Venture Capital

Venture capital funds buy minority stakes in young companies that mostly have no profits, often no revenue, sometimes no product — in exchange for a share of what they might become. The expected outcome for any single investment is failure; the model works because the rare winner returns 100x or more.

This is the power law in its purest financial form: in a typical portfolio of 25 startups, one or two outcomes determine the entire fund. Half return nothing; the median fund barely beats bonds; the best funds — persistently the same famous names — return multiples of everything else. Access to those names, not analysis, is the scarce resource.

Money flows in stages — pre-seed, seed, Series A, B, C… — each round pricing the company anew, each new investor diluting the old until (with luck) an IPO or acquisition converts paper into cash a decade later.

Deal machinery

• Preferred stock: VCs buy preferred with liquidation preferences (get paid first, often 1x money back before common sees anything), anti-dilution clauses, pro-rata rights and board seats.
• Valuation vocabulary: "pre-money" + new cash = "post-money"; ownership = investment / post-money. Headline "unicorn" valuations price only the newest, most protected share class — the whole company is usually worth less than shares-outstanding × last-round price.
• SAFEs and notes: early rounds often defer pricing entirely (convertible instruments with caps/discounts).

Fund economics

2/20-style fees on ~10–12 year funds; reserves held for follow-ons (doubling down on winners is where returns concentrate). DPI (cash actually distributed / paid-in) is the honest metric; TVPI (paper + cash) flatters the interim years — "TVPI is vanity, DPI is sanity."

The cycle

2020–21: ZIRP-fueled mania — record rounds, instant unicorns. 2022–24: repricing, down rounds, and a quiet graveyard. The recurring lesson: entry valuation matters even when the asset is a dream, and vintage-year diversification is the only defence against timing the mania wrong.

Valuing the unvaluable

Startup "valuations" are negotiated prices of option-like preferred stock, not DCF outputs. Rigorous approaches treat the capital structure as a stack of call options on exit value (each preference tier a strike), valued with backward induction or simulation; the practical industry substitutes comparables (revenue multiples by stage/sector) and the round market's clearing price.

The power-law mathematics

Empirical exit distributions fit \(P(X > x) \sim x^{-\alpha}\) with \(\alpha\) near 2 — variance barely finite, means driven by tails. Consequences: portfolio size matters (too few shots → likely zero winners), follow-on concentration into winners is optimal, and fund returns are unforecastable from anything but access. Manager persistence is real in VC (unlike most asset classes) — success begets deal flow begets success.

Marks, secondaries and the truth

Interim NAVs are last-round prices — stale the moment markets turn. The growing secondary market in startup shares and LP stakes provides the honest price signal (2022's 30–60% secondary discounts told the story a year before official marks did). Tender offers and structured secondaries are becoming the exit valve as IPO windows shorten.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.