From 0 to 1: unlocking the secrets of business and the future

Chapter 13 Look at the money

Money begets money. "Whoever has, he will be given more, and he will have more. Whoever has not, even what he has, will be taken away." (Matthew Chapter 25, Section 29) When Einstein declared that compound interest is " He also resonated with this biblical adage when he called it the "eighth wonder of the world", "the greatest mathematical discovery of all time", or even "the most powerful force in the universe".Whichever narrative you subscribe to, the message is the same: Don't underestimate exponential growth.In fact, there is little evidence that Einstein actually mentioned any of this.But shoving words to Einstein just reinforces the message that interest on the intellectual capital that Einstein gave throughout his life continues to flow after his death, and that even words he did not say are credited to him.

Most of the words of those who came before have been forgotten.Only a few people, such as Einstein and Shakespeare, have been quoted by later generations.Don't be surprised, because a small number of people often achieve great results. In 1906, the economist Wilfredo Pareto proposed what became the "Pareto Law", also known as the 80–20 Rule.This is because he found that 80% of the land in Italy is in the hands of 20% of the people - a phenomenon as natural as 20% of the pea pods in his garden produced 80% of the total peas.This bizarre model of doing more with less can be seen everywhere in the natural world and in human society.For example, the most destructive earthquake causes more damage than all the smaller earthquakes combined, the largest city is bigger than all the tiny cities combined, and monopolies capture more value than millions of similar competitors. many.Regardless of whether Einstein said those words or not, the power law is the law of the universe and the most powerful force in the universe. The reason for this name is that the exponential equation describes the most uneven allocation.It completely defines the environment around us, and we are hardly aware of it.

This chapter explains how the power law works when you look at the money: In venture capital, investors strive to profit from exponential growth in the early days of a company, and only a small fraction of companies compare Other companies gain exponentially in value.Most businesses don't need to deal with venture capital funds at all, but everyone needs to be clear about one thing, and one thing even venture capitalists are trying to be clear: The world we live in is not the normal world. under the power law.

The Power Law in Venture Capital
The venture capitalist's job is to identify promising start-up companies, invest in them, and profit from them.They raise money from institutions and wealthy individuals, and use it as capital to invest in technology companies that they think will appreciate in value.If they turn out to be right, they get a cut of the proceeds—usually 20 percent.A VC fund is rewarded if the company it invests in rises in value, if the company it invests in goes public, or is acquired by a larger company.Venture capital funds typically take 10 years to exit because successful companies need time to grow.

But most of the companies backed by venture capital funds don't wait to go public or be acquired, and often fail at the outset.Because of these early failures, venture capital funds lose money initially.When a successful company in the portfolio enters a period of exponential growth and begins to scale up, venture capitalists hope that the value of the investment fund will be greatly improved within a few years, reaching breakeven, or even revenue greater than expenditure.

The most important question is when will this exponential growth occur.For most funds, the answer is never.Most startups fail, and the investment evaporates.Every venture capitalist knows that his job is to find successful businesses.Still, even seasoned investors know that's just the surface.They know that companies are different, but they underestimate the extent of the differences.

The mistake is that they expect a normal distribution of venture capital returns: that is, hopeless companies will fail, mediocre companies will stay flat, and good companies will double or even quadruple their returns.Assuming this unremarkable pattern, investors make multiple portfolios in the hope that returns from successful companies will offset losses from failed ones.

But the "cast a net and pray" approach usually loses all.That's because venture capital returns don't follow a normal distribution, but a power law: A small number of companies outperform all others.If you value casting a wide net instead of focusing on just a few companies whose future value will be overwhelming, you will miss these rare companies in the first place.

The performance of the Founders Fund explains this distorted pattern: Facebook was the best-performing company in our portfolio in 2005, returning more than all other portfolio companies combined.Palantir, the second-best performer, brought in more returns than all companies excluding Facebook combined.This highly uneven pattern is not accidental: it has been seen in our other funds as well.The biggest secret in venture capital is this: The best investments in successful funds return as much or more than all other investments combined.

This leads venture capitalists to come up with two very strange rules.The first rule is to only invest in promising companies whose profits can reach the total value of the entire investment fund.This rule is so horrible that it eliminates most possible investments in one fell swoop. (Remember that even very successful companies are usually small.) This rule leads to a second rule: because the first rule is too strict, no other rule is needed.

Consider the consequences of breaking the first rule.Andreessen Horowitz invested $2010 in Instagram in 25.When Facebook bought the company for $10 billion two years later, Andreessen had made $7800 million—a 312-fold return in less than two years!This stunning return has also earned it a reputation as the best company in Silicon Valley.But oddly enough, that wasn't enough, because Andreessen Horowitz's fund is $15 billion: If it only wrote checks for $25, the company would have to find 19 Instagrams to break even.This explains why investors always invest more in worthwhile companies. (To be fair, Andreessen would have put more money into Instagram's later rounds if the previous investments hadn't taken away the money.) The venture capital fund has to find a number of companies that can successfully go from 0 to 1. Then support them with all your financial resources.

Of course, no one knows in advance exactly which companies will be successful, so even the best VC firms will have a "portfolio."But for a good portfolio, every business has to really have the potential to be extremely successful.Our Founders Fund only focuses on five to seven companies because these companies have unique fundamentals and we think they will all be worth billions of dollars in the future.Investing is like buying lottery tickets whenever you focus not on the nature of your business but on the financial question of its suitability for a diversified hedging strategy.And once you think you are drawing a lottery, you are already mentally prepared to lose money.

Why People Don't See the Power Law

Why don't professional venture capitalists see the power law?One is that it takes time for the power law to manifest itself clearly, and even tech investors often live in the present and cannot predict the future.Imagine an investment firm investing in 10 companies with the potential to become monopolies—already an unusually disciplined portfolio in itself.Those companies are very similar in their early stages before exponential growth.

Over the next few years, some companies will fail and some will succeed; valuations will change, but the difference between exponential and linear growth is not clear.

But 10 years from now, venture capital funds will no longer have successful and failed investments in their portfolios, but only one major investment and others.

But no matter how obvious the results of the power law are, they do not reflect everyday experience.Because investors spend most of their time managing new ventures and startups, most of the companies they run are decidedly mediocre.Much of the difference that investors and entrepreneurs perceive every day comes from differences in degrees of success, not the difference between absolute dominance and failure.And no one wants to walk away from an investment, and venture capitalists tend to spend more time on the companies with the most problems than on the most successful ones.

If investors who specialize in exponentially growing startups ignore power laws, it should come as no surprise that everyone else does.The distribution of the power law is very wide, it is obvious, but it is ignored by people.For example, when most people outside of Silicon Valley think of venture capital, they probably picture a bunch of weirdos — like ABC's Shark Tank, only without the commercials.After all, less than 1% of new companies formed each year in the United States receive venture capital, and all venture capital investment accounts for less than 0.2% of gross domestic product.But the results of these investments have disproportionately boosted the economy as a whole.VC-backed companies account for 11 percent of all jobs in the private sector.Indeed, 12 big tech companies are all backed by venture capital funds.Those 12 companies are worth more than $2 trillion combined, more than all other tech companies combined.

Take advantage of the Power Law

The power law is not just important to investors, it is important to everyone because everyone is an investor.The biggest investment an entrepreneur can make is taking the time to start a new company.Therefore, every entrepreneur must think about whether his company will be successful and valuable in the future.Likewise, everyone is an investor.You choose a career because you believe that the work you choose will be worthwhile for decades to come.

The most common answer to the question of how to secure future value is a diversified portfolio - "don't put all your eggs in one basket", and everyone is told not to put all their eggs in one basket.Like we said, even the best venture capitalists list their portfolios, but investors who understand the power law list as few companies as possible.Portfolio ideas stem from folk wisdom and financial industry conventions that say it's best to diversify your bets.The more companies you invest in, the less risk you are exposed to in an uncertain future.

But life is not a portfolio to a startup founder nor to any individual.An entrepreneur can't "diversify" himself: You can't run a dozen companies at the same time and hope that one of them will stand out.And individuals can't keep more than a dozen occupations with similar possibilities at the same time for the sake of diversification of life.

What schools teach us is just the opposite: institutionalized education imparts undifferentiated general knowledge.Everyone in the American education system has not learned to think in terms of power laws.Every middle school has a 45-minute class regardless of class, and every student moves forward at the same pace.In college, the model student is obsessed with learning an off-the-wall skill in order to secure his future.Every university believes in "excellence", and the hundreds of pages of alphabetized class schedules that the education department randomly gives out seem to ensure that "it doesn't matter what you do, as long as you do it well".It doesn't matter what you do?What a complete mistake.You should focus all your attention on what you are good at, and before doing so, think carefully about whether this thing will become valuable in the future.

This idea applied to startups is that even if you are very talented, it is not necessary to start your own company.Too many people start their own companies now.People who understand the power law are more hesitant to start a business than others: They know that joining a fast-growing, top-notch business will lead to greater success.The power law means that differences between companies dwarf differences in roles within companies.If you start your own business, you own 100% of the equity, and if the company fails you lose everything.On the contrary, if you only own 0.01% of the equity of Google, the return you will get in the end will be incredible (more than 3500 million US dollars.) If you have started to run your own company, you must remember the power law and run the company good.The most important things are unique - one market may outperform all others (as we discussed in Chapter 5).One distribution strategy usually outperforms all others (covered in Chapter 11).Timing and decision-making also follow a power law, with some critical moments far more important than others (see Chapter 9).But you can't trust a world that negates the power law and prevents you from making accurate decisions with the power law.The most important thing is often not seen at a glance, it is even like a secret.But in the power law world, you really can’t afford to not think hard about where your actions put the company on the 80–20 curve.

(End of this chapter)