“The Winner Takes It All” was a huge 1980’s hit by the Swedish pop group ABBA. It’s a sad song, reflecting the end of a romance. And just like their other hit: “Money, money, money” it’s also a huge issue in the venture capital industry.
You see: venture capital is like a game of cricket. In theory the batsmen can hit 6 sixes from the 6 balls in every over, but in practice this is very rare. Even hitting a total of six runs in an over is an above-average batting performance. In venture capital portfolios, one investment making a 10 x return (the winner) can cover a number of other non-performing investments, a bit like a single six in an over of cricket makes up for quite a few dot balls.
There is a power law in venture capital that the best investment returns make more money than the rest of the investments combined. For example, Sequoia Capital invested a total of $60 million into Whatsapp to reap a profit of $3.5 billion when it sold the mobile messenger service to Facebook for $22 billion. That’s a 58 X return on its investment in the company and a 2,7 X return on the $1,3 billion fund that the investment came from. Deals like these motivate venture capitalists to take risk on a range of other investments even when they know that many of them will fail and return zero. And the availability of risk-seeking venture capital is a necessary ingredient to fund entrepreneurs and incentivize innovation. That is the good part.
But there is a more sinister side to “The Winner Takes It All” when it comes to competition. Simply put, there are markets where the best performers are able to capture a very large part of the rewards and the remaining competitors are left with very little.
A good example of a winner-take-all company is Facebook. A social network, as the name suggests, benefits from the network effect. When a network effect is present, the value of a product or service increases with every new user. Take the telephone as example: when more people own telephones, the more valuable the telephone is to each owner. Metcalfe even proposes this as another law: that the value of a network is proportional to the square of the number of users. While the actual maths behind this “law” isn’t proven, it does drive home the point. Imagine you develop a website that does everything that Facebook currently does. Assume you make it free and you add another benefit: no advertising, ever.
Do you imagine this new social network will catch on? The answer is that you are highly unlikely to convert anyone from Facebook. They wouldn’t leave an established network for a new place where there are no friends or contacts – even to get rid of irritating ads. This means that Facebook is firmly entrenched as the big winner in the social networking market. The only quasi-competitors are those where the networks hardly intersect with each other say China’s RenRen or Russia’s VK. They too are big winners in their culturally segregated markets.
It’s great to be a winner in any segment where Metcalfe’s law protects you from competitors. Unfortunately these new monopolies create huge wealth disparities because a select few are able to capture increasing amounts of wealth that would otherwise have been more widely distributed throughout society. The Winner Takes It All-Network-Effect is why Bill Gates from Microsoft tops Forbes’ list of the world’s richest people at $79 billion, with Facebook’s Zuckerberg 16th at $33 billion.
So ABBA was right all along, it’s sad that the winner takes it all.