Venture portfolio returns follow a power law: most of the money comes from very few companies. Working through a portfolio's arithmetic shows why missing the best company matters more than avoiding the worst.
11 min read · Level 5
I think the most counter-intuitive fact in early-stage investing is that a portfolio where half the companies fail can be excellent, and one where none fail can be poor. Once that arithmetic is felt rather than just understood, most decisions about breadth, sizing and follow-ons become clearer.
Consider a portfolio of 20 equal investments of 1 unit each:
Outcome Companies Multiple Returned Failure 10 0x 0 Break-even 5 1x 5 Good 3 3x 9 Very good 1 10x 10 Outlier 1 50x 50 Total 20 74
Portfolio multiple = 74 / 20 = 3.7x
Now remove the single outlier and replace it with a failure:
Total returned = 74 - 50 = 24 Portfolio multiple = 24 / 20 = 1.2x
One company out of twenty produced 50 / 74, about 68%, of everything returned. Half the companies returned nothing, and the portfolio still did well.
Two implications:
The cost of a failure is capped at the amount invested (1 unit here). The cost of missing an outlier - by not investing, or investing too little - can be most of the portfolio's return.
Because it changes how investment decisions should be made. Avoiding failures matters far less than being in the rare company that returns many times the capital.
It also explains why concentration is dangerous for early-stage investors: with only five companies, the chance of holding any outlier is much lower than with twenty or thirty.
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The chance of holding at least one outlier.
If each investment independently has a 3% chance of being a 50x outlier, the chance of holding none is 97% multiplied across all holdings:
Holdings Chance of no outlier Chance of at least one 5 0.97^5, about 85.9% about 14.1% 20 0.97^20, about 54.4% about 45.6% 40 0.97^40, about 29.6% about 70.4%
The probabilities are illustrative, not predictions. But the pattern holds: breadth is how early-stage investors give themselves a realistic chance of the outcome that drives returns.
Judging a portfolio or a decision by its failure rate, when returns are driven almost entirely by the size and presence of the few largest outcomes.
List outcome groups with counts and multiples.
Calculate how much of the return depends on one company.
Recalculate the portfolio without the best company.
Choose breadth that gives a realistic chance of an outlier.
When planning an early-stage portfolio or judging whether it is working.
Do not assume power-law patterns apply equally to later-stage or income-focused private investments, where outcome distributions are narrower.
Analyses of venture capital fund and deal-level returns published by industry data providers and venture firms have repeatedly found that a small percentage of investments account for the majority of total returns, and that many individual investments return less than their cost.
Return concentration is not a feature of a few lucky funds; it is the normal shape of venture returns.
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