Venture capital: One success pays for all the failures

Two friends, an idea, a computer. No profit, no sales. And yet, someone is going to give them money.

That is venture capital: funding very young companies, knowing most of them will fail.

The first cheque is called seed funding. It often comes from people close to them, or individual investors called business angels.

In exchange, they take a share of the capital. Say twenty per cent. The founders keep eighty.

If the idea takes off, more money is needed. Then come the rounds: A, then B, then C.

In each round, new shares are created for the new investors. The earlier holders' share is diluted.

Say twenty-five per cent given up in round A: the founders drop to sixty per cent.

Twenty per cent in round B: forty-eight. Fifteen per cent in round C: forty point eight.

They own less than half of their own company. But of a company worth much more.

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Say in round C, investors pay one hundred million dollars for ten per cent. The company is then worth one billion.

One billion dollars without being listed: that is what is called a unicorn. The word dates from two thousand thirteen.

But this billion is on paper. It is the price paid for a small piece, multiplied by all the shares.

And the latest investors often have protections: they are repaid first if the company is sold for less.

The founders' forty point eight per cent is worth four hundred and eight million. On paper, too.

Why do investors take such bets? Because of a strange rule: the power law.

Say a fund invests one million in fifty young companies. Fifty million in all.

Forty-nine fail and return nothing. Just one succeeds, and returns one hundred times the stake: one hundred million.

The fund has doubled its money. Thanks to a single company out of fifty.

In this world, the average means almost nothing. The whole result lies in a few rare, giant successes.

For a fund, missing the winner costs more than funding ten losers.

For an individual, the lesson is clear. A single young company is a lottery ticket. You need many to stand a chance.

And a unicorn valuation is not money. It only becomes money the day someone actually buys.