Your explanation makes sense but is predicated on the VC being able to reliably rank these companies along expected returns.
The perfect VC with perfect foresight might be able to pick just 1 investment and get the best returns from that.
If returns are distributed on a power-law distribution (with the top performer returning a multiple of the second one and so on), then any deviation between the VC ranking and the outcome distribution of returns is very costly. What if I only invest in my predicted top 5, but the real top 1 is ranked 6 in my estimate?
If what matters is to reliably capture the top performers, then the perfect VC would get the top 5 with only 5 investments. But for imperfect VCs, it might be worth it to invest in 50 just to approach 100% chance of capturing these 5 top performers, the 45 others are just the cost of doing that.
> But for imperfect VCs, it might be worth it to invest in 50 just to approach 100% chance of capturing these 5 top performers, the 45 others are just the cost of doing that.
Yep! This is exactly how most funds operate. They invest in 30 or 40 companies over 3-4 years with the hope that 30-40 is enough to hit 1-2 big winners. The more confident a VC is in their picking skills, the more likely they are to invest in 15 or 25 companies in a fund, instead of 30+.
The perfect VC with perfect foresight might be able to pick just 1 investment and get the best returns from that.
If returns are distributed on a power-law distribution (with the top performer returning a multiple of the second one and so on), then any deviation between the VC ranking and the outcome distribution of returns is very costly. What if I only invest in my predicted top 5, but the real top 1 is ranked 6 in my estimate?
If what matters is to reliably capture the top performers, then the perfect VC would get the top 5 with only 5 investments. But for imperfect VCs, it might be worth it to invest in 50 just to approach 100% chance of capturing these 5 top performers, the 45 others are just the cost of doing that.