Power Law Policy
Extreme outcomes drive tax revenue Power Laws Let's do a thought experiment. The year is 1800. You’re a loan officer at a bank. Farmers come to you asking for a loan - maybe to purchase new equipment, buy more land, or make investments to improve their farm’s productivity. What are your criteria for granting a loan? You’ll primarily want to do 2 things: avoid the losers, and reduce risk. To avoid the losers, you’ll want to learn about a farmer’s reputation and character. Are they honest and hard working? Do they have any major vices that might undermine their productivity? To reduce risk, you’ll assess the value of their collateral. How valuable is the land the bank would repossess in the case of a default? In short, you’re much more interested in minimizing downside than you are in maximizing upside. Why? Well, giving a loan to an excellent farmer probably isn’t going to make you much more money than giving a loan to a median farmer. If a farmer has an incredible yield and produces 3x more than expected - which is very unlikely - you don’t get paid 3x the interest. Your goal is to maximize the number of loans in your portfolio that don’t default. Most of your loans are given to farmers with fairly consistent profiles - similar plans, business models, skill sets, and characteristics. You’re hoping for a consistent batting average, and you aren’t counting home runs. Now, let’s jump to the present. Instead of a loan officer, you’re a venture capitalist, investing in early stage startups, hoping to maximize the value of your fund. How does this change your criteria? As a VC, extreme outcomes drive the return on your fund. Accordingly, you care more about unique advantages and differentiators that give a startup a chance at becoming the winner in its category. Most investments will lose money, and many will go to zero, so the structure of financing needs allows for uncapped success when you pick a winner. You want to bet on startups that, if massive
How so?