Concentrated Or Bust? The Case for Late-Stage Diversification in VC (Part I)
Author: Luke Skertich
Editor extraordinaire: Jeff Weinstein
Traditional Late-Stage Portfolio Construction
In our last blog post, we interviewed prominent GPs and LPs across the ecosystem and presented best practices for modeling, raising and deploying opportunity funds. From these conversations, one of the most pronounced, recurring messages we received was the perceived importance of concentration in an opportunity fund, with the standard portfolio ranging from 5–10 companies in size.
This argument around late-stage portfolio concentration stems from the emphasis venture investors place on ownership. Conventional VC wisdom states that a high level of ownership in startups is vital because venture capital returns follow a power law distribution whereby a small number of exits drive the overwhelming majority of returns. Thus, it’s important to own enough of these companies so that when they exit (target $1B+ outcome), they drive enough value to return an entire fund. Historically, a VC portfolio will only make money if the best investment ends up being worth more than the whole fund. In practice, it’s quite hard to be profitable as a VC if you don’t achieve those numbers.
Traditional venture investors typically aim to buy at least 15% of a company from an early-stage investment, and try to maintain this ownership through pro rata investments across the life of a company. To justify 15%+ ownership in a company, VCs must maintain an active role (board member, advisor, soothsayer). As Roelef Botha from Sequoia states:
[S]ince the distribution of startup investment outcomes follows a power law, you cannot simply expect to make money by simply cutting checks. That is, you cannot simply offer a commodity. You have to be able to help portfolio companies in a differentiated way, such as leveraging your network on their behalf or advising them well. 
Each company traditionally requires a substantial time investment in addition to capital, so the number of deals a fund can do is capped by the number and capacity of its partners; a typical partner at a lead VC may make 2–3 investments per year and sit on 8–10 total boards. Given these practical limitations on portfolio size (typically 30 companies or fewer per fund), and that an opportunity fund consists of a small subset of winners, it is no surprise that the typical opportunity fund we profiled contained 5–8 investments.
Correspondingly, there is a high level of prestige associated with being an active investor who takes board seats. This strategy is so widely accepted that those who employ it often derisively call higher frequency, hands-off investors “spray and pray”.
But what if investors were not constrained by these traditional parameters, especially at the late stage? Longitudinal performance of the venture capital asset class has yielded mediocre results on average, with only consistent, frequent success from the top 10% of funds. What if there was a better way of constructing a late-stage fund? We at FJ believe that for the first time ever, there are enough credible late stage opportunities for investors to build a portfolio that captures the benefits of diversification.
Angel Investing Sides-Steps Traditional Boundaries
Angel investors are individuals who typically underwrite startups with a small check at the ‘Angel’ or ‘Pre-Seed’ round in exchange for a small piece of equity in the company. The traditional angel archetype is a wealthy professional or founder with a prior successful exit. The passage of the “JOBS Act” in 2012 has seen a further proliferation of angel investing from startup execs to prominent athletes. Regardless of the “who”, the accepted best practice is to diversify. Leading examples include :
- #1 Fabrice Grinda (245 investments)
- #9 Mark Cuban (110 investments)
- #18 Jason Calacanis (72 investments)
- #49 David Sacks (44 investments)
One thing in common? There is a large enough basket size to catch the outliers.
How We Do It At FJ
At FJ Labs, we consider ourselves Angel investors at scale. We look at everything from Pre-Seed to pre-IPO, we are co-investors by design (meaning we are price takers not price setters), do not take board seats and ultimately are not overly prescriptive with our founders. We have sector focus: marketplaces, e-Comm / e-Comm enablement, crypto, fintech, supply chain & logistics, and proptech (in that rough order) though we leave room for creativity. Finally, we are global by nature: 50% US/Canada, 20% Europe, 20% LATAM, 10% rest of the world with a significant portion allocated to India.
We see ~200 deals per week, ~100 of which are out of scope. Of the remaining ~100, a member of the investment team takes a first phone call with half. We take the best companies to our Investment Committee and take a second call to dig in on our biggest questions, typically led by the resident skeptic on the team. We meet once more as a team and commit. Between portfolio companies and net new investments, this leads to ~200 transactions per year!
Why We Do It — Early Stage Power Law
As discussed, venture is a power law game and the power law is strongest at the earliest stages.
Correlation Ventures proves this for individual investments (above). And AngelList captures fund level performance below:
The AngelList chart highlights two key problems with venture capital as an asset class:
- Mean performance is less than 2x (underperforming public markets given a similar time horizon)
- There are only a few funds that return 3x+ (for instance, the odds of capturing a 22x return rests at ~1%)
What’s the optimal strategy in this environment?
The mathematically optimal strategy in a power law environment is to invest in more deals to increase the likelihood of backing the breakout winners. Abe Othman & Nigel Koh looked at the performance of more than 10,000 AngelList investor portfolios and found that investors who invest in more deals do better, both in mean and median return. In context, the typical investor with a 100-investment portfolio outperforms the investor with a single investment by almost 9% a year (and this delta widens with a bigger basket).
But, you say, doesn’t this limit your upside?
The short answer is no. While each new company in the portfolio will most likely lower your average return, when it doesn’t, it increases the average by a lot. With some assumptions here, you can see general probabilities of multiple (return on size of fund) broken down by portfolio size (number of companies invested in per fund).
Thus, an indexing strategy of investing in the entire early-stage venture universe will outperform roughly three-quarters of early-stage venture capital funds. Top quartile on a consistent basis doesn’t sound too bad, but achieving the basket size might. Let’s come back to that.
Angel Investing As A Practice
Angel investing is well-known and practiced at Angel, Pre-Seed, and Seed stages. In fact, over the last ten years, a dense ecosystem of angels and super angels has developed. In turn, angels begot super-angels begot angel funds. Take SV Angel as an example. Per Pitchbook, they have made at least 954 investments across 10 funds since 2009, 439+ exits, and have invested in generation companies the likes of Twitter, Google, Square, Airbnb, Facebook, Snapchat, Stripe, Dropbox, Square, Pagerduty, Slack and Github. Add others who have now raised institutional angel funds like BoxGroup, 500 Startups, Slow Ventures, Hack VC, Lowercase, Correlation Ventures, and iSeed — and of course, us at FJ Labs — to the mix and you have a list of some of the most prolific investors in the global entrepreneurial ecosystem. AngelList has only accelerated this trend, initiating a Cambrian Explosion of solo capitalists and angel funds who have given rise to a new era of angel investing.
What each of these groups and individuals have in common is that they invest early, invest in a large basket, and benefit from the power law, driving incredible, outsized, consistent returns. Of course access is paramount to executing on this approach. Jerry Neumann and AngelList posit that the best angel investors don’t just carry an access premium but layer on an astute filter for the best potential 100x+ companies. Time dimension is also key to power law outcomes, meaning that there is a longer period to compound growth.
That all being said, no one has really done angel investing in a diversified manner before at the late stage. Angel investing is thought of exclusively as a seed/pre-seed activity.
Stay tuned for Part II in which we will demonstrate why, contrary to popular belief, diversified portfolio construction is optimal for late stage venture investing.
 Quote, Warren Buffet