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.