Summary of ‘Zero to One’, Chapter 7: Follow the money
Summary: Performance follows a power distribution. In a fund, the best company will earn more than all the rest combined. In a company, one market and one distribution method will perform far better than the rest. In a career decision, one path will be much better than the rest. But we don’t see the power distribution - instead, we see a normal distribution. Schooling teaches that all skills are useful - just pick one. We don’t understand exponential growth; we see small early differences and think they’ll stay that way. As a result, we pour effort into fixing failures instead of growing successes. But we should instead pick a small group of candidates, each of which has the potential to vastly succeed.
Compound interest is powerful. Money makes money. In 1906, Pareto expounded the “Pareto principle”, or 80-20 rule: a small few radically outstrip all the rivals. Power laws of distribution are seen everywhere in nature. The same is true of companies: “monopoly businesses capture more value than millions of undifferentiated competitors”. Even venture capitalists struggle to understand this.
Venture capitalists (VCs) try to find valuable early-stage companies. They take money from investors and bet it on tech companies. But most of these companies fail: they do not hit the exponential growth sought.
VCs know companies are different, but they underestimate how different. They assume company success follows a normal distribution, so they scatter money everywhere.
But the correct approach is to focus and find the really valuable few. At Founders Fund, Facebook returned more money than everything else combined. This is the rule of venture capital. This has a strange implication: you should only invest in something with the potential to return more than the entire fund. Andreessen Horowitz netted a 312x return on Instagram, but this was not nearly enough, because it never had the potential to yield their entire $1.5B fund! VCs need to find the unicorns and back them with everything. We should still have a small portfolio (Founders Fund invest in ~6 companies in one year’s fund), but each must have the potential for vast success.
Why don’t we see the power law? In early stages, we can’t tell the difference between linear and exponential growth. The investments look similar. VCs then suffer from sunk cost fallacy, spending time on the problematic companies.
The power law is important for everyone, because everyone is an investor: founders in their companies, individuals in their careers. Schools encourage diversification of skills, but the students cannot “diversify” themselves - they must choose a path!
Don’t necessarily start your own company; it could be much more valuable to join a successful one. But if you start a company, remember the power law: one market will be best, one distribution strategy will be best.
This page copyright James Fisher 2018. Content is not associated with my employer.
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