Power Laws, Not Panic

With five decades of experience in venture capital, CEO Len Batterson has a "conversation" with AI app ChatGPT which offers no experience but a lot of resources.

In January of 2023, Barron’s published this statement: “Venture capital investing hit a rough patch in 2022, as the downturn in the economy and weakening equity markets rippled through the start-up world.”  In more good news (not), the venture capital research firm PitchBook noted that total exits from venture capital investments—both acquisitions and initial public offerings—were just $71B in 2022, down more than 90% from $753B in 2021. As the new issue market effectively shut down, and merger-and-acquisition activity slowed. It was the worst year for VC exits in dollar terms since 2016.

We asked Len Batterson, VCapital co-founder, CEO, and Chief Investment Officer, who has 50 years of venture capital investing and management experience, to have a “conversation” with the artificial intelligence app OpenAI’s ChatGPT, offering no experience but a lot of resources, about the potential impact of an economic storm on a venture capital portfolio.

Is it time to panic about venture capital investing? 

ChatGPT: No, it is not time to panic about venture capital investing. While venture capital investing has seen a decline in recent years, the industry is still relatively healthy overall, and there are still plenty of opportunities for investors to make money. Venture capital firms are still investing in innovative startups, and venture capitalists are still looking for promising investments.

Len Batterson: During my five decades in the industry, I have experienced the growth of venture capital across many ups and downs. I can answer the question with confidence, certainly not. Whether the recession in the early 1990s, the web implosion of 2000, the financial meltdown of 2008, and now the inflation-driven slowdown of 2022, the economic impact of COVID-19 and related supply change disruptions, geopolitical instability created by the war in Ukraine, and rising inflation and interest rates, the venture capital industry will survive, and it will thrive.

How will venture capital firms optimize their portfolio during an economic storm?

LB: A strategic approach that VCapital follows to position venture capital to achieve high returns and has stood the test of five decades is the Power Law, with intense focus on the selection process. The present VCapital investment pool reflects and is built on the Power Law, deploying generalist skills with specific specialty experience employed when needed. While challenging economic conditions do contribute to more start-up failures, applying Power Laws to a portfolio or fund can produce positive overall outcomes.

ChatGPT: Venture capital firms will typically take a more conservative approach in their investment strategies during an economic storm. They may focus more on defensive investments, such as those in healthcare, technology and e-commerce, as these sectors are typically more insulated from severe economic downturns. In addition, venture capital firms may invest in industries that are well-positioned to capitalize on opportunities that arise from the downturn, such as companies developing new technologies or those offering services to businesses that are suffering from the downturn. Finally, venture capital firms may look for opportunities to invest in distressed companies, where they can acquire assets at reduced prices.

Define Power Laws in venture capital investing. 

LB: We like Peter Thiel’s definition because we like baseball references. They are easy to understand. Spend the most time on the small handful of big winners because home runs far outweigh base hits. 

Over the past six years, we have made 13 investments in later-stage seed investments or early-stage Series A investments. Of our initial thirteen, two have failed with much of the capital recovered; one failed without any likely recovery, two others have a more uncertain outcome, while eight each have the potential of returning much of the total capital invested in the entire pool.

Several of these eight are in a position to be multi-billion dollar exits. At this point in the development of these companies, only some pools would be in this strong position. 

Generally, in early-stage VC investing, the lemons ripen before the oranges. At year six or seven in a fund or pool, there are many lemons and few growing to be oranges. Several of the current VCapital investments have the potential to mature into orange groves. The technical developments in several of the investments may spin into one or more product applications or even new sister companies. If history is any guide, this spin-out approach often results in the highest returns, with one of our pools returning 160% net return annually due to a spin-out and another achieving an IPO.

ChatGPT: Power laws in venture capital investing refer to the phenomenon that a small number of investments generate a majority of returns. This means that a few investments return disproportionately higher returns than the other investments. The idea is that the majority of the funds that are invested will not generate any returns, while a few investments will generate a high return. This can be seen in the distribution of returns, with a small number of investments generating a large portion of the total returns.

What are Power Law strategic and tactical approaches? 

ChatGPT: Power Law strategic and tactical approaches focus on achieving exponential growth, rather than linear growth. They involve creating a strategy and tactics that focus on leveraging small initial investments to generate large returns. This is often done by focusing on high potential opportunities, such as network effects, economies of scale, and leveraging existing technology and infrastructure. These approaches also involve focusing on the long-term, and planning for the future. The goal of Power Law strategies and tactics is to maximize the return on investment, while minimizing risk.

LB: Complementing VCapital’s strong strategic Power Law positioning is a tactical plan focused on further enhancing the potential to return much of the capital of the entire pool. Tactics for 2023 include:

• Continue to support current investments with additional follow-on investments when warranted.
• Launch Series C VCapital round to support firm management, marketing, and investment development.
• Coordinate investment selection, diligence, and funding with the 58 members of the Midwest Venture Capital Consortium (over 10 billion in available capital to invest).
• Identify and select investments with spin-out potential and initiate the process.
• Provide focus and strategic direction to those companies moving toward exits.
• Develop and launch new funds or pools to support current investments. 
• Add new investments each year with billion or multi-billion exit potential.

How will venture capital continue to impact society? 

ChatGPT: Venture capital will continue to have a major impact on society by providing capital to startups and other businesses in order to help them grow and innovate. This type of capital allows businesses to expand into new markets, launch new products, and create jobs. Venture capital also helps foster innovation, as the investors provide resources and advice to entrepreneurs and businesses looking to develop new technologies and products. Furthermore, venture capital helps to promote economic growth, as investments in new businesses create jobs and drive economic activity. Finally, venture capital has a positive impact on society because it helps to support social causes, such as providing educational opportunities for low-income students, funding medical research, and providing access to clean energy.

LB: The venture capital industry brought dramatic change to society and culture by creating and deploying biotech, nanotech, medical, social media, the World Wide Web, and numerous other world-altering contributions. Currently, firms such as VCapital are pursuing cancer cures, quantum computing, advanced computer high-speed processing, nuclear fusion, genomics, artificial intelligence, sensors, solar cells, biotech, nanotech, neuroscience, and other world-altering technologies. Moreover, many of these technologies are entering the era of exponential growth, which means almost incomprehensible rates of change.

Closing remarks? 

ChatGPT: It is possible that the best investment in a VC fund or pool can outperform the rest of the fund combined, however it is not guaranteed. Each individual investment carries its own risks and rewards and no one can predict with certainty which investments will be successful. The success of any given venture capital fund or pool depends on many factors such as market conditions, timing, management decisions, etc. It is important to do thorough research before investing in any venture capital fund or pool to ensure that you are making an informed decision about your money.

LB: We appreciate your interest and support and look forward to working with you during the new and exciting year of 2023 as we begin to move toward the successful exits of our investments.