Why Good VCs Say No to Good Companies: The Power Law of Venture Returns
Emrah · A venture fund's economics force every partner to ask one blunt question about every deal: can this single company return the whole fund? Here is what that means for the people on both sides of the table.
The Story
In 1995, Arthur Rock, one of the earliest and most respected venture capitalists in Silicon Valley, looked at a company called Yahoo and passed. He is remembered as an investor who backed Fairchild Semiconductor, Intel, and Apple in their early days. But when a small search directory crossed his desk, he saw something that looked more like a hobby than a business worth backing.
Sequoia partner Michael Moritz looked at the same company and saw something else: a fast-growing audience and an advertising model that resembled television more than software. He wrote a check for one million dollars. That single investment became one of the largest returns in Sequoia's history, and it helped shape how the firm invests today.
This story sits near the start of Sebastian Mallaby's book The Power Law: Venture Capital and the Making of the New Future (Penguin Press, 2022). Mallaby, a journalist and senior fellow at the Council on Foreign Relations, spent years interviewing venture investors to explain why an industry built on so much failure keeps producing outsized results. His answer starts with a distribution, not a formula: venture returns follow a power law, where a small number of investments produce almost all the value, and most of the rest lose money or barely break even.
The Idea
Our earlier piece, The Fund Has a Clock Too, looked at Scott Kupor's breakdown of how a fund is built: limited partners commit capital for about ten years, general partners charge roughly 2 percent a year in fees, and take about 20 percent of the profits once the fund clears a return threshold. Mallaby's book explains what that structure forces a GP to do with every single check they write.
A fund manager running 200 million dollars in commitments earns about 4 million dollars a year in fees. That is a salary, not a fortune. Real wealth for a GP comes from carry, and carry only pays out once the fund as a whole returns enough money to clear its hurdle. That means a GP cannot make their number by picking twenty solid, unremarkable companies. They need at least one company big enough to return the entire fund by itself, with the rest of the portfolio adding another one to three times on top.
So the real question in every partner meeting is not "is this a good company." It is "can this company alone return the fund." Rock's Yahoo decision and Moritz's Yahoo decision were not really a disagreement about the company. They were two different answers to that second question, based on two different reads of how big the outcome could get.
How Founders Should Read This
A founder who does not know this math takes a rejection personally. They assume the product was not good enough, or the market was not convincing enough. Often neither is true. The company was simply the wrong size for that particular pool of money.
A 50 to 80 million dollar exit is a life-changing outcome for almost any founder. It can also be a rounding error for a 300 million dollar fund built around finding one company that returns the whole thing. If a founder is building something solid, profitable, and likely to sell in that 50 to 80 million dollar range, they should think twice before taking a large check from a fund that needs a billion-dollar outcome to hit its own targets. A smaller fund, or an investor whose math actually matches the company's realistic ceiling, is often a better partner than the biggest name in the room.
The practical move: when a term sheet lands, ask not just about valuation and check size, but about the fund's size and what kind of exit it needs from this specific investment to matter to its own returns. That answer tells a founder more about how the relationship will go under pressure than almost anything else in the deal.
How Investors Should Read This
For an investor, this logic is not optional, it is structural. Every deal eventually runs into one filter: does this have a realistic path to returning the fund on its own. That filter is why perfectly good companies with modest, achievable outcomes get passed over. A 20 million dollar exit is statistically meaningless inside a 300 million dollar fund built to find one 10x-plus winner. The math simply does not care how well-run the company is.
There is a red flag worth watching from outside a fund too: assets under management growing faster than proven returns. When a firm raises bigger and bigger funds without a track record that justifies the size, the fee income from managing more capital starts to matter more than the carry that is supposed to align a GP with great outcomes. That is when a fund's incentives quietly drift from finding the next Yahoo toward managing more money comfortably. Kupor's fee structure and Mallaby's power law point at the same warning sign from two different angles.
Fund size also decides how much ownership a GP needs at entry, and how much capital they can commit to follow-on rounds later. A fund chasing fund-returning outcomes needs meaningful ownership early, which shapes how aggressively it negotiates a term sheet in the first place.
Where the Two Views Collide
Here is where the founder's math and the investor's math genuinely diverge, not just in emphasis but in what counts as success. A founder building a strong, durable, profitable business sees a 60 million dollar acquisition as validation of years of work. A GP running a fund built for outlier returns sees the same 60 million dollars as a company that used up capital and partner time without moving the fund's overall numbers.
Neither side is wrong. They are running two different equations. The founder has one shot, this company, this life. The investor has fifteen or twenty shots in the portfolio and needs one or two of them to be enormous. A board conversation about taking more risk for a bigger outcome can look reckless from the founder's seat and completely rational from the investor's seat, because the investor is diversified against that risk and the founder is not.
The founders who navigate this well are the ones who ask, early, whether their company is being underwritten as a fund-returner or as a solid contributor to the portfolio average. That single answer changes how a board will react to a good-but-not-great acquisition offer two years later.
The Takeaway
Two term sheets can carry the same valuation and the same check size and still come from completely different math. One fund needs this company to be a home run. The other only needs it to be solid. Before signing either one, ask which kind of bet you actually are.
Why This Matters for PROMPT
When PROMPT raises its next round, this filter cuts both ways. A fund that needs a billion-dollar outcome to hit its own return targets will push for growth at a pace that may not fit a profitable, founder-led software business. Matching investor size and return expectations to PROMPT's realistic outcome range, rather than optimizing for the largest possible check, is a concrete filter to apply before any term sheet gets signed.
Source: Sebastian Mallaby, "The Power Law: Venture Capital and the Making of the New Future," 2022 — Penguin Random House
