Have you ever wondered why some VCs seem comfortable with most of their investments failing?

Or why investors keep pouring money into startups when the odds of success seem so low?

The key is to understand the power law – one of the most important concepts in startup investing.

Buckle up, friends. This week’s edition of Small Bets is a doozy.

What Is the Power Law?

Power law in startup investing means that a teeny tiny percentage of companies will deliver massive returns, and most others will return little or nothing.

This is the fundamental economic model that makes venture capital work.

You could invest in 10 companies, and the chances are that 9 of them will return nothing, or a smal return, like a 1x or 2x return.

If just one of your companies is a huge success (and I mean huge), that will more than make up for all those other losses.

Let’s talk about a real-world example.

If you had invested $5,000 in Uber at the seed round – and held until IPO – that investment would have been worth $25 million (a 5,000x return).

The Mistake New Investors Make

A question we get from new investors quite often is: "How can I get more of my portfolio companies to succeed?".

But here's the thing: If you had 10 companies in your portfolio and 9 were "successful" but only returned small multiples, your portfolio would still likely underperform compared to having just one massive winner.

Nine companies returning 5x returns won’t hold a candle to 1 company that provides a 100x return.

⭐️ What truly matters isn't how many companies succeed, but how big of a success the winners are.

Why Traditional Thinking Fails

Let’s talk about linear thinking.

Linear thinking means you expect that what you put in and what you get out will match up, and that the average of all your results tells the true story.

For example:

• When you work at a job, you expect that working 40 hours will earn you twice as much as working 20 hours.
• If you save $100 a month, you'll have saved $1,200 after a year – no more, no less.
• If you drive at 60 mph, you'll cover exactly twice the distance as driving at 30 mph in the same time.

These are all examples of linear relationships where the outcome directly matches the input.

Here's what linear thinking looks like in investing:

• If you invest in 10 companies and 2 fail, you're down 20%
• If the remaining 8 companies return 2x each, your portfolio returns 1.6x overall (80% × 2x)
• To improve returns, you need to either reduce failures or increase the average return

This kind of thinking makes perfect sense for traditional investments like stocks or real estate. If you buy 10 rental properties and 2 lose money while 8 perform well, your overall return is indeed the average performance.

🚨 But venture capital doesn't work this way.

In venture, returns follow a power law distribution where outliers dominate everything else.

Adding more investments doesn't dilute your returns – it actually increases your chances of finding that one extraordinary company that returns 100x or more.

When most people see a portfolio with one massive winner and nine failures, they think, "What a shame – if only the other nine had succeeded too!" But experienced VCs think, "Let's find more companies like that winner, even if it means having more failures too."

This is why accelerators like Y Combinator keep increasing their batch sizes and investments.

With great deal flow (and that part is key), investing in more companies actually increases their chances of finding those rare power law winners.

Each massive success more than compensates for all the failures combined.

What It Means to Be a Power Law Winner

When VCs talk about finding winners, they're not looking for 2x or 3x returns. They're hunting for companies that can deliver 100x, 1,000x, or even 10,000x returns.

Let's put some numbers to this:

If you invest at a $5 million valuation, a "100x winner" would exit at $500 million.

But in reality, you'll face dilution through future funding rounds – about half your ownership might be diluted away.

So you're really looking for billion-dollar outcomes to achieve that 100x net multiple.

Why Can't We Just Pick More Winners?

"Why not just try to pick more winners? Why not aim for nine out of ten companies returning 4x?" - most people

The problem is that it’s really hard to find product-market fit. And startups, by definition, haven’t found it yet.

Finding product-market fit involves a whole lot of luck. Even the best investors and founders only succeed 30-50% of the time.

Product-market fit isn't just a seed-stage challenge. Companies struggle with it at pre-seed, seed, Series A, and sometimes even approaching Series B. It takes time, iteration, and… did we mention luck?

It Boils Down to This

The power law is fundamental to startup investing.

It’s not about the number of wins or the percentage of your successful companies, but rather how successful your successful companies are.