What Drives Power Laws in Entrepreneurship and Venture Capital?
Tags: Power Law, Startup, Venture Capital, Entrepreneurship, VC

Power Law Drivers in Entrepreneurship and Venture Capital

(1) Preferential Attachment

This power law mechanism is commonly expressed in the maxim ‘the rich get richer’. Or if you’re religiously inclined, the Bible says ‘for whoever has, more will be given to them.’

Academics call this phenomenon preferential attachment (or cumulative advantage). It’s when an initial endowment makes subsequent gains more likely. This leads to a privileged position where early wins lead to further benefits that cumulatively add up to an outsized advantage.

I’ve seen this privilege play out in my life in a small way. Getting my first book deal was a low probability event but once that door was open, getting the second, third, and fourth book contracts became more likely.

Preferential attachment isn’t always fair and it contributes to inequalities in the world that I won’t go into here. However, understanding it in the context of entrepreneurship and venture capital can inform strategy.

Preferential attachment in action. Notice how the larger blobs more easily scoop up the smaller ones. Original video here.

We see preferential attachment in entrepreneurship when an ex-Google engineer finds it easier to raise money and recruit talent for their startup because of their pedigree. We also see it in network effects, where each user added to a platform increases the likelihood that other users will flock to it.

Meanwhile in venture capital the best startups preferentially attach to funds which already have success in their portfolio. In other words, success begets more success and as Samir Kaji puts it: “One massive hit is often all it takes to “mint” an investor, regardless of how serendipitous the investment was.”

To benefit from preferential attachment, identify positive feedback loops in your field then look for ways to engineer them to your advantage.

(2) Self-organized Criticality

Despite the unusual name this power law driver is something you’re already familiar with. We see it in ‘overnight success’, which is actually an inaccurate description of something that’s so common in nature that theoretical physicists gave it a technical label 30+ years ago: ‘self-organized criticality’.

This power law mechanism is expressed in snow avalanches, neural networks in the brain, earth quakes, financial market crashes, and even social upheavals. It’s a process where lots of seemingly benign interactions in a complex system can ‘self-organise’ that system to a ‘critical’ state³ such that even the tiniest subsequent input can unexpectedly lead to dramatic change.

A useful analogy here is a pile of rice. If you build one by adding a few grains at a time, most of the grains don’t have much impact. But after a while, adding just one grain of rice can lead to an avalanche.

Video sourced and edited from Andrew Hoffmann

This is similar to overnight success. Except that even though the description suggests instant success from nowhere, most successful people make it only after years of metaphorically adding small grains of rice to a pile of effort.

You can read Sarah’s story here and from this tweet

In startups, getting to product-market-fit is a similar affair. Companies have to iterate continuously until something clicks so that the business can start to scale. Even in later years, those same businesses have to persevere before they can benefit from a step-change in growth.

One example I really like here is that of Microsoft when it was still a startup. In 1980 it secured a landmark contract to supply IBM with an operating system — an event that arguably changed the course of tech history.

However, this event didn’t pop into existence on its own. Lots of prior events had already placed Microsoft at a point of “criticality”. To name but a few:

Bill Gates and Paul Allen had been writing and selling software for almost 10 years already and were well-suited to getting the job done.

Among other reasons IBM had attracted decades of anti-trust investigations against it and to avoid further regulatory scrutiny, it accepted a non-exclusive contract with Microsoft.

The latter point meant that Microsoft was free to sell its software to other computer manufacturers and as PC hardware become commoditised, the business grew without restriction and saw its revenues balloon almost 10x, from $16m in 1981 to $140m in 1985.

Uneventful steps taken frequently can also lead to outsized outcomes in venture capital. Fred Wilson was writing and thinking about bitcoin for years before he met and invested in Coinbase. In fact he met the company because he was willing to persevere through a lengthy office hours session at Y Combinator with 16 startups across 4 hours of back-to-back pitches.

To benefit from self-organized criticality, play the long game and take heed of Seneca’s observation that “luck is what happens when preparation meets opportunity”. Or putting things more poetically:

“Chance can be on our side if we but stir it up with our energies, stay receptive to the glint of opportunity on even a single hair above the underbrush, and continually provoke it by individuality in our attitudes and approach to life.” — James H. Austin in Chase, Chance, and Creativity.

(3) Multiplicative Processes

Power laws also emerge when events are multiplicative instead of additive. One example is word-of-mouth. If you have a fantastic restaurant experience you don’t just tell one other person about it (which would be an additive process). You tell lots of friends who then go on to tell many others too.

Other examples of this process include population growth, the spread of viruses, and rapid wealth accumulation (getting rich through investing is a multiplicative process while building wealth through a salary is additive.)

Multiplicative processes are perhaps the simplest power law generator: a value is multiplied by some variable and the result is further multiplied by another variable. Repeat this process and you get exponential growth.

Viral growth simulation by Grant Sanderson

In startups, hiring a ‘10x employee’ is a multiplicative process. An elite performer can substantially change the trajectory of a business while most hires tend to be additive.⁴ For VCs, blogging is multiplicative networking. Ideas can spread faster online compared to offline 1–2–1 conversations.

To benefit from multiplicative processes, you have to identify and seek out multiplicative factors — much like preferential attachment — then look for ways to engineer them to your advantage.