One Startup in 100 Pays for the Other 99
Even veteran investors cannot pick the winner in advance, so the job is to stay in business long enough to recognize it.
Joys of Compounding · Ho Nam - Lessons in Venturing Differently - [Art of Investing, EP.3]Ho Nam, co-founder of the venture firm Altos Ventures, which backs young startups, starts with a rule every investor knows. In venture capital, about 20% of deals produce about 80% of the profits. That is the power law, and no one argues with it.
The surprise is what happens when you apply that rule inside itself. The same lopsided pattern repeats even among just the winners.
Take 100 startups. Twenty of them produce 80% of the profit. Now look only at those 20. Again, about 20% of them, or four companies out of the original 100, produce about 80% of that 80%, or 64% of the total. Do it once more. Twenty percent of those four, or 0.8 companies, produce 80% of that 64%, or 51.2% of all the profit.
Rounded off, that means less than one deal in 100 produces more than half the gains. Put another way, the top one deal in 100 makes more money than the other 99 combined.
That math changed how Nam thinks about chasing hot startups. The usual idea is that each year brings a small handful of crucial startups, and a firm must win one or become irrelevant. He says those deals rarely exist. In Sequoia's 50-year history as a venture firm, there has been only one Google. In Trinity Ventures' history, there was only one Starbucks. As Nam puts it, citing investor Charlie Munger, "no one's that lucky and no one's that good."
Nor can anyone reliably pick the winner up front. Sutter Hill, another venture firm, for decades asked its own partners and its outside backers to guess each year which deal would do best. The partners were no better than the outsiders. Nam called that randomness "venture lotto."
The consequence is patience. If you back 100 companies and stay with them long enough, the great one should eventually become so obviously outstanding that it smacks you in the face. Spotting the losers is easier than spotting the great company. As Nam puts it, "If they keep running out of cash, that's a sure sign that something's wrong." The hard job is telling a good company from a great one.
A good company can create wealth that lasts generations, but it will not mint billionaires. Altos has helped create billionaires, Nam says, but never "a Mark Zuckerberg or Elon Musk" worth $100 billion or $200 billion. That is fine, because almost no one gets even one of those in a lifetime.
Questions people ask
Is the 80-20 rule exact?
The 80-20 rule, also called the Pareto principle, is a rough pattern found in many fields, from sales to website traffic. It is not a law of physics, but a shorthand for the fact that outcomes are often concentrated in a small share of causes.
Should investors just hold the one winner forever?
In principle, yes, but in practice investors sell pieces for liquidity, to return money to backers, or to fund their lives and charities. Nam says it is fine to sell with no regrets, even something that might rise tenfold.