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Venture Investing and the 80/20 Rule

Almost a year ago, my Hatcher partners and I went looking for data that would give us an indication of our progress vis a vis the rest of our colleagues in venture capital.  This set us on a nearly year-long journey of discovery, in which we looked deeply at data for nearly 20,000 deals, dozens of venture investment funds and holding companies, and thousands of startups. What we discovered was in part revolutionary (this is the part that forms the basis of our Optimal Investment Model), in part a new way of looking at old concepts, and, in part confirmatory.

Take the 80/20 rule - the long-quoted "rule" that 20% of a venture portfolio is responsible for over 80% of the returns (aka the Pareto Principle).  As Investopedia.com helpfully explains:

The 80-20 rule was first introduced by Italian economist Vilfredo Pareto, who, in 1906, observed that 80% of Italy's land was controlled by 20% of its population. From there, it was developed by Joseph Juran, a 20th century figure in the study of management techniques and principles. Jurin took the rule and applied it to a number of different facets of business and the economy. It is now used to describe almost any type of output in the real world.

The Pareto Principle has been used to explain everything from infection rates to salary distributions within companies.  With respect to venture capital, a lot of people have quoted the "80/20" rule over the years (some investors, like Peter Thiel, take it to an extreme when they say things like "the biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined"...)  We thought it would be fun to prove (or disprove) the rule ourselves, using data from over 11,300 deals and 60 venture groups. 

Here's what we discovered: when we looked at all the data, the 80/20 rule was confirmed by an overwhelming 91% of the investment groups in our study*.  In other words, over ninety percent of venture firms studied received over 80% of their returns from 20% of their portfolio.  

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What does this mean, in practical terms, for fund managers and limited partners?  It means that a lot of the time, when a fund manager is attempting to "pick winners" in a small portfolio, they are looking for the proverbial needle in the haystack: those one or two companies that will make a difference.

This is enormously difficult to do.  Unless of course, you're mitigating the problem by applying a different model, like the Hatcher+ Optimal Investment Model, which I'll be talking about in an upcoming post. 

*The Thiel quote is included in a great blog about the Pareto Principle (or "Power Law" as they call it) by Ho Nam at Altos - you can read it here.

*Consulting firm Redseer was commissioned by Hatcher to conduct the study required to support its investment thesis.

Sharp John Sharp

John is a Partner at Hatcher Plus, the leading data-driven venture capital investment firm. John has extensive commercial experience at the senior management level, having been the Chief Executive Officer of Authentium, Inc. the Managing Director, Asia, of WorldSpace, and CEO of Hatcher, the precursor company to Hatcher+. A tenacious and driven executive with longstanding board-level and C-suite level management experience within high-growth companies, John also brings a strong history of capital raising from an extensive network of investors globally. As Chairman and CEO of cybersecurity pioneer Authentium (acquired by CYREN in 2010), John co-authored three US patents and developed and sold cybersecurity solutions to some the largest organizations in the world, including the US Department of Commerce, NASA, AOL, British Telecom, Comcast, Cox Communications, Google, McAfee, Microsoft, Symantec, and Telstra. As CTO at Hatcher+, DocDoc, Heardable, and ThoughtRiver, John has designed and developed several highly-innovative technology platforms using cutting-edge approaches to data processing, user interface design, and workflow optimization. John is a frequent blogger and an in-demand speaker at venture events globally, and has extensive experience implementing ESG solutions as Chairman and/or board member of numerous start-ups, including director roles at trade finance provider ASYX and payment aggregator Mozido, and roles as Chairman of MENA-based financial services pioneer Telr, and the leading Cambridge-based legal services technology company, ThoughtRiver.