???????? Hi friends!

Well, here we are, at the end of September looking down the barrel of a new year once again.

There are two narratives out there in venture land:

We’re back and life has never been so good.

It’s all shot to bits and it’ll take another couple of years to resolve itself.

I take a more pragmatic approach.

Neither life nor startups follow a linear path, so it pays to expect the unexpected.

Remember that things almost always resolve themselves over the long term.

For all the Londoners, I’ll be at the London Venture Capital Network’s drinks and networking event this Thursday at Dream Factory – I’ll be hot mic’d and cornering unsuspecting founders and VCs alike to get the skinny on what they’re up to!

Drop me a line if you’re going to be there ????????

In this weeks Off Balance, I’ll be chatting about:

???? VCs Now vs VCs Then
???? Finding a way to exit early investors
???? The Power Law: what does it mean and why should you care?

As a side note, I’d love to give a shoutout to EmergeOne portfolio client, Continuum Industries, that just locked in its $10m Series A led by Singular ????????

Read more below.

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

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Now let’s get into it.

Now vs Then

The meme below has been doing the rounds on social media this last week.

And once you get over the LOL imagery and take a minute to think, there is a story to be told…

For a start, over the last decade, we have been very involved in short term thinking, especially in venture land.

Too many deals were being done as a result of ‘hot rounds’, FOMO, party rounds and everything in between.

Much of the thinking was less about the fundamentals of the business, and more so around whether there was a ‘greater fool’ that would carry the bag down the track.

If you could invest early and then find someone to take the next round, you could show a paper return, increase your MOIC (multiple on invested capital), raise a larger fund and perpetuate the cycle.

Startups started buying into this hype, building fairly inconsequential software businesses (inconsequential from the perspective of the long term impact they could have on the world – let’s face it, a better to do list is hardly going to change the face of humanity).

And this could be done because of the abundance of capital out there willing to fund these businesses and then mark them up when the next investor came along.

Much of this short term thinking, along with a pretty loose attitude to cash, was perpetuated by the sort of literature that was being pushed out (and often pushed on) founders.

Books like ‘The Lean Startup’ and others like ‘Blitzscaling’ taught founders that they should move fast – the former pushing fast iteration and the latter almost vaunting profligacy in the pursuit of scale.

The problem with fast iteration is that whilst that might be ok for software products – especially ‘simple’ d2c or b2b products – it’s a lot harder for anything deeptech or in the hardware space.

You can’t build a new type of engine and fix the problems as and when they arise. The product is going to need to be almost fully baked by the time it even gets into a customer’s hands.

That takes time. And time requires money.

Sadly, too much money has been wasted not only on needless side projects or vanity features, but also on full blown businesses that had no need to exist.

It has been a very odd feeling over the last 8 years that I have been involved in the venture ecosystem, trying to reconcile this sort of attitude with my own training in finance and old school manufacturing where the most basic principle is sell a widget for more than it costs you to make it.

My shareholders would have hauled me over the coals if I just threw money at every problem, hoping they’d resolve themselves.

The reality is that scarcity breeds innovation, which is why the next epoch of the startup cycle has the potential to be transformational.

Or at least, that’s what I’m hoping.

How can did I add value?

Recently on one of the various founder groups I’m in, a couple of conversations sprang up around how to deal with early investors on the cap table.

This may be the case because you feel they aren’t adding a huge amount of value, or because you’ve got an incoming investor that maybe wants a larger chunk of equity which would dilute you more than you intended.

The solutions are similar, even if the implications are slightly different. So let’s take a look…

Share Buyback and Cancellation
If your business has sufficient capital, it might be able to buyback shares from your shareholders and then cancel them, thereby reducing the total number of shares outstanding.

This really only works if you have excess capital that you don’t need for growth – highly unlikely in an early stage business, and, you will need to get the appropriate consents in place as well as needing to convince the shareholders to sell.

On a positive note, it provides a return to those early investors as well as increasing all the remaining shareholders’ ownership.

Share Sale to a Third Party
If your business doesn’t have the cash, you might be able to find an investor that would like to purchase the shares from the existing shareholder. This means you don’t change the total number of shares outstanding, just who holds the ownership.

Again, you will need various consents for this to happen, and be warned that if an offer is made, you may need to make a similar offer to other existing shareholders.

There are potential tax implications for the seller and the buyer (in the UK at least) depending on the total value of the shares and the original purchase price. But these are the responsibility of the buyer and seller, not of the business.

This is one of the methods that might work if you have an investor looking to overfund a round. Say you have only £500k available but they want to invest £1m, you could offer the £500k as fresh equity with the balance being used to acquire existing shareholdings.

This is called a secondary share sale.

Debt / Equity Swap
Less utilised, but potentially achievable if you don’t have the capital available nor can find a third party buyer is to see if you can get the existing shareholders to essentially convert their equity into debt.

This has a few implications on the business…

It results in greater percentage ownership to remaining investors (because essentially the shares are being bought back and cancelled).

Debt holders typically have a number of rights that equity holders don’t – not least they will likely receive interest on the loan, or may demand that interest and capital are paid on a regular basis.

In these circumstances, knowing that the business has the cashflow to sustain repayment is critical.

If the business were to go under, debt holders are normally first cab off the rank in terms of getting repaid.

(Note: much of this will depend on your Articles of Association / Corporate Charter or equivalent, as well as any shareholder agreement and the rights associated with the specific shareholder and / or their specific share class. So this shouldn’t be taken as definitive advice and you should check with both your accountants and lawyers for the tax and legal implications of anything you might do. Things become additionally complicated if we’re talking about S/EIS shareholders).

The reality is that there are not a huge number of ways you can ‘get rid’ of early investors.

On the one hand, if the business is doing well then why would they want to sell off their chances of significant future upside? And, conversely, if the business isn’t doing great, how are you going to be able to offer to buy the shares at a valuation that doesn’t put them under water on their initial investment?

In fact, if they are S/EIS investors then they may prefer for the business to fold so they can recover some of their initial investment from HMRC.

Whatever you do, you should think long and hard about the implications, and always, always talk to a lawyer and someone that understands the tax implications for the business.

Remember it’s not your job to give tax advice to the shareholders – that’s their issue to deal with.

Off Balance

I know a lot of you have been waiting for this one. Let me tell you, it’s probably the least understood, most important and, equally, most talked about concepts in Venture Capital (at least if you’re on the investment side).

Power Law

We’re going to dig into a few things here including:

➡️ What do we mean by Power Law?
➡️ Power Law in the world of startups
➡️ What does this mean for VCs?
➡️ Strategies for navigating the Power Law
➡️ Critiques and limitations of the Power Law in VC

So what are we waiting for? Let’s get into it ????????????????????????

Power Law

What do we even mean by Power Law?

Power Law, related to the Pareto Principle also known as the 80:20 rule is often represented by the equation: y=axk

y is a function or, the result

x is the parameter you are going to change, aka the variable

k is the exponent or the factor by which scaling occurs

a is a constant

What this means is that small changes can lead to large outcomes – exponential outcomes – which can be quite difficult for the human mind to grasp because we are better at linear thinking (if x doubles, so does y).

For example, it’s intuitive that if one person needs 1 litre of water a day, then 2 people need 2 litres. This is linear thinking and would be equivalent to k being equal to 1.

But what happens in exponential functions?

Let’s look at the area of a circle (the result, y).

We know that we calculate the area as being equal to pi (the constant, a) multiplied by the radius of the circle (the variable, x) squared (i.e. k = 2).

Looking at a range of results where we double the radius, a each time we see the following:

What we’re seeing is a relationship where a relative change in one quantity results in a proportional relative change in another.

Put simply, it means that a small number of events or entities can have a disproportionately large impact.

In this case, increasing the radius of a circle 16 times leads to a 256 times increase in the area of the circle.

Applying this to VC: the Power Law implies that a very small number of investments will provide the majority of the returns.

This is unlike things that follow a pattern of normal distribution where results cluster around the mean.

Instead, in a Power Law distribution, while many startups might go to zero or produce minimal returns, a few outliers can generate immense profits.

This compensates for the losses and indeed pushes the portfolio to generate supernormal returns, paying back the invested capital of the entire fund and even more (from which VCs earn their carry – the percentage of the profits that they are due).

Peter Thiel is widely accredited, in his book Zero to One, for having recognised the fact that VC is subject to Power Law, stating as follows:

Power Law in the World of Startups

Startups operate in a high-risk, high-reward environment. The majority of them fail within the first few years – some manage to survive, others don’t have the sort of returns that VCs look for, whilst a few go on to redefine entire industries.

This distribution of outcomes is not normal but, as discussed, follows the Power Law.

There are plenty of reasons we see this distribution, but essentially what you are looking for is that certain something which triggers that exponential growth.

Examples may be market dynamics, technological breakthroughs, network effects, or first-mover advantage.

Network effects is a really important one that we often see in marketplaces and social media. As more users join, the platform becomes more valuable for all users.

I mean, would X or LinkedIn be valuable if there were only a dozen users on there? Or would Uber be useful if there were a million drivers but only 20 customers?

I’ll cover network effects in a separate issue, but it’s worth checking out this pod with Sameer Singh and his writings here where he goes deep into different aspects of network effects and their impact on how you should think about your venture.

The point is that whatever the trigger for your business to start exhibiting exponential growth, it is ultimately this that makes it attractive for venture capital investors – not only because of the large outcomes, but also because of the timing of those outcomes.

Take a business that grows linearly, starting at $1m and adding $1m per year of revenue. The business would take 99 years to get to $100m.

Now take a business that grows by 2.5x every year, it gets to $100m within 6 years – well within the normal time horizon for a VC fund to harvest returns from their portfolio.

What does this mean for VCs?

Clearly, this means that if a VC is looking for its portfolio to distribute per the Power Law, it means that they must identify and invest in potential outliers – this is why every investment that a VC makes must have the potential to return their fund.

And given how few of these types of businesses actually do end up returning such a substantial amount of capital, missing out on one can have massive implications on the overall performance of the fund.

This therefore means that VCs must look at much riskier deals than one might normally consider in a balanced portfolio, but critically must also be able to identify and mitigate as much of that risk as possible.

They know that most of their portfolio will likely go to zero, but the one or two that really go big will more than compensate for those that don’t.

However, this doesn’t mean that VCs invest blindly. Rigorous due diligence, market analysis, and founder vetting are crucial to increase the odds of picking winners.

Strategies for Navigating the Power Law

Given the Power Law dynamics, VCs employ several strategies to optimise their portfolios:

Diversification: By allocating into a diverse set of startups across sectors and stages, VCs can mitigate the risk of any single failure. This is a simplification as there is also merit in taking a more concentrated approach – we covered portfolio construction in a previous issue and it’s worth checking that out if you haven’t already.

Deep Market Research: Understanding market trends, technological advancements, and consumer behaviours can help VCs identify startups with outlier potential. This is why you often see specialist VC firms which only invest in one vertical or one stage as opposed to taking a more generalist approach.

Active Portfolio Management: Whilst not hands on in management, like say private equity firms are, VCs, rather than being wholly passive investors, may still take active roles in their portfolio companies. They will often take board seats to shape strategy, offer mentorship, introduce potential high calibre employees, networking opportunities, and other value adds. All of this is with a view to giving their investee companies the best chance at success.

Indeed, they may even actively work to find a buyer for the business if the company does not look like it is going to succeed. In this case, it might be better to receive some value back from the investment rather than seeing it go to zero.

Critiques and Limitations of the Power Law in VC

One of the major critiques to the Power Law is that it leads to – no, it drives – an all or nothing // move fast and break things // growth at all costs attitude to venture building.

Because companies know that they need to have significant outcomes, they may do things that they would ordinarily not consider (selling at a loss, hiring more staff than they need to cover inefficiencies).

What this can lead to is, ultimately, otherwise sustainable businesses being killed off as they are not able to sustain the growth that the Power Law demands.

Some also argue that not all VC returns are power-law distributed. They believe that with the right strategies, VCs can achieve consistent returns across their portfolios.

The other major problem is that there is also the risk of confirmation bias.

If VCs become too fixated on the Power Law, they might overlook startups that don’t fit the typical “unicorn” mould but could still provide solid returns. Though some would argue that solid returns are not what the business of venture capital is all about.

I hope the above breakdown was useful, but at the end of the day, real-world examples offer the best illustrations of the Power Law in VC.

Companies like Airbnb, Dropbox, and WhatsApp were once early-stage startups that many may have been overlooked or dismissed.

But, the VCs who recognised their potential and invested early reaped exponential returns when these companies achieved massive success.

A great example of this is Uber’s early investors. Famously, Benchmark Capital invested $11m into Uber’s Series A and received a 591x return on their investment – $6.5bn – when they exited their position.

But it’s always worth noting, for every unicorn, there are countless startups that didn’t make it. This just underscores the high-risk nature of VC and the Power Law dynamics at play.

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you’d love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish