Does Size Matter (In VC)?

Do the initial valuations and check sizes that venture capitalists choose to bet on significantly determine the final outcome of their investments?

TL;DR

This article engages with the recent discourse around the role of valuations in venture capital, inspired by Hunter Walk's insights. It unpacks the power law dynamics in VC, emphasizing that a few successful bets often make up for numerous failed ones. It argues that while seed stage ownership is important, it might not be crucial in a future 'centacorn' situation, providing a case study to illustrate this. The piece also advocates for a diverse investment strategy to capture potential outliers. In response to Walk's arguments, it suggests that focusing solely on valuations, ownership targets, and check sizes might limit potential opportunities. The key lies in striking a balance between these factors, staying adaptable, and embracing the thrilling unpredictability of the VC landscape.

In the ever evolving and complex world of venture capital (VC), one question that often stirs up heated debate among investors, entrepreneurs, and market observers alike is: "Does size really matter?" More specifically, do the initial valuations and check sizes that venture capitalists choose to bet on significantly determine the final outcome of their investments?

The genesis of this discourse lies in Hunter Walk's thought-provoking piece, "Paying Too Much Too Often." In his article, Walk firmly emphasizes the critical role that valuations play in venture capital, asserting that the size of the initial check, valuation, and ownership targets are factors of paramount importance. He suggests that these initial markers can make a significant difference in the financial return from an investment.

In response to Walk's arguments, this article seeks to explore the nuances of the relationship between size, i.e., valuation, and outcomes in VC. While we acknowledge that initial valuations have their role, the idea that size or valuation is the primary determinant of success in VC is something we aim to probe deeper into. By bringing in concepts such as the power law, seed stage ownership, and the advantages of making more bets, we plan to present a comprehensive examination of the role size plays in VC and its potential impacts on investment returns.

We invite you to join us on this journey as we delve into the intricate workings of the VC world, challenge conventional wisdom, and uncover potential strategies for success. Whether you're a seasoned investor, an entrepreneur at the helm of a startup, or an intrigued observer of this high-stakes game, we hope this exploration enlightens and provokes thoughtful conversation about the dynamics of venture capital.

The Power Law in Venture Capital

In order to delve deeper into the dynamics of venture capital, we must first understand the concept of the power law and its profound impact on the VC landscape.

The power law, a term borrowed from mathematics, states that a small number of occurrences can have a disproportionately large impact. This concept, though applicable across various fields, finds particular resonance in the world of venture capital. A VC's portfolio returns often demonstrate this principle: a tiny fraction of investments generate the lion's share of returns, often compensating for the majority of the portfolio that either fails or provides modest returns.

In essence, the power law dictates that in a VC's portfolio, the best investment will return more than the rest of the portfolio combined. The second best will yield more than the third through the last, and so forth. This paints a clear picture: in venture capital, a few home runs, or 'outliers,' significantly overshadow the numerous base hits.

Applying the power law to Hunter Walk's position on valuation and ownership, we see a need for a more nuanced understanding. If only a small number of investments are going to yield substantial returns, and these returns are, in essence, unpredictable at the time of initial investment, focusing solely on initial valuation might risk missing out on these potential outliers.

The implications of the power law, therefore, suggest that venture capitalists should aim not just to manage ownership and valuation, but also to capture as many potential outliers as possible. It is these outliers that have the ability to become unicorns, or even centacorns, and can make all the difference in the overall performance of a venture fund. As we continue to dissect the importance of valuation in VC, this concept will remain central to our exploration.

Power Law Dynamics: The Key to Venture Capital Success

The power law not only dictates the dynamics of venture capital investments, but it also dramatically influences the distribution of returns. To gain a more precise understanding of this phenomenon, let's take a closer look at how this distribution tends to play out in a typical VC portfolio.

Venture capital, by nature, is a high-risk, high-reward endeavor. A venture capitalist invests in a pool of startups, understanding that a significant percentage of these ventures may not succeed. However, the VC is also betting on the possibility that a few of these startups will beat the odds and achieve exceptional success.

The power law comes into play here as these few winners do not just compensate for the losses from failed investments, they often far outstrip them. A successful startup in a VC's portfolio can yield returns that are orders of magnitude larger than the initial investment, even reaching 100x, 1000x, or more. These significant returns can cover the losses from numerous unsuccessful bets and still result in a profitable portfolio overall.

For instance, if a VC fund invests in 20 companies, with each investment being $1 million, it is not uncommon for 15 of these companies to fail, resulting in a loss of $15 million. Of the remaining five, three might return the original investment, and one might yield a 5x return. However, one startup might become a runaway success and bring a 100x return, which in this case, would equate to $100 million. Despite the majority of the investments failing, the fund would still be significantly profitable.

This return distribution, influenced heavily by the power law, encourages VCs to make multiple bets. While the failure rate may be high, the massive returns from the successful startups can more than cover these failures. As a consequence, the power law pushes VCs to diversify their portfolios to increase their chances of capturing these outlier successes. This perspective underscores the importance of having a comprehensive strategy beyond focusing on valuation and ownership alone.

The Impact of Seed Stage Ownership on Future Returns

While the power law and the chase for outliers shape the broad contours of venture capital strategy, it's essential to zoom in on the more granular aspects that can influence a fund's returns. One such factor that plays a pivotal role is the degree of ownership at the seed stage.

Hunter Walk and Homebrew's approach highlight the importance of achieving a target ownership stake. Indeed, the size of the ownership stake that a VC firm secures at the seed stage can significantly influence future returns. Owning a larger piece of the pie at the inception stage means that, if the startup becomes a runaway success, the returns can be disproportionately larger, aligning with our understanding of the power law.

From this perspective, focusing on securing a certain level of ownership rather than emphasizing valuation seems to make strategic sense. After all, a larger slice of a smaller pie can often be more valuable than a smaller slice of a larger one, particularly if the smaller pie experiences exponential growth.

However, is it always beneficial to maximize ownership at the seed stage? Does this strategy limit the potential for diversification, and therefore, the opportunity to capture outliers? Could a more flexible approach to seed-stage ownership lead to better outcomes, particularly in the context of the power law?

In the next sections, we'll explore these questions further. We will look at how different strategies can influence a VC firm's ability to identify, invest in, and reap significant returns from those rare and incredibly valuable outlier companies. The aim is not to challenge the significance of seed-stage ownership but to examine its role in the bigger picture of venture capital investment strategy.

Rethinking Seed Stage Ownership: The Centacorn Conundrum

Within the venture capital universe, the future centacorns - the elusive startups destined to reach a valuation exceeding $100 billion - are the most prized possessions. The journey to becoming a centacorn, however, is riddled with uncertainties and dynamism, which can influence the relationship between seed stage ownership and eventual returns.

In theory, a larger ownership stake at the seed stage could translate into greater returns when the startup reaches centacorn status. However, a crucial factor that complicates this seemingly straightforward equation is the process of dilution.

As startups progress from their seed stage and raise subsequent rounds of funding, original stakes held by early-stage investors get diluted. Even though early investors get a smaller piece of an increasingly larger pie, the size of that piece isn't always directly proportional to the original ownership percentage due to dilution from subsequent rounds.

Therefore, while a larger seed stage ownership could potentially lead to higher returns, it's not a guarantee, especially in the context of a future centacorn. Several other factors come into play, such as the startup's capital efficiency, the terms of subsequent financing rounds, and the exit valuation.

Moreover, a rigid focus on maintaining a high level of ownership at the seed stage could also limit a VC firm's ability to diversify its investments. Since the venture capital sector operates under the power law, as discussed earlier, diversification is key to increase the chances of investing in outlier startups. Hence, a balance must be struck between acquiring substantial seed stage ownership and ensuring enough diversification to maximize the odds of capturing a future centacorn.

Ultimately, while seed stage ownership is undeniably a significant aspect of venture capital investing, it is one part of a broader, more complex landscape. Understanding this complexity and the various elements at play is essential to formulating an effective and resilient investment strategy.

Practical Examination of Seed Stage Ownership: The Facebook Scenario

To further elucidate the point of seed stage ownership's impact on future returns, let's turn our attention to some real-world and hypothetical instances.

One of the most remarkable examples is that of Peter Thiel's early investment in Facebook. In 2004, Thiel invested $500,000 for a 10.2% stake in the then-fledgling social network. Despite the dilution of his stake in subsequent funding rounds, he still owned nearly 3% of the company at the time of its IPO in 2012. His initial investment had grown into over a billion dollars.

But consider this: Imagine another VC firm, 'Alpha Ventures', at the same time had the opportunity to invest in Facebook. However, they aimed for a minimum 15% seed stage ownership, which Facebook was unwilling to give. So, Alpha Ventures passed on the investment opportunity, adhering to their rigid ownership target.

Fast forward to the present day, and it's clear that despite not hitting their desired ownership target, a smaller stake in Facebook would have yielded extraordinary returns due to the social media giant's phenomenal success. This fictitious scenario shows how a stringent focus on seed stage ownership could potentially result in missing out on opportunities to participate in the growth of spectacularly successful companies.

What do these case studies teach us? Seed stage ownership is important, but it is not the only factor determining the magnitude of returns. Thiel's early investment in Facebook resulted in extraordinary returns, not just because of his initial ownership stake, but also because of Facebook's exceptional growth trajectory.

Moreover, the imagined scenario with Alpha Ventures emphasizes that having a rigid ownership target could potentially limit a VC firm's ability to participate in extraordinary success stories. The venture capital game, operating under the power law, is as much about the bets you make as it is about the ones you miss.

These case studies demonstrate that while ownership percentage at the seed stage can play a crucial role in determining future returns, it's one piece of the puzzle. The timing of the investment, the growth trajectory of the startup, and the willingness to remain flexible on ownership targets can all significantly influence the final outcome. Therefore, a nuanced approach, recognizing the importance of seed stage ownership while also valuing diversification and the potential for outlier success, can potentially lead to more effective VC strategies.

The Advantages of Making More Bets

In venture capital, perhaps the only certainty is uncertainty. Predicting which early-stage startup will become the next industry titan is often akin to finding a needle in a haystack. Given this inherent unpredictability, one strategy that venture capitalists can employ to enhance their chances of success is making more bets—that is, investing in a larger number of startups.

By spreading their investments across a diverse array of startups, venture capitalists increase their chances of stumbling upon a breakout success. This approach acknowledges the power law dynamics at play in venture capital: the vast majority of returns are driven by a small minority of investments.

Having a larger portfolio of investments enables venture capitalists to mitigate the risks associated with startup failures. In the high-risk world of VC, a significant percentage of startups will inevitably fail or deliver less than satisfactory returns. By making more bets, VCs can absorb these failures while still positioning themselves to profit from the rare, high-performing outliers.

Furthermore, a strategy of making more bets inherently promotes portfolio diversification, reducing exposure to sector-specific or company-specific risks. It's a method of not putting all eggs in one basket, which can be especially beneficial in a volatile and rapidly evolving startup landscape.

Finally, by casting a wider net, venture capitalists can also gain a broader view of the market and emerging trends. This holistic perspective can, in turn, lead to more informed decision-making in future investments.

In sum, while there's no one-size-fits-all approach in venture capital, making more bets can certainly be a robust strategy. It not only increases the odds of discovering the elusive unicorns and centacorns but also offers risk mitigation and market insight benefits. Yet, it's crucial to remember that simply making more bets is not enough; each bet must be a calculated decision, based on thorough due diligence and sound judgment.

Dialogue with Hunter Walk: A Response to His Arguments"

Hunter Walk presents compelling arguments about the importance of valuation, ownership target, check size, and the need for discipline in VC. His approach is driven by a nuanced understanding of the sector and a clear strategic vision. However, as with any discussion, it's beneficial to consider alternative viewpoints. Here, we offer a point-by-point response to his arguments.

Valuation: Walk emphasizes the role of valuation as a crucial guardrail in evaluating investment opportunities. While we agree that valuation is an important factor, it should not overshadow other key considerations. The unpredictability inherent in the VC landscape sometimes makes it difficult to adhere strictly to valuation guidelines. It's essential to maintain flexibility, considering not just the valuation, but also the startup's potential to disrupt or lead in its sector.

Ownership Target: Walk outlines an approach where meeting the ownership target often takes precedence over valuation. While maintaining significant ownership can lead to substantial returns in case of a startup's success, the trade-off is a potentially smaller portfolio. The power law nature of VC means that the next big hit could come from an unexpected quarter, and having a broader portfolio increases the chance of capturing such outliers.

Check Size: Walk uses a 'max check size' strategy to guide his investments. While this provides a useful framework for maintaining discipline and consistency, it could potentially lead to missed opportunities. For instance, in situations where the required commitment exceeds the 'max check size,' the common decision is to walk away. However, under certain circumstances, it might be worth making an exception. The future 'Facebook' of the world might be worth that extra risk.

Discipline and Portfolio Size: Walk advises emerging managers to maintain discipline and ensure hitting a minimum portfolio size. We concur with this advice but would also emphasize the importance of portfolio diversity. A diverse portfolio not only spreads risk but also enhances the potential for uncovering high-performing startups in different sectors.

Valuation Negotiations: Walk rightly points out that valuation negotiations reveal a lot about founders and their vision. We fully agree with this. Understanding a founder's mindset, their relationship with investors, and their future goals is absolutely essential for making an informed investment decision.

In conclusion, while we acknowledge the importance of Walk's parameters—valuation, ownership target, and check size—we believe that flexibility, diversification, and a willingness to take calculated risks should also be key considerations in the complex game of venture capital.

Navigating the Tightrope: Valuations, Diverse Bets, and the Future of Venture Capital

In the world of venture capital, no singular strategy guarantees success, just as no single argument possesses the ultimate truth. The dynamics of VC are complex, subject to an intricate interplay of factors. Hunter Walk's perspective—emphasizing valuations, ownership targets, and check sizes—offers valuable insights into one approach to VC investing. Yet, as we've discussed, there are also strong arguments for embracing diversity in investments, accepting flexibility in ownership targets, and understanding the power law dynamics that govern venture returns.

Ultimately, the key to success in VC may lie in achieving a balance—between valuations and making bets, between adherence to investment guidelines and maintaining portfolio diversity, and between following proven strategies and remaining open to evolving market trends.

Valuations matter, but they shouldn't overshadow a startup's potential for disruption or growth. Ownership targets are important, but a strict adherence to them may limit the portfolio's scope. Larger check sizes can yield larger stakes, but the opportunity cost could be missing out on other potentially rewarding investments. It's a challenging balancing act, but one that venture capitalists must perform.

Looking forward, as the startup ecosystem continues to evolve, flexibility and adaptability will be key. The future may belong to those VCs who are willing to take calculated risks, who see value in a diverse array of innovative ideas, and who understand that the game's biggest winners often come from the most unexpected places.

Strategies will be shaped and reshaped, rules will be set and broken, and the venture landscape will continue to shift. As we navigate these changes, the dialogue on investment strategy—sparked by thinkers like Hunter Walk and fueled by countless others—remains crucial. In the end, the VC world will continue to be a thrilling space for those daring to bet on the future and its limitless possibilities.

What do you think? Let me know in the comments below and also let me know what you would like to learn about next.