WHY MARKET MATTERS MOST TO VCS

A lot of things can go wrong for a startup.

In fact, the vast majority of startups ultimately fail. They fail because they didn’t find product-market fit, got beat by a competitor, were pre-empted by newer, better technology or were unable to figure out an effective go-to-market strategy. They also fail for all sorts of human reasons: cofounder breakups, bad hires, culture issues and the simple, heartbreaking realities of life.

As both a VC and former founder, I understand this all too well. And that understanding is fundamental to the decisions that I make as an investor.

It Starts with the Power Law

You’ve undoubtedly heard or read about the significance of power law distributions (aka “power law”) to venture investing, but most people don’t appreciate how fundamental a role the concept plays in the investment decisions that VCs make.

It’s long been understood that venture returns are best described by a statistical distribution known as power law, in which a small number of investments are responsible for the majority of the returns. (You may also have heard this referred to as the “Pareto principle” aka “the 80/20 rule”. Pareto distributions are, in fact, a type of power law distribution.)

My far more educated brother-from-another-mother, Jerry Neumann, once wrote a deep dive into the economic theory behind power law distributions in venture investing. If you want to go really deep on the topic, read this.

In 2014, Correlation Ventures released a landmark study of 21,640 VC investments that took place over the course of 9 years and the returns generated by their investors:

The study empirically confirmed that the returns of venture-backed startups indeed follow a power law distribution — although the distribution was far more skewed than many investors previously believed. What the chart above shows is that nearly 90% of all venture investments result in returns that are inconsequential to the majority of VCs. That might seem like an exaggeration (for most people, a 1 - 5x return-on-investment is pretty good), but if you’re an early-stage VC, it is indeed the case.

Seth Levine of Foundry Group wrote a great post shortly after Correlation’s study came out that explained why. In his post, Seth described the returns of a hypothetical $100M fund and noted that if the fund failed to invest in at least one company that returned more than 5x, it would ultimately fail to generate a positive return for its investors (i.e. it would lose investors money).

Going further, for a $100M VC fund to generate a positive (but not great) return for its investors, it typically must invest in at least one company that returns 10x or more. But here’s the thing: the target return for top-performing VC funds is 3x. For that to happen, a $100M fund must invest in at least...