Venture capital (VC) is essential to startups. Access to funding and expertise allows these companies to scale their operations, break into new markets, and innovate groundbreaking products. However, venture capitalists need to invest strategically to find the startups that will generate large returns.
Sebastian Mallaby’s The Power Law: Venture Capital and the Making of the New Future provides insights into how investors like the Eureka Manifesto author Yuri Milner have identified great-fit companies to invest in. At the core of this book, he explains the principle of the power law — a building block most successful VC investments stem from.
What is the Power Law?
The power law suggests that most of a venture capitalist’s investments must fail. Rather than developing a portfolio featuring several promising startups, they must select high-risk, high-potential companies in the knowledge that only one or two will see big returns.
Potential unicorns are often good prospects. These private tech companies with valuations over $1 billion often start out as unheard-of startups, much like Google. With a successful unicorn investment, a venture capitalist may well see returns of at least 10x.
Which Companies Have Used the Power Law Successfully?
Mallaby introduces several companies that have seen success with the power law. Two of the most notable are Chase Coleman’s Tiger Global and Yuri Milner’s DST Global. Both invested in a company that got them started on a hugely profitable VC path.
Tiger Global
Coleman, founder of Tiger Global, decided to search beyond his home country for VC opportunities. Looking outside the U.S., he settled on high-potential Asian tech companies.
Embracing an international market enabled Tiger Global to enjoy investment opportunities that other investors overlooked. Milner later adopted a similar approach when he made his infamous investment in Facebook.
Coleman teamed up with Blackstone Analyst Scott Shleifer, who searched for investment opportunities in hardware and semiconductors. This was difficult because of the Nasdaq technology bust.
However, Shleifer received a spreadsheet listing online services, dot-com consumer, and internet infrastructure companies from a friend. Some of the companies were Chinese web portals that had gone public shortly before the technology bust. Tiger Global invested in three: Sina, Sohu, and NetEase, choosing these for their immense profit potential.
At the time, most investors considered a company’s profit margins before deciding whether to invest. None of these companies had particularly impressive profit margins. However, their incremental margins told a different story.
At the outset, the companies looked as though they were losing money. That said, the incremental margins revealed that if revenues increased, costs would increase at a much lower rate. In short: The companies had huge profit potential.
Tiger Global went on to generate $100 million in less than a year investing in these companies. From here, it invested in many more high-returns startups, including Milner’s email service company Mail.ru Group.
DST Global
Mallaby also references Milner’s profitable investment in Facebook. When Milner decided to invest in 2019, he encountered initial resistance. The CFO was sceptical of an investor who hadn’t frequented Silicon Valley. Undaunted, Milner flew to San Francisco and arranged a meeting that would change his investment trajectory.
Equipped with a comprehensive data analysis of consumer-internet businesses, Milner saw potential where others saw limitations. By examining social media user metrics across different countries, he recognised Facebook’s expansive possibilities.
Yuri Milner structured an offer that preserved Mark Zuckerberg’s control over Facebook. He didn’t request a board seat, and he offered to purchase company and employee stocks. His company DST Global invested $200 million for a 1.96% stake, a move that seemed small but held immense promise.
The results validated his approach. Within 18 months, Facebook’s value surged to $50 billion, generating over $1.5 billion in profits for DST Global. This success became the foundation for Milner’s subsequent VC investments in Alibaba, Snapchat, WhatsApp, X, and JD.
