Peter Thiel, author of Zero to One, is an entrepreneur, philosopher, public intellectual, chess wizard and philanthropist. But these days he is known mostly as a very successful investor. When Thiel provides investment advice, people take note.
In chapter seven of Zero to One, Thiel explains his broad investment thesis, which, at the most abstract level, is dominated by the power law distribution. Such distributions are characterised by massive asymmetry. For example, in venture capital, it is not unusual that the most successful company in a fund will provide higher returns than all the other companies in the fund combined.
This leads to the heuristic that each investment you make should have the potential to return the entire fund (that is, to cover all the investments made out of that fund). Thiel says “investors who understand the power law make as few investments as possible.”
Thiel illustrates his argument by pointing out that Andreessen Horowitz made a relatively small investment of $250,000 in Instagram and received a 312x return, or $78 million. Not bad, right? Wrong, says Thiel, because $78 million nowhere near covers Andreessen Horowitz’s $1.5 billion fund from which they made their investment.
But contrast this to the advice given by Nassim Nicholas Taleb in The Black Swan on the same topic:
Make sure that you have plenty of these small bets; avoid being blinded by the vividness of one single Black Swan. Have as many of these small bets as you can conceivably have. Even venture capital firms fall for the narrative fallacy with a few stories that “make sense” to them; they do not have as many bets as they should. If venture capital firms are profitable, it is not because of the stories they have in their heads, but because they are exposed to unplanned rare events.
So whom are we to believe? The Thielian school would have you invest large amounts in as few startups as possible. The Talebian school would have you invest smaller amounts in as many companies as possible. Taleb, it should be noted, wrote a strong endorsement for Zero to One; all told, it is a book worth reading.
I think what Thiel is saying is not so much that investors need to make as few investments as possible, per se, but that, given the power law and its implication for the distribution of returns from a VC’s portfolio companies, it makes sense that the size of the cheques a VC writes (assuming the stake they receive in return is about the same for each investment) should be tuned such that any single investment is capable of returning the fund. This puts a natural limit on the number of investments that can be made.
But here’s the thing: this logic means you’re placing an implicit upper bound on the returns you think the best company in your portfolio will make. Basically you’re saying “I believe in Black Swans, but on average the best performer in each fund has the potential to return the value of the entire fund but won’t do much better than that.” If this weren’t the case, you’d be taking Taleb’s advice, because in a world where Black Swans exist, one of your many small bets might hold the potential of returning your entire fund. (Note: the original TechCrunch article on unicorns explained that about 1 in 1,538 US tech startups founded after 2003 were valued at more than $1 billion in 2013.)
It’s interesting to note that Instagram is now valued at $35 billion by Citigroup. So, hypothetically, if they had IPO’d at the end of 2014 instead of selling to Facebook in 2012, that little $250,000 investment Andreessen Horowitz made would have paid off their entire fund, nearly twice over.[This was the last of three articles critiquing Peter Thiel and Blake Masters’ book, Zero to One. Part one is a general review. Part two questions Thiel’s representation of the early history of Apple, and his advice about minimum viable products drawn from that (mis-)representation.]