WHY PEOPLE DON’T SEE THE POWER LAW?

Get More Than $7000 Small Business Credit If You Are A Small Business In Kitsap County!

KITSAP/BUSINESS—Why would professional VCs, of all people, fail to see the power law? For one thing, it only becomes apparent over time, and even technology investors too often live in the present. Imagine a firm invests in 10 companies with the potential to become monopolies—already an unusually disciplined portfolio. Those companies will look very similar in the early stages before exponential growth,

Over the next few years, some companies will fail while others begin to succeed; valuations will diverge, but the difference between the exponential growth and linear growth will be unclear,

Investment return

After 10 years, however, the portfolio won’t be divided between winners and losers; it will be split between one dominant investment and everything else.

But no matter how unambiguous the end result of the power-law is, it doesn’t reflect daily experience. Since investors spend most of their time making new investments and attending to companies in their early stages, most of the companies they work with are, by definition, average. Most of the differences that investors and entrepreneurs perceive every day are between relative success levels, not between exponential dominance and failure. Since nobody wants to give up on investment, VCs usually spend even more time on the most problematic companies than they do on the most obviously successful.

investors

If even investors specializing in exponentially growing startups miss the power law, it’s not surprising that most everyone else ignores it, too. Power law distributions are so big that they hide in plain sight. For example, when most people outside Silicon Valley think of venture capital, they might picture a small and quirky coterie—like ABC’s Shark Tank, only without commercials.

After all, less than 1% of new businesses started each year in the U.S. receive venture funding, and total VC investment accounts for less than 0.2% of GDP. But the results of those investments disproportionately propel the entire economy. Venture-backed companies create 11% of all private-sector jobs. They generate annual revenues equivalent to an astounding 21% of GDP. Indeed, the dozen most prominent tech companies were all venture-backed. To gather, those 12 companies are worth more than $2 trillion than all other tech companies combined.

WHAT TO DO WITH THE POWER LAW

The power law is essential to investors; instead, it’s important to everybody because everybody is an investor. An entrepreneur makes a significant investment just by spending her time working on a startup. Therefore every entrepreneur must think about whether her company is going to succeed and become valuable. Every individual is unavoidably an investor, too. When you choose a career, you act on your belief that the kind of work you do will be valuable decades from now.

The most common answer to the question of future value is a diversified portfolio: “Don’t put all your eggs in one basket,” everyone has been told. As we said, even the best venture investors have a portfolio, but investors who understand the power law make as few investments as possible. The kind of portfolio thinking embraced by both folk wisdom and financial convention, by contrast, regards diversified betting as a source of strength. The more you dabble, the more you are supposed to have hedged against the uncertainty of the future.

But life is not a portfolio: not for a startup founder, and not for any individual; an entrepreneur cannot “diversify herself: you cannot run dozens of companies at the same time and then hope that one of them works out well. Less obvious but just as important, an individual cannot diversify his own life by keeping dozens of equally possible careers in ready reserve.

Our schools teach the opposite: institutionalized education traffics in a kind of homogenized, generic knowledge. Everybody who passes through the American school system learns not to think in power-law terms. Every high school course period lasts 45 minutes, whatever the subject. Every student proceeds at a similar pace. At college, model students obsessively hedge their futures by assembling a suite of exotic and minor skills.

WHAT TO DO WITH THE POWER LAW

Every university believes in “excellence,” and hundred-page course catalogs arranged alphabetically according to arbitrary departments of knowledge seem designed to reassure you that “it doesn’t matter what you do, as long as you do it well.” That is entirely false. It does matter what you do. You should focus relentlessly on something you’re good at doing, but before that, you must think hard about whether it will be valuable in the future.

For the startup world, this means you should not necessarily start your own company, even if you are extraordinarily talented. If anything, too many people are starting their own companies today. People who understand the power law will hesitate more than others when it comes to founding a new venture: they know how tremendously successful they could become by joining the very best company while growing fast. The power law means that differences between companies will dwarf the differences in roles inside companies. You could have 100% of the equity if you fully fund your own venture, but if it fails, you’ll have 100% of nothing. Owning just 0.01% of Google, by contrast, is incredibly valuable (more than $35 million as of this writing).

If you do start your own company, you must remember the power law to operate it well. The most important things are singular: One market will probably be better than all others. One distribution strategy usually dominates all others. Time and decision-making themselves follow a power law, and some moments matter far more than others. However, you can’t trust a world that denies the power of law to accurately frame your decisions for you, so what’s most important is rarely apparent. It might even be secret. But in a power-law world, you can’t afford to think hard about where your actions will fall on the curve.

Subscribe
Notify of
0 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
0
Would love your thoughts, please comment.x
()
x