The Power Law in Venture Capital: How Strategic Investments Shape Long-Term Gains

Budding investors will find a wealth of venture capital (VC) insights in Sebastian Mallaby’s acclaimed book, The Power Law: Venture Capital and the Making of the New Future. Shortlisted for the Financial Times Business Book of the Year and named one of The Economist’s Best Books of 2022, it’s a must-read for anyone who wants to understand the strategies that lead many investors to generate massive returns.

The Power Law explores the stories of high-profile venture capitalists like Yuri Milner, who have changed the face of investing through a concept coined the “power law.” But what is this law, and how does it work?

Understanding The Power Law in Venture Capital

According to the power law, one investment will yield far larger returns than all other combined investments a venture capitalist makes. As Mallaby notes, many investors see the majority of their returns from backing one single company, despite investing in many.

This principle has unfolded repeatedly in VC, revealing that a normal distribution of returns is rare. Instead, most investments will likely break even or fail, just as many companies themselves do.

This rate of “failure” is especially common when venture capitalists back startups, which are riskier to invest in. These companies tend to run in uncertain environments. They may follow unknown business models, operate in unknown markets, or use unknown technologies.

However, startups are also some of the smartest companies to invest in. The ones that grow exponentially often generate billions. These startups tend to grow at scale with access to global markets and at low costs.

Because of this, the right startups have the power to swipe the majority of a market share, leaving other companies with just a slice. This has been the case for companies like Amazon, Google, and Facebook — a core case study in The Power Law: Venture Capital and the Making of the New Future.

Power Law Success Stories

In The Power Law, Mallaby explains that many companies like startup backer Y Combinator and investment company Horsley Bridge have seen the power law unfold. For Y combinator, just 2 of its 280 investments in 2012 generated three-quarters of its returns. For Horsley Bridge, only 5% of its capital produced 50% of its returns between 1985 and 2014.

However, one of the most influential examples of the power law in action is venture capitalist and Eureka Manifesto author Yuri Milner’s investment in Facebook. In 2019, Milner — now famous for his investment philosophy — contacted Facebook’s chief financial officer to show interest in investing.

The CFO didn’t believe Milner was serious as he hadn’t visited the tech startup hotspot Silicon Valley before. Milner wanted to visit, but the CFO told him not to come to San Francisco just to see him.

Despite this conversation, Milner booked a flight to San Francisco. When he arrived, he phoned the CFO again, asking if they could meet. Surprised but impressed, the CFO suggested they meet at a Starbucks.

Yuri Milner’s Strategy for Facebook

During the meeting, Milner laid out a proposal for Facebook. A Goldman Sachs banker had told him that the social media platform might need to raise capital at a discount to the $15 billion valuation in its previous round. Despite this, Milner was willing to bid high with a starting offer of $5 billion.

Facebook had just hit the milestone of 100 million users, which meant many investors thought it was coming close to its saturation point. However, Milner had created a vast spreadsheet of data on consumer-internet businesses in several countries, and this data suggested otherwise. The spreadsheet tracked factors like daily users, monthly users, and average time spent on sites.

Milner had also already invested in a similar company, VKontakte, and witnessed this company’s growth firsthand. Given the trends in this company’s growth, he was confident other investors were wrong. He knew that Facebook still had a long way to go.

Although the social media platform wasn’t in the top five websites in the U.S., it was in the top three across many other countries. If the U.S. followed the typical pattern that Milner had seen before, Facebook would have much growth ahead.

Additional Revenue Opportunities

Milner also noted that Facebook was behind other social media websites in terms of converting users into revenue. Because of owner Mark Zuckerberg’s position in Silicon Valley, he had found it easy to raise funds from investors. However, he hadn’t faced much pressure to create revenue from customer spending.

Meanwhile, comparable companies in other countries had been under intense pressure to generate revenue from users from the beginning. In China, most social media revenue came from selling virtual gifts. If they could do this, so could Facebook.

All of this research allowed Milner to highlight where Facebook was an outlier in the social media market and pinpoint further growth opportunities for the company.

How Yuri Milner Created an Attractive Offer for Mark Zuckerberg

Inspired, the CFO invited Milner to meet Zuckerberg. Milner adapted his bid to make it especially appealing to the CEO, who wanted to maintain control over Facebook.

Milner knew Zuckerberg had recently turned down an advance from an investor who’d requested two board votes. With this in mind, he said that he wouldn’t take a board seat and that Zuckerberg could vote his shares however he liked. This meant that Milner’s investment wouldn’t dilute Zuckerberg’s control over Facebook. In fact, it would increase this control.

Next, to make his bid even more attractive, Milner offered to buy employee stock on top of his shares.

Zuckerberg had promised his employees — stock-option millionaires — that they could sell around a fifth of their vested stock to buy cars or apartments. He believed the investor that would lead Facebook’s next round of financing would buy additional shares from employees. However, due to the financial crisis, this hadn’t happened.

In fixing this problem, Milner paid one price for the company-issued stock and a lower price for the secondary stock that Facebook employees sold. This allowed him to keep the offer enticing to Zuckerberg while keeping acquisition costs down.

How The Power Law Played Out for Yuri Milner

As the stock market recovered, many rival suitors approached Zuckerberg. Milner was able to outbid each of them. Their offers of $5-8 billion couldn’t compete with Zuckerberg’s desired $10 billion, which only Milner could pay.

Milner’s data-driven approach allowed him to take a chance on Facebook and see immense returns that exemplify the power law. This was his big win that went on to launch a highly profitable investment journey.

His investment company, DST Global, bought $200 million worth of company-issued stock in return for a 1.96% stake. DST also purchased secondary employee stock at a lower valuation of $6.5 billion, buying more than $100 million of these cheaper shares and increasing the blended valuation to $8.6 billion.

As Milner expected, Facebook’s audience and revenue boomed. 18 months later, the company was worth $50 billion, and DST had profited over $1.5 billion.

Yuri Milner’s String of Strategic Investments

Milner’s power law success acted as a springboard, and DST went on to invest in other major technology companies like Twitter (now X), Snapchat, Alibaba, WhatsApp, and JD. Having generated major returns, Milner then created his Breakthrough Foundation to fund a host of philanthropic, mainly scientific ventures. These include:

• The Breakthrough Prize — the world’s biggest science award.
• The Breakthrough Initiatives — five space science programmes that investigate the possibility of life beyond our Universe.
• The Breakthrough Junior Challenge — a global contest for teenagers that educates the world on complex science via fun, creative videos.

Just as only a few investments will generate big returns, only a few individuals can garner recognition via the Breakthrough Prize and Breakthrough Junior Challenge, and only a few discoveries unveiled in the Breakthrough Initiatives can change the world. But power can come in small numbers. We just need to find the opportunities that transform our lives for the better.

A Venture Capitalist’s Startup Strategy

As the power law proves itself repeatedly, investors know that the cost of missing a high-stakes investment opportunity is high — possibly infinite. Venture capitalists must embrace risk and see failure as necessary rather than negative.

Strategic venture capitalists will seek potential “unicorn” startups — private companies valued at over $1 billion without being listed on the stock market. These are the startups that are often goldmines waiting to erupt.

Venture capitalists will adopt investment strategies that combine high-risk tolerance and diversification with a resilient search for these companies. They will typically invest in various startups, aware that they need a range to hit gold with a big winner.

To learn more about VC strategy, read The Power Law: Venture Capital and the Making of the New Future.