There’s an old saying that goes, “Know the rules of the game, and you’ll play better than anyone else.” Let’s take baseball as our example. Aiming for a home run often means accepting a higher number of strikeouts. Consider the legendary Babe Ruth: he was a leader in both home runs and strikeouts, a testament to the high-risk, high-reward strategy of swinging for the fences.

Yet, aiming solely for home runs isn’t always the best approach. After all, the game’s objective is to score the most runs, not just to hit the most home runs. Scoring involves hitting the ball, running the bases, and safely returning to home base. Sometimes, it’s more strategic to aim for a base hit, like a single, which offers a much higher chance of advancing runners on base and scoring.

The dynamics change entirely in a home run derby contest, where players have five minutes to hit as many home runs as possible. Here, only home runs count, so players focus on hitting just hard enough to clear the fence, rendering singles pointless.

Imagine if the derby rules also rewarded the home run’s distance, adding extra runs for every foot the ball travels beyond the fence. For context, the centre field is typically about 400 feet from home plate. So, a 420-foot home run, clearing the centre field by 20 feet, would count as a 20-run homer. This rule would drastically alter players’ strategies. Not only would they swing for the fences with every at-bat, but they would also hit as hard as possible, aiming for the longest possible home runs to maximize their scores, even if it reduced their overall chances of hitting a home run.

This scenario mirrors early-stage venture capital, where I liken it to a home run derby with uncapped runs. The potential upside of investments is enormous, offering returns of 100x, 1000x, or more, while the downside is limited to the initial investment. Unlike in a derby, where physical limits cap the maximum score, the VC world is truly without bounds, with numerous instances of investments yielding thousandfold returns.

This distinct dynamic makes assessing VCs fundamentally different from evaluating other asset classes, where protecting the downside is crucial. In the VC realm, the potential for nearly limitless returns makes losses inconsequential, provided VCs invest in early-stage companies with the potential for exponential growth. The risk-reward equation in venture capital is thus highly asymmetrical, favouring bold bets on moonshot startups.

For illustration, let’s consider two hypothetical venture capital firms: Moonshot Capital and PlayItSafe Capital.

Moonshot Capital approaches the game like a home run derby with uncapped runs. They aim for approximately 20 companies in their portfolio, expecting that around 20% will be their home runs—or “value drivers”—capable of generating returns from 10x to 100x or more. 

Imagine they invest $1 in each of 20 companies. One yields a 100x return, three bring in 10x, and the remaining are strikeouts. The outcome would be:

(1 x 100 + 3 x 10 +16 x 0) x $1 = $130

Their $20 investment becomes $130 (or 6.5x), a gain of $110, despite 17 out of 20 companies being strikeouts. Yes, you are correct. 85% of the portfolio companies failed!

PlayItSafe Capital, on the other hand, prioritizes downside protection, ensuring none of the portfolio fails but also avoiding riskier bets. In the end, one company generates one “10x” return, five companies return 3x, and the remainder is equally split between breakeven and failing.

(1 x 10 + 5 x 3 + 7 x 1 + 7 x 0) x $1 = $32

Despite several “successes” and very few “losses,” the fund’s return of $12 pales in comparison to Moonshot Capital’s. Even increasing the number of companies generating a 3x return to 10 with no loss (which is almost impossible to achieve for early-stage VCs) only yields a $29 gain from a total investment of $20:

(1 x 10 + 10 x 3 + 9 x 1) x $1 = $49

No one should invest in the early-stage VC asset class with the expectation of such a paltry return.

As illustrated, success isn’t about minimizing failures, nor is it about the number of “3x” companies or even the number of “unicorn logos” in the portfolio, as how early when the investment was made to these unicorns is crucial as well. One needs to invest in a unicorn when it was a baby-unicorn, not after it became a unicorn.

In summary:

Venture funds live or die by one thing: the percentage of the portfolio that becomes “value drivers”, i.e. those capable of generating returns of 10x, 100x, or even 1000x.

At Two Small Fish Ventures, we are the IRL version of Moonshot Capital. Every investment is made with the belief that $1 could turn into $100. We know that, in the end, only about 20% of our portfolio will become significant value drivers. Yet, with each investment, we truly believe these early-stage companies have the potential to become world-class giants and category creators when we invest. 

This is what venture capital is all about: not only is it exhilarating to be at the forefront of technology, but it’s also a great way to generate wealth and, more importantly, play a role in supporting moonshots that have a chance to change how the world operates.

P.S. This is Part 1 of this series. You can read Part 2, “Winning the Home Run Derby with Proper Portfolio Construction” here.

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