Bubbles and Unicorns


(Image sources: 1, 2)

Recently, there has been a lot of talk about a possible bubble in startup valuations. The question I want to explore is: "How are VC investment returns affected by bubbles?" That is, if it's a bubble, should VCs (and by extension, startups that need VC funding) close up shop for a few years and wait until market conditions change?

Assertion #1: VC returns are governed by power laws

Most VC funds have somewhere between 15 and 50 portfolio companies. It turns out that almost all of a fund's returns will come from its best 1-3 investments. Here's a chart of outcomes for a typical individual investment:

Angel investing returns

(Source: Returns to Angel Investors in Groups)

Assigning some sample numbers, this chart suggestions that:

This distribution results in an expected multiple of 2.65X for the overall fund (pretty close to the 2.6X mentioned in the upper-right of the chart).

The noteworthy bit is that for a typical portfolio, 5% of the investments will be responsible for more than half of the total returns, and 13% of the investments will be responsible for more than 3/4 of the returns. This is what people mean when they say that VC returns follow the power law: the bulk of the returns are to be found in the outliers, not in the most common outcomes. If a fund invests in Twitter or Nest early on, the fund will be hugely successful; if none of the investments becomes a $1b+ company, then the fund will be mediocre at best. Trying to eke out an extra 1.5X or 6.5X exit is relatively meaningless when a 40x exit could return the entire fund. That's why investors and founders swing for the fences.

Assertion #2: Investing in a power law distribution is only worthwhile if you might find an outlier.

A typical VC fund makes investments for 3-4 years, then holds onto those investments until every company in the portfolio either goes public, gets acquired, or fails. If outlier companies (i.e. the Twitters and the Nests) predictably occur in some years and not others, then it would be prudent to only invest in the good years. For example, if it turned out that 95% of all $5b+ companies were started during a recession, then making venture capital investments during economic booms would be unwise.

Assertion #3: Great companies are founded every single year

I spent some time trying to dig up the most successful companies founded in each year since 1997 (the year that the Dot-com bubble began according to Wikipedia). The most notable companies that I found are listed below.

(Note: the list is not meant to be exhaustive.)

Year Company Valuation**
1997 Priceline $59b
Netflix $40b
1998 Google $370b
VMWare $37b
1999 Salesforce $47b
Jawbone $3.3b
2000 TripAdvisor $13b
Pandora $3.4b
2001 Guidewire $3.9b
SuccessFactors $3.4b
Bloom Energy $3b
2002 LinkedIn $27b
SpaceX $12b
GoPro $7b
2003 Tesla $34b
Splunk $9b
Tableau $8b
2004 Facebook $247b
Palantir $20b
2005 Workday $15b
Palo Alto Networks $15b
2006 Twitter $23b
Lending Club $5.7b
2007 Dropbox $10b
Fitbit $7b
2008 Airbnb $25b
Cloudera $4.1b
2009 Uber $41b
WhatsApp $19b
Square $6b
2010 Pinterest $11b
WeWork $10b
Nest $3.2b
2011 Wish $3b
SoFi $1.3b
2012 Instacart $2b
2013 Zenefits $4.5b

Observations and conclusions

The years when bubbles were bursting (2000-2002, 2008) were quite strong. So were the Dot-com bubble years (1997-1999) and the year before the real estate bubble popped (2007). Great companies are created every year. There's no clear pattern of which years produce at least one $10b+ company and which years do not. Actually, the pattern is that almost every year produces a $10b+ company!

Because VC returns follow a power law, it doesn't matter if there's a bubble or not, it only matters that there are at least one or two huge companies created each year. Examples from the last two decades show that great companies are formed consistently, year after year, which means that even if we are near the peak of a bubble, founders should keep building companies and investors should keep investing in those companies.

** Valuations are: 1) market caps for publicly traded companies, 2) reported valuations for privately held companies, and 3) acquisition prices for acquired companies. All numbers are as of June 2015.

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