The Babe Ruth Effect in Venture Capital | When To Prioritize Growth Over Profitability? | VC Remote Jobs and More
Babe Ruth Effect in Venture Capital | Startup's Profitability Vs Growth | VC Remote Jobs
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📢 The Babe Ruth Effect in Venture Capital
"How to hit home runs: I swing as hard as I can, and I try to swing right through the ball... The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I've got. I hit big or I miss big."
— Babe Ruth
One of the hardest concepts to internalize for those new to VC is what is known as the “Babe Ruth effect”:
Building a portfolio that can deliver superior performance requires that you evaluate each investment using expected value analysis. What is striking is that the leading thinkers across varied fields — including horse betting, casino gambling, and investing — all emphasize the same point. We call it the Babe Ruth effect: even though Ruth struck out a lot, he was one of baseball’s greatest hitters.
— "The Babe Ruth Effect: Frequency vs Magnitude” [pdf]
The Babe Ruth effect occurs in many categories of investing but is especially pronounced in VC. As Peter Thiel observes:
Actual [venture capital] returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution.
The Babe Ruth effect is hard to internalize because people are generally predisposed to avoid losses. Behavioural economists have famously demonstrated that people feel a lot worse about losses of a given size than they feel good about gains of the same size. Losing money feels bad, even if it is part of an investment strategy that succeeds in aggregate.
People usually cite anecdotal cases when discussing this topic, because it's difficult to access comprehensive VC performance data. Horsley Bridge, a highly respected investor (Limited Partner) in many VC funds, was kind enough to share with me aggregated, anonymous historical data on the distribution of investment returns across the hundreds of VC funds they've invested in since 1985.
As expected, the returns are highly concentrated: about ~6% of investments representing 4.5% of dollars invested generated ~60% of the total returns. Let's dig into the data a little more to see what separates good VC funds from bad VC funds.
Home runs: As expected, successful funds have more "home run" investments (defined as investments that return >10x):
(For all the charts shown, the X-axis is the performance of the VC funds: great VC funds are on the right and bad funds are on the left.)
Great funds not only have more home runs, but they also have home runs of greater magnitude. Here's a chart that looks at the average performance of the "home run" (>10x) investments:
The home runs for good funds are around 20x, but the home runs for great funds are almost 70. As Bill Gurley says: “Venture capital is not even a home-run business. It’s a grand slam business."
Strikeouts: The Y-axis on this chart is the percentage of investments that lose money: This is the same chart with the Y-axis weighted by dollars invested per investment:
As expected, lots of investments lose money. Venture capital is a risky business.
Notice that the curves are U-shaped. It isn't surprising that the bad funds lose money a lot, or that the good funds lose money less often than the bad funds. What is interesting and perhaps surprising is that great funds lose money more often than good funds do. The best VC funds truly do exemplify the Babe Ruth effect: they swing hard, and either hit big or miss big. You can't have grand slams without a lot of strikeouts.
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📢 Featured Article: Profitability vs Growth - A Dilemma For Startups
In recent times there has been a drastic shift in startups from focusing on growth to making business profitable. But is this possible for every startup to achieve profitability at an early stage without focusing on growth? In search of this - I came across an article which talked about - When to prioritize profit. When to prioritize growth. and examples of successful companies in some of these categories. I have written a summary of that article.
Due to changes in economic situation/funding winter, Investors have grown more cautious, while founders are much more focused on burn and profitability metrics even early on. The “growth first” mentality has given way to profitability.
Image: Profitability vs. Growth Image (Google Image)
How should founders and VCs strategically decide when to blitz scale versus when to focus on profitability? The right approach depends on factors like market dynamics, access to capital, business model, and the stage of the business. But as a founder, it’s important to understand where to focus at an early stage because if you have this idea - you will work on the right strategy.
Under what circumstances does prioritizing profit make sense?
Demand slows down — customer demand may change due to factors like economic conditions, industry headwinds, interest rates, etc. Slowing demand means that there’s less revenue growth potential, so it’s time to conserve runway
Access to funding is uncertain — When capital is scarce, investor sentiment shifts, or milestones for the next round look unattainable, focus on profitability can help extend the runway
After core product validation — after demonstrating product-market fit and customer traction, it’s time to refine the business model and path to profitability
Low-margin business model — for startups competing on price and high volume vs. high margin, tracking and improving unit economics is crucial from the early stages
High customer acquisition costs — when the costs of acquiring customers are too high relative to customer lifetime value, it signals a need to focus on improving unit economics before aggressive growth
Lifestyle business goal — for founders not focused on building unicorns or billion-dollar exits, profitability may take priority
Some scenarios where focusing on rapid growth could be the wise strategic choice:
Fast-growing market — when the overall market is experiencing rapid adoption and growth, capitalize on the rising tide by fueling growth
First mover advantage — when it’s a disruptive innovation or new business model, grow to capture market share before competitors, especially if it’s a winner-take-all or winner-take-most market
Abundant capital — when funding is readily available and investors are prioritizing rapid growth, utilizing capital to expand aggressively rather than focusing on near-term profitability can align interests
Before product-market fit — when the product is still in development and product-market fit remains unproven, the focus should be on iterating, building, and finding traction
Network effect — for businesses that benefit from network effects such as marketplaces and social media platforms, unfavourable unit economics early on are typical and can be offset by focusing aggressively on growth. Focusing on growth to achieve scale can justify delaying profitability until the market is established
Economies of scale — for businesses like manufacturing and infrastructure with high fixed costs, growth is key even at a loss in order to reach economies of scale and drive down unit costs over time. The larger the scale, the higher the profitability
Adjacencies and new products — when new complementary products or markets significantly expand TAM, aggressively expanding to them before competition arises can be prudent
While rapid growth at the expense of profits can be strategically timed to capitalize on opportunities, growth cannot be sustained forever without eventual profitability. The key is evaluating whether the timing to reach profitability should be immediate or longer-term depending on factors such as those listed above.
If you want to read the full article - here is the link.
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📬Tweet: Interesting Life Story Of New Product Hunt’s CEO!
Recently Rajiv Ayyangar, the New CEO Of Product Hunt shared a tweet on how Product Hunt changed his life and now he is stepping in as CEO.
From launching his first startup’s product on product hunt and eventually raising funds from a16z, he has come a long way. It’s a great read for founders and investors. Have a Look! 👇
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✍️Written By Sahil | The Venture Crew Team