We invest with the hopes that some of these companies will achieve spectacular success by going on to be worth billions of dollars.
But most will fail. Not with a bang that makes headlines, but with a whimper where nobody will notice. No news articles will be written about the slowly dying technology startup that gradually runs out of money and turns the lights off. We know that many of the companies we invest in will fail, but that is the business of seed-stage venture capital investing.
Taken as a group, the math of a venture portfolio works out to some very high investor returns. When an investment goes wrong, you lose a little, but when an investment goes right, you win big. For example, Jason Calacanis turned $100,000 into $100 million by being the first to check into Uber. It can take just one true whale to make up for all the zeros. It is a power law distribution.
The Power of the Power Law.
“To those who have much, more will be given.” – The Bible.
That doesn’t seem right or fair, but that is how the universe works. This principle of accumulated advantage plays out both in nature and in every human creative domain, including entrepreneurship. A power law distribution looks like this:
To the right is the long tail, and to the left are the few that dominate.
Most people would prefer not to think about it, but power law distributions are indeed all around us. Venture capital seems very risky because each individual investment is very risky. A small number of investments will produce most of the investor returns. Interestingly, even the largest companies in the world form a power law distribution, where Apple and Microsoft have market capitalizations of around $2 trillion. Still, the 8th largest company is less than 1/4th the size. So, beware stock pickers. No wonder index investing and ETFs have become so popular.
Surely the evil and monopolistic nature of capitalism must be the reason for this distribution to be so slanted towards the most prominent companies. But what if we look at playoff wins by NFL quarterbacks? The NFL is a league with the same rules for every team and player, and the league even has a salary cap to maintain balance and parity. But if you graph the NFL playoff wins, you’ll see yet another power law distribution. Note that the chart doesn’t even account for the hundreds of other quarterbacks who played in the NFL and won zero playoff games.
How about the population of cities in the United States? To those who have much, more will be given. That’s New York and Los Angeles on the far left, with several million people in their cities. But the vast majority of cities are only a couple hundred thousand people.
This power law distribution applies to the number of times songs are listened to, the net worth of individuals, the economic size of countries, and even the size of stars in the universe. It is like a law of the universe. It is no wonder that this pattern also applies to startup investing. So don’t let the high failure rate of startups deter you as a venture capital investor. You need an indexed approach because the big winners can be enormous.
Pulling Back or Leaning In
Will the economy crush these startups even if they were meant for success? Probably not. A healthy early-stage software company grows at 10% per month or more, so a macroeconomic contraction of a couple of percentage points shouldn’t matter too much. In fact, it can help the early-stage company attract talent that otherwise might be locked away at other businesses.
Timing the market downturn doesn’t matter much either in early-stage venture capital. This is because early-stage venture capital exits (acquisitions or initial public offerings) take 7 to 10 years to occur, so the exit price is very much uncorrelated to current macroeconomics. Unless you feel you can accurately predict what will happen a decade from now. You can time the market when it comes to your entry price. The price at which you can invest today in early-stage venture capital is certainly correlated to today’s macroeconomic conditions. Right now, everything is going on sale, and valuations may continue to decline. Perhaps the time to do less venture capital investing was precisely when everyone else was doing it the most – in 2020 and 2021.
"Even though 2023 looks like it will be an excellent opportunity to buy low in seed stage companies, we should still expect a broad pullback in VC investingEven though 2023 looks like it will be an excellent opportunity to buy low in seed stage companies, we should still expect a broad pullback in VC investing."
In my opinion, now is the best time to get interested in early-stage tech companies, as fewer dollars will be competing over those deals. Successful startups get started across the country. Buying low always feels difficult in the moment, but one must be greedy when others are fearful. I think 2023 will be a great time to be investing in early-stage VC.
Even though 2023 looks like it will be an excellent opportunity to buy low in seed stage companies, we should still expect a broad pullback in VC investing. History indicates that most of the pullback will come from more recent entrants. Investors, corporations, and philanthropies that finally decided to dabble in venture investing timed it about as well as they did their bitcoin adoption. Capital droughts may also play out geographically, as cities that just started to have some momentum in their venture capital “ecosystem” see an excessive number of their investors pull back. History says they’ll all pull back and put their capital elsewhere. Some because they must and some because they’re just no longer interested.
Why I’m in Houston
The Bay Area in California is by far the biggest hub for VC investing. New York and Los Angeles are the next largest hubs. Then there’s a long list of other cities where VC investing occurs, and way down on the list you get to Houston, Texas. Although Houston is where I’m based and where I grew up, I will admit that it is far from the venture capital hub of the world. Nevertheless, there are some advantages to being based in Houston, especially now that video conferencing is an acceptable form of meeting. But the main reason I’m still here in Houston is because of the opportunity I see ahead.
Houston has low taxes, plenty of lands to expand into, cheap labor, and a regulatory environment where people are allowed to build things without ten years of environmental reviews. Going in-depth on why Houston, Texas, will boom can get complicated. However, I think the war in Ukraine gave us a glimpse: energy and commodities still really matter, and America needs to bring manufacturing back home.
Peter Zeihan, a geopolitical strategist with solar panels on his roof, is more bullish on Houston over the next 30 years than any other city in the world. Why?
1.Houston is the number one energy hub for the United States in terms of refining and shipping energy products.
2.Houston has the largest petrochemical system in the United States. From batteries to makeup to plastics – it comes from Houston more than anywhere else.
3.Houston is part of the largest manufacturing hub in the United States - the Texas Triangle (Austin/San Antonio, Dallas/Fort Worth, and Houston). I’ll mention again that there is so much land to expand into, which cannot be said of the Northeastern or Western United States.
4.Houston is the second largest source of machinery in the United States – the things that make things.
5.Houston is the second largest exporter of agricultural products and food processing.
What do these have things in common? They’ll all be in global shortage for many years to come.
From a venture capitalist’s standpoint, video conferencing enables us to work from anywhere. So why not live in a boom town that makes the physical things the world will need for decades to come? Founders may or may not build their companies in Texas, but their customers will increasingly be here.
The Global Disorder and the American Resurgence
The news is mostly doom and gloom. Many seem to think that America is falling apart. However, I am quite bullish on the future of the United States. We have great working-age demographics since the baby boomers had kids (unlike Europe, China, and almost all the rest of the developed world). We have all the oil and gas energy we need to be energy independent and the option of being a massive energy exporter. We have reliably sunny and windy regions that make renewable energy function well. We have the technical capability and the political stability to build nuclear power plants if we ever decide to. In short, we have all the energy we need and can even make money supplying other nations with that energy and related energy technology. No matter the politics, the economic advantages are too strong for the United States to struggle with energy. I look for it to be our greatest strength as a nation going forward.
The United States is also in control of global supply chains since we are the only country with a navy capable of securing global supply chains. You may have noticed shifting and breaking supply chains over the last few years from COVID-19 and the Ukraine war. This is likely to continue as the United States no longer needs to import energy from other countries and, therefore no longer needs to secure that supply. The long-term result is a gradual pullback from global conflicts that may break out.
While the United States secures its supply chains and re-shores production, other globalization-dependent countries will struggle. You may have read that China’s navy has more boats than the United States navy. This is just more media fear-mongering. China’s navy can’t compete with the United States navy and isn’t even close.
If you’re worried about Chinese technological supremacy, I’ll direct your attention to their inability to make a functional COVID-19 vaccine despite their obviously urgent need for it. The west’s vaccines are far from perfect, but they significantly reduce the mortality rate of COVID-19. China’s vaccine is entirely ineffective.
Finally, we get to innovation. If you’re worried about Chinese innovation outpacing American innovation, I think you misunderstand how innovation fundamentally occurs.
Why Invest in Startups
Individual entrepreneurs are the innovators that move society forward. The ones who succeed are the backbone of the economy despite being a small part of the population. Entrepreneurs make something people want, engage in a series of willing transactions with their customers, and make a profit doing it. They raise our standard of living, create jobs, and change the world.
The next big technological breakthrough cannot be predetermined. It cannot be centrally planned. It is the random chaos of competition from new individuals and their companies which determines the next big innovation. And while nobody knows where the next big breakthrough will come from, we do know that it will come and will probably seem obvious in hindsight. Funny how that works.
Go back and look at the power law charts. The next amazing idea can’t be decided by congress or a government panel. Effective innovation is never done by a committee. It is a bumpy ride where success will go to a small group of winners. That is how actual progress happens. That’s what makes everyone wealthier.
The United States is fundamentally constructed to unleash the power of the entrepreneur. It is time we celebrated that a bit more. The innovators are why we will continue to succeed. As a startup investor, you have the chance to support entrepreneurs in the earliest stages of their journey. Don’t miss the next great cycle of innovation, wherever it may come from because those who succeed will succeed spectacularly.