Early-stage investing is fraught with risk and largely results in binary outcomes for the investor.  VCs take a bet on a number of startups hoping that at least 2 of the 20 deals provide a return greater than > 10x (read potential unicorns), whilst knowing that more than half shall fail. This is explained by the power-law curve where small events lead to large outcomes. 

Top-performing VC funds know this and leverage the power law to make an exponential number of bets. This is explained in the chart below but also now more defined in the Indian ecosystem with the likes of marquee investors such as Sequoia, Accel, etc. launching seed/ pre-seed programs (Surge, Atoms) to make a large number of small-sized bets – their objective is clear: to have lower future misses by having the optionality on access. Y Combinator has followed this model and funded more than 3,500+ startups since 2005.

Gradually other investors/ VCs too, have followed this in India as startups started providing exits to VCs post-2015. This has also resulted in the emergence of ‘spray and pray’ VCs/ accelerators – who deploy capital with a limited amount of due diligence, while the larger funds consider the investment a marketing and access expense. 

This poses a peculiar question for family offices, such as ours, with substantial but limited, responsible capital – should we too follow the trend and hop on the funding spree with the hope of lucking it out with a few investments? The power law makes it clear that we need to make a large number of bets – but does a large number of bets simply ensure a potential multi-bagger return? This will be tantamount to Gambling – mistaking a roll of dice for Optionality. To put this another way, the average of 1000 different people tossing a coin can be different than the path of one person tossing a coin 1000 times. 

A paper published by Morgan Stanley in 2020 drives home this point - Return dispersion, the difference between the best and worst funds is very wide in venture capital relative to other asset classes. That means the ability to identify and gain access is crucial

Should we then look to invest in emerging trends/ themes?  Some VCs follow this and are successful as well. However, one must only look a few years back to see if this holds:  

• Did VCs make 10x money in e-commerce platforms outside of Flipkart, Myntra? 
• Food delivery platforms and cloud kitchens were the rage in 2017-19 – How many delivered returns beyond Zomato, Swiggy?

While the above questions are overly simplified and investors will have made/ make money in opportunities beyond the said companies, it’s clear that sub-sectors tend to consolidate towards 2-3 large players and receive the bulk of the follow-on funding. We are witnessing this in spaces in the ed-tech sector as well. Morgan Stanley’s research also shows that leaders do well than followers – one cannot simply piggy-back on trends set by other investors

Our key takeaways for building our investing thought paradigm are:

• As an early-stage investor, we must make an adequately large number of high conviction bets 
• We must bet on businesses/ founders first and then look at broader markets/ themes they operate in rather than vice versa

Naturally, our thought paradigm is an ever-evolving one – like all things in VC. We will also plan to publish our framework on assessing start-ups and developing conviction in a separate blog shortly. Critique and conflicting views are welcome. Please write to Siddharth or Dhruv with your views

Data and Image credit:

Benedict Evans

Morgan Stanley