how VCs think and act.

• Develop a robust business model: Build a business model that focuses on sustainability and achieving cash flow breakeven as soon as possible. Focus on creating real value that ensures growth and profitability, regardless of the scale. This foundation will not only attract a broader spectrum of investors but also provide a buffer against the boom-and-bust cycles (as we are currently experiencing).

• Be capital efficient: Even if you can readily raise tons of venture money at great valuations (did anybody say AI?), think twice.

• Build open and transparent communication with your investors: Investors are typically open to alternative success pathways if they truly understand the real challenges facing your startup.

• Work on your exit strategy: For every IPO there are at least 30 exits by acquisition, whether by a strategic partner, private equity firm, or others. Your investor will not spend much time on this (busy with the outliers) - this is your job!

In-depth reads and sources 🙏

• The Power Law in VC (VCLab)

• Understanding the Power Law: Do Venture Capitalists Take Enough Risks? (VC Factory)

• The Power Law in Venture Capital (Marginal Futility)

• Power Law of Distributed Returns (The New Wave IV)

• The ingredients of an outlier – Build the start-up that every VC dreams of (Fortech Investments)

• Don’t sacrifice your startup to the Power Law (Touraj Parang)

📖 Infographic of the week

Founder salaries by stage and location

Thank you Creandum for this comprehensive analysis. Check out the full report here.

📅 Calendar of main VC events in the upcoming weeks

👉 Networks and relationships are key: start building them

February
• Finovate Europe | London, UK | Feb 27-28
• 4YFN | Barcelona, Spain | Feb 27-29
• Web Summit | Qatar | Feb 26-29
• 0100 Conference DACH 2024 | Vienna, Austria | Feb 28-29 (👋 I will be there - let me know if you are also attending)

March
• PEI Nexus | Orlando, US | Mar 6-8
• SuperReturn Private Credit Europe | London, UK | March 11-23
• Mind the Tech | New York, US | Mar 4-5
• Hello Tomorrow | Paris, France | Mar 18-22
• GPC Conference | New York, US | Mar 25-27

👉 Get the full list of events in 2024 here

This was it for today.

Almost.

All gratitude goes to Christian - you are the leading champ on this week’s referral leaderboard 💪🙏

Who wants to be next?

See you next Tuesday,
Stephan 👋

Issue #11 | 27 February 2024