The Insider’s Guide to Venture Capital Portfolio Strategy
Join us as we reveal the fundamental principles for crafting a winning VC portfolio.
Venture capital (VC) has gained popularity and attention in the financial industry — particularly among the wealthy who may have pursued careers in music or film but are investing in startups instead. However, regardless of the glitz, venture capital investing is not everyone’s cup of tea — success in this field is not easy. And data proves this.
The main issue with Indian venture capital (VC) investments is the lack of data. While organizations like Bain track the number of deals, sectors, exits, and investments in the Indian VC industry, they do not estimate investor returns. The VC market in the US is more mature, and the scarce data from this market shows VC returns have been lackluster. Lacklustre in the sense that US VC returns have not significantly outperformed the public market since the late 1990s.
While the reasons are many (and complicated), one reason is that VC funds do not follow some of the fundamentals of VC investing. There are subtle nuances that separate VC investing from other investment classes. And in this article, we’ve highlighted three such nuances, or as some call them — the fundamental principles of venture capital.
Core Principles of Venture Capital Funding
When you’re thinking about making a venture capital portfolio, understand that the vast majority of your fund’s returns would be generated by very few companies. This means two things:
Failed investments aren’t important
Every investment you make has the potential to be the most important investment you make
This might sound counterintuitive, especially if you’re from a finance background. You know all about the efficient market hypothesis, so you’d assume the returns you make would be evenly distributed across your portfolio. But in the venture capital investing scene, this might be counterproductive.
And this is because most new companies die. They don’t make it past the first couple of obstacles. And it happens more frequently than we’d like to expect. And data supports this. As per a report, nearly 55% of new companies in the country perish. The 45% that survive stay in business for over 20 years.
When it comes to startup investments by VC funds, the data is not encouraging. As per a study of over 21,000 financings spanning 2004–2013, over 65% of VC deals returned less than the invested capital. In fact, the data showed that the best VC funds had more investments that did not pan out.
This suggests that the number of failed investments made by VC firms may not negatively impact its overall returns. In fact, the two are inversely related.
You might ask, then – what drives a VC fund’s performance?
Data shows returns of the best-performing funds mostly come from a select few investments that produce significant and unexpected returns.
Have you heard of Pareto Principle? Also known as the 80/20 rule, it states that roughly 80% of the effects come from 20% of the causes. This principle also seems to work in the venture capital industry – approximately 90% of a fund’s return comes from less than 20% of the deals.
Plus, data shows these better funds also have clocked oversized returns from this handful of deals.
Consultant and independent analyst Benedict Evans succinctly said, “The best VC funds don’t just have more failures and more big wins — they have bigger big wins.”
Takeaway: The returns of a VC fund are heavily influenced by the performance of its most successful investments. These investments account for most of the fund’s overall performance.
So, if failed investments don’t matter and if most VC returns are driven by only a few successful investments that pan out exceedingly well — then a successful venture capitalist should look to invest in those companies that display the potential for these outsized returns without worrying about failing. Instead of being concerned with the downsides, VCs should focus on the upsides.
The previous discussion brings us to the following questions —
How do you figure out if an investment would be successful?
How many such investments do you make to increase your chances of success?
To determine an investment’s success, a VC must examine the company — its market, competition, and other relevant factors to assess its potential for growth and profitability.
Some VCs, such as Dave McClure of 500 Startups, believe that having a larger portfolio with a greater number of investments increases the chances of finding a successful bet.
This is based on the idea that if the probability of finding a successful investment is low, then having more investments increases the chances of finding one. McClure suggests that a VC portfolio should include a minimum of 50–100+ companies to have a reasonable chance of finding a successful investment.
However, this venture capital portfolio strategy is not widely followed by most VC firms.
Having said that, it is important to note that no investment is guaranteed to be successful, and a thorough assessment of investment opportunities is just one factor. The most effective approach may involve a combination of both these and other factors.
Other factors that may be important include strong industry expertise and a proactive approach to finding and evaluating investment opportunities.
The final principle of venture capital is the follow-on strategy, or the ability to invest additional money into the future fundraising rounds of the companies in your portfolio.
If only a few of your investments would be super-successful, then identify the successful investments and double down on them. Plus, you already know the business and how it makes money at this stage. You know the cultural dynamics, board minutes, and downside budgets.
As Fred Wilson, partner at Union Square Ventures, says – one of the most common mistakes VC managers make is they don’t reserve for follow-on investments. Most funds often invest 70–80% of their first fund before starting a new one and then running out of money. This prevents them from participating in the follow-on rounds.
Overloading the portfolio with too many companies can also contribute to this issue as it may not allow for proper support for all of the companies.
While many people believe that venture capital involves choosing which companies to invest in, the reality is that this is only half the job.
The other half involves actively managing the portfolio, including providing support and value through board work, follow-on investments, and working toward successful exits. This latter aspect can be challenging to learn, but those VC firms that excel at it often see great rewards. And at the end of the day, this sets a successful venture capital apart.
As an investor evaluates potential investment opportunities, it is important to consider lessons learned from previous successes. For example, if you have a firm conviction in a product or service, you should be willing to invest with confidence and not be deterred by potentially higher valuations.
This approach can pay off in the long run, as demonstrated by examples such as WhatsApp and Facebook, where investors’ returns can be meaningful if they are the only investors at the exit.
Sequoia was the sole investor in WhatsApp’s Series A funding round in 2011, worth $8 million. This valued the company at $80 million. In the Series B round as well, Sequoia was the only investor. When Facebook acquired WhatsApp in 2014, Sequoia’s $60 million investment turned into $3 billion.
Firms with this kind of conviction often have a larger share of ownership than those that invest in deals in a field crowded by VCs.
Ultimately, the key advantages for VC investors lie in doing the necessary research, identifying early-entrant or outlier companies, and putting in the work to help those companies succeed.
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