Power Law? Or Power Ball?: Why Portfolio Theory Stinks for Most Entrepreneurs

This isn’t a blogpost intended to diminish other investor’s business models, but rather — objectively call attention to a few facts and highlight that these facts are not talked about enough. These are:

1. VC Funds by definition have well-diversified portfolios and thus take on inherently less risk of failure

2. Most entrepreneurs have the vast majority of their net-worth, tied up in a single, illiquid private company stock (their own business)

Now, there is more to unpack with each party.

On the investor side — not every investor is the same. At PeakSpan, we are proud of our industry leading capital loss ratio (the % of dollars that you invest when go to $0). Ours is of < 3% whereas (on a relatively large sample set of 75+ scale-up investments), according to TechCrunch, 50% of VC investments result in a capital loss event (through which you can imply the entrepreneur sees very little if any return on his or her sweat equity. These stats should strike you as very different.

On the entrepreneur side — if you are independently wealthy, have family money, or have past successful exits — and you want to now swing for the fences, this strategy could very well make sense. With a thoughtful idea, a massive TAM, and, perhaps, some Gen-AI angle, a multi-time entrepreneur should have no trouble finding a VC partner willing to “go big” with them. That’s because this plays right into the power law, a concept that has generated monster returns for many VCs. If you can accrue a portfolio of entrepreneurs who are willing to “go big or go home,” you are maximizing your chances of winning with the power law, that is — have 1–2 investments generate 90% (or more) of your returns.

The tragedy here, which is not talked about enough — is that for the most part, entrepreneurs playing this power-ball-esque game of chance are NOT previously successful or independently wealthy. Yet, they are willing to bring in a VC partner who is fundamentally misaligned and what typically ends up happening is….you play the power-ball together with inherently risky strategies.

If it works, you are a hero, you win big, you are a success story and get to sit center stage at SaaStr and appear on the cover of TechCrunch. But if you lose — you lose your business and what may have been a material slice of your wealth pie. Don’t worry though, your VC firm will happily give you a free t-shirt and an EIR role as a consolation prize!

Moral of the story — when selecting your next equity partner. Ask them what their target return is and ask them for their capital loss ratio. Think about what behavior this is going to drive and whether you are aligned with the level of risk implied by this plan. There is a risk-optimized path to success and it’s certainly not swinging for the fences on every pitch. Find an equity partner that is going to work with you to achieve success without having to play the power ball.