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. Behavioral 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 get access to 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 runsAs expected, successful funds have more “home run” investments (defined as investments that return >10x):

Screenshot 2015-06-06 11.55.45

(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, they have home runs of greater magnitude. Here’s a chart that looks at the average performance of the “home run” (>10x) investments:

Screenshot 2015-06-06 11.55.55

The home runs for good funds are around 20x, but the home runs for great funds are almost 70x. As Bill Gurley says: “Venture capital is not even a home run business. It’s a grand slam business.”

Strikeouts: The Y-axis on the this chart is the percentage of investments that lose money:Screen Shot 2015-05-25 at 9.48.04 PMThis is the same chart with the Y-axis weighted by dollars invested per investment:

Screen Shot 2015-05-25 at 9.45.05 PM

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 the great funds lose money more often than good funds do. The best VCs 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.


VCs are experts at analyzing industries and identifying new opportunities, which is why it’s odd that the VC industry itself has so stubbornly resisted change.

Two years ago I wrote a post where I argued that innovative new VC firms are finally starting to change this:

Top tier entrepreneurs are frequently selecting their investors, not vice versa. The VCs most sought after are mostly new firms: big firms like Andreessen Horowitz, Union Square Ventures, and First Round, and micro-VCs like Floodgate (fka Maples), Betaworks, and Ron Conway.

Since then, the trend has become even more pronounced. VC is only partly about investing. It is primarily a service business whose purpose is to help entrepreneurs.

When Andreessen Horowitz (“a16z”) started out three years ago, like a lot of people I thought “OK, really interesting entrepreneurial founders, but how will they be as investors?” Then I started hearing chatter among entrepreneurs that they really wanted to raise money from them. “We’re talking to X, Y, & Z — but Andreessen is the firm we really want” became an increasingly common refrain.

Earlier this year I got to meet the a16z team and observe the operation directly. There are over 60 people at the firm. Only six people do traditional VC activities: investing, joining boards, and helping out. The rest are exclusively focused on helping entrepreneurs.

The “startup idea” behind a16z is: instead of spending the bulk of the fund fees on partner salaries, spend it on operations to help entrepreneurs. There is a marketing team (=helps you get noticed), a talent team (=helps you recruit), a market development team (=helps you get customers), and a research team (=helps you figure stuff out).

Spending time there, I had the same feeling I have whenever I meet a great startup: “This is obviously the future, why didn’t someone do it before?”

So I’m super excited to say that I’m joining a16z as their seventh General Partner. I’ll specialize in consumer internet investments but will be open to anything ambitious that involves technology. I’ll be based in California, but plan to do a lot of investing in NYC.

I’ll miss seeing my Hunch colleagues on a daily basis. Many of us have been working together for eight years, through two startups. I’d also like to thank everyone at eBay for being so welcoming and supportive.

Shoehorning startups into the VC model

Tech startups go in an out of fashion. When they’re in fashion, as they are now, entrepreneurs and VCs get lots of attention. Most of this attention focuses on things that involve money, like financings and acquisitions. For some entrepreneurs, raising venture capital becomes a goal unto itself, instead of what it should be: a heavy burden that only makes sense in certain cases.

A startup should raise venture capital (or “venture-style” angel/seed funding) only if: 1) the goal is to build a billion-dollar (valuation) company, and 2) raising millions of dollars is absolutely necessary or will significantly accelerate growth.

There are lots of tech companies that are very successful but don’t fit the VC model. If they don’t raise VC, the founders can make money, create jobs, and work on something they love. If they raise VC, a wide range of outcomes that would otherwise be good become bad.

Unfortunately, many of these startups graft VC-friendly narratives onto their plans and raise too much money. Short term it might seem like a good idea but long term it won’t.

The best source of capital is customers. The next best is the founders (cash or forgone salaries), or investors who are less aggressive about returns than VCs. Every startup has its natural source of financing. Venture capital is the natural source of financing for only a small fraction of startups, despite what the press might lead you to believe.

Critics and practitioners

“When art critics get together they talk about Form and Structure and Meaning. When artists get together they talk about where you can buy cheap turpentine.” – Picasso (via Ribbonfarm)

When I was a kid, I tagged along with my grandfather who was an oboist in a big city symphony. I was struck by the dramatic discrepancy between the culture of the audience and the culture of the musicians. Before the show, the audience attended fancy events, and talked in abstract terms about classical music. After the show, the musicians played poker, told jokes, swigged bourbon, and traded tips about the best places to get parts for their instruments.

In the context of startups, it’s convenient to read the Picasso quote as a tidy summarization of the difference between critics (VCs and the tech press) and practitioners (entrepreneurs). There is some truth to this. When entrepreneurs get together, they tend to talk about tactical details. VCs and the press talk about trends, markets, and other abstractions.

But Picasso was just being modest. He thought about the meaning of his art far more deeply than his critics did. The same is true of great entrepreneurs. “Cheap turpentine” is important, but so is “Form and Structure and Meaning”. The best ideas emerge from the interplay between the two modes of thought.

Revisited: big VCs investing in seed rounds

A few years ago, the trend of companies raising smaller seed rounds combined with the emergence of new seed funds caused many big VCs to create seed investment programs. This triggered a debate among entrepreneurs and investors about whether it was risky for seed-stage companies to take small investments from large VCs. (I blogged about the issue here, here, here).

Since then, enough founders have directly experienced the downside of taking seed money from big VCs that I think it’s safe to say there is no more room for debate. I can think of about 15 founders I’ve spoken to recently who tried or are trying to raise Series As but are seriously hampered by the fact that a big VC invested in the seed round but isn’t participating in the Series A. (I’d love to mention specific companies and firms but it wouldn’t be appropriate for me to do so – I guess I’ll just have to cite Jay Rosen’s “I’m there, let me tell you what I see” principle of reporting).

There are two important nuances to point out here. First, there are big VCs who invest in seed rounds the right way – with the genuine expectation to follow on and the intention to help out during the seed stage (some that I’ve invested with include USV, True, and Spark). One important sign of this is how much they want to invest. If a $300M fund wants to invest $100K, they are buying an option. If they want to invest $500K, they are more likely making an investment.

The second nuance can be counterintuitive: the danger of taking seed money is positively correlated with the reputation of the firm. If a top VC invests in the seed round and then passes on the A, other VCs will have difficulty overlooking that the smartest money that knows the company the best isn’t following on. If the VC isn’t well respected, it is easier for other VCs to second guess them.

I’m not revisiting this issue to criticize big VCs. A healthy startup environment requires smart, ethical investors at all stages. But I don’t think these big VC seed programs benefit anyone. And there are enough angry entrepreneurs out there that I expect the message will get through.