Don’t Sacrifice Your Startup to the Power Law
5 Unconventional Strategies to Thrive Against the Odds
In Silicon Valley, the “power law” reigns supreme and dictates a game of high stakes and monumental returns. Yet, within this framework lies an existential challenge for entrepreneurs: navigating a path that optimizes for their startup’s success while contending with the investor mindset that optimizes success at a portfolio level.
While much has been said about power law from the investor perspective (see, for example, its well-researched history by Sebastian Mallaby), it is time we take a closer look and rethink the power law from the entrepreneur’s point of view.
The Entrepreneur’s Dilemma:
Power law in venture investing represents the fact that in venture capital portfolios, a couple of successes more than cover for the losses by the rest. Historically, a very small single-digit percentage of deals account for the majority of venture returns. Pursuing the power law has worked out quite well for many VC firms and attracted ever increasing funding into the sector (peaking at over $600 billion in 2021), fueling global innovation at unprecedented levels. Because of power law dynamics, venture capitalists seek out only those startups that have massive return potential, which explains their fixation on Total Addressable Market (TAM)) and their relentless push on each portfolio company to go for scale and market dominance as soon as possible. “Go big or go home” is not an empty slogan, but an unquestioned edict in the cult of the power law!
As a natural consequence of the power law, those startups that don’t exhibit the highest levels of ambition or potential don’t get funding and/or support from the venture capital community. The clear winners in a portfolio tend to get the most attention from investors and the struggling ones, not so much.
Venture Capital is the only asset management class that focuses on return/potential maximization rather than risk management/minimization. -Michael Tan
While the power law has been the invisible hand guiding the venture capital community, the fundamental problem for entrepreneurs is that they do not have the luxury of a portfolio. Because investors have a portfolio, they have significantly less at risk in a startup than the entrepreneurs in that startup do (who, after all, have all their eggs and more in that one basket). Most startups fail, and the chances that your startup may be a unicorn is well, very, very, very low at best. Thus, while both investors and entrepreneurs want their companies to succeed, there is an inherent, structural misalignment in incentives, asymmetry in risk tolerance, and clash in definition of “success” for the two groups. What is considered success for entrepreneurs is more often than not considered a failure by investors.
For example, most entrepreneurs would be elated selling their startup for $50 million after a venture round that valued that startup at $30 million post money, but most venture capital investors would want to dissuade those entrepreneurs from taking that course of action and urge them to aspire for much bigger exits instead. What is a life-changing outcome for most entrepreneurs is at best perceived by most VCs as a missed opportunity brought about by lack of courage and/or ambition. Because they have the benefit of a portfolio, investors are far more willing to roll the dice and go for a bigger outcome in the future than entrepreneurs, who would much rather seize that metaphoric bird in the hand.
The power law, as a guiding principle, has led to a dysfunctional dynamic between investors and founders, to the detriment of both. Among the manifestations of this dysfunction is what I’ve come to identify as the “exit taboo.” This is essentially the reluctance against entrepreneurs openly discussing exit strategies, which not only undermines the very fabric of startup culture but also precipitates the untimely end of many promising ventures. (For those interested in a more nuanced dissection of this issue, I’ve delved into it in greater detail in an article for the Harvard Business Review.) Another manifestation is a lack of open and honest communication by entrepreneurs of problems plaguing their startup, worrying that investors may give up on supporting them if they suspect their startup may not scale as fast and grow as large as they had initially expected. Thus, they keep on not delivering the “bad news” until it is too late to do something about it.
And therein lies the good news: once you recognize this asymmetry in incentives and its consequences, there are actually several things you can do not to fall victim to it.
What You Can Do:
- Develop a Robust Business Model: Build a business model that stands on the merits of sustainability and resilience. Develop a line of sight to cash flow breakeven as soon as possible. Focus on creating real value for your customers, a strategy that ensures growth and profitability, regardless of the scale. This foundation will not only attract a broader spectrum of investors but also provide a buffer against the boom-and-bust cycles that the pursuit of unicorns can engender. Fundability has more to do with group psychology (i.e., what leading investors consider to be “hot” sectors) than objective prospects of your startup. I have been involved in several startups that didn’t make it to their next round of funding and shut down just because of timing: the investment community was looking to invest in something else and was just not into them.
- Be Capital Efficient: Even if you can readily raise tons of venture money at lofty valuations (here is looking at you AI startups), think twice. Most consider the size of a venture round a success metric, but unfortunately that is usually not the case unless you are truly a growth stage company ready to just pour fuel on the fire and take off. The problem with a large funding round for your startup is that it (a) unnecessarily inflates your valuation and thereby reduces the population of your potential acquirers and future investors, (b) increases the likelihood of ugly and demoralizing down-round financings (a fate shared by many of the 700+ unicorns currently in limbo), and © forces you to scale prematurely, growing in a direction that may not have been the optimal path had you taken more time to iterate and listen to your customers.
- Communicate Transparently with Your Investors: In the startup world governed by the power law, founders often hesitate to share challenges with investors, fearing it might deter support. However, this misses a key point: knowledgeable investors, aware of the long odds for massive success, are typically open to alternative success pathways if they truly understand the real challenges facing your startup. Recognizing this can transform the founder-investor dynamic from a high-stakes gamble on becoming a unicorn to a strategic partnership to find the right outcome, be it an exit or something else. Only by fostering a culture of transparency, startups and investors can collaboratively navigate towards achievable and meaningful results.
- Work on Your Exit Strategy: Counter the “exit taboo” by openly considering and planning for various exit strategies long before an exit is necessary. For every IPO there are at least 30 exits by acquisition, whether by a strategic partner, private equity firm, or others. Creating and executing against a clear exit plan is the best ways to build value and strategic options for your startup, as I discuss in detail in my book Exit Path.
- Cultivate a Supportive Network: Build a network of mentors, peers, and advisors who understand the nuances of your industry and the complexities of growing a business under the power law shadow. This community can offer invaluable advice, alternative perspectives, and potential connections to investors who respect and support varied paths to success.
Navigating the power law in Silicon Valley requires a blend of strategic acumen, clear communication, and a steadfast commitment to your vision. By understanding the investor mindset and the dysfunctions resulting from power law, you can carve out paths to success that are both sustainable and aligned with your values. The journey is challenging, but with the right strategies, it’s possible to thrive within — and perhaps even reshape — the dynamics shaped by the power law.
