How to Hit a “Home Run” in the Industry of Highly Concentrated Returns?
Ways to think about portfolio construction and reserve allocation when you launch your first pre-seed / seed fund
‘All I can tell them is pick a good one and sock it. I get back to the dugout and they ask me what it was I hit and I tell them I don’t know except it looked good.’
- Babe Ruth
Contrary to the general wisdom of venture capital, successful pre-seed and seed investing from a sub-$50m fund is a lot about initial portfolio construction. Of course, in ideal world, you want to get as much ownership percentage as early as possible, and reserve lots of capital to follow on in later rounds. But we don’t live in ideal world. In the real world of being an emerging manager with limited capital, you need to choose between larger upfront ownership — and hence accept a higher risk of missing big — or allocating the majority of available capital to subsequent rounds. Though this last strategy is well-adopted by larger multi-stage VC firms, it presents unique challenges for smaller emerging fund managers, posing a high risk of ending up with meaningfully lower ownership percentage and mediocre cash-on-cash returns.
Building a portfolio that can deliver superior performance is not easy, and emerging managers encounter particular challenges in doing so. Horsley Bridge historical data shared with a16z states that only about ~6% of investments representing 4.5% of dollars invested generated ~60% of the total returns. And strategies mastered by successful multi-stage investors might not be immediately applicable to the first-time managers. Consider the very rough math of a small venture fund: if I invest out of a $25M fund and aim to have a portfolio of 20 companies, net of management fee and various associated expenses, I have ~$18.3M of capital available for investments, or ~$1.2M per portfolio company on average. To have a shot at returning a fund, I thus need to own ~5% of my best companies at exit. Taking into account that we don’t know who the winners are at this stage (as ‘lemons are not yet ripe’), and assuming 2x dilution from the first round of capital to the liquidity event, we’re looking at 10% target ownership at Round One.
This is already a challenging goal to meet, since at least in my experience, the pre-seed valuations / SAFE caps of startups with solid founding teams and interesting business ideas addressing major customer pain are in the $10m — $15m range. Furthermore, as a fund manager, you want your outperforming portfolio companies to show a consistent growth (2.5x and higher in a bull market, as it is today) of valuation step-up multiple in the subsequent rounds of financing*, and a resulting increase in price per share. This, paired with the sharp increase in early-stage valuations in recent years, makes the strategy of doubling down on winners through executing pro-rata right prohibitively expensive for most emerging seed fund managers.
Speaking about pro-rata right, even if you are able to secure this right as a seed investor, the earliest VCs don’t always get to take it, because if it’s a fast growing company, there often isn’t room. While this is less of an issue for multi-stage VCs with real market power and a great reputation, micro-funds with no negotiation leverage in the form of unlimited supply of cash and superior prior traction are more likely to be squeezed out of following rounds. This leaves you in the position of having to re-allocate your follow-on portion to a different, potentially less exciting company in your portfolio.
VCs are in the returns business, not the investment business. What really matters is cash-on-cash return multiples and hence exit value and end ownership in one’s winners are of paramount importance. And as pre-seed/seed fund managers, we don’t have unlimited resources to invest in a single company, making cultivating sound judgment and strategy at the early stage essential to one’s success. Although there is no one-size-fits-all ‘best way’ to think about portfolio construction and reserve allocation, here are some of my core guidelines, drawn from deep reflection on my own portfolio and the insights of some of the best super-early-stage investors in the world:
1. The right portfolio size is a judgment call, a function of GP bandwidth and striking the right balance between diversification and concentration. While the ‘spray and pray’ approach does not really work due to the Human Resources constraints of GPs, thinking carefully about a number of new investments to make annually and staying hands-on is a great mental exercise of which I will talk more in future articles.
2. ‘Buy low, sell high.’ Aggressively investing when equity is the cheapest and following on opportunistically until we raise larger pools of capital in subsequent funds seems like a viable strategy but requires enormous conviction, price discipline and guts. Following on is important to show support to entrepreneurs and build relationships with later stage investors but investing full pro-rata makes little economic sense at this fund size level.
3. Data analytics, especially based on historical performance unique to you, are the queen. Ability to pick the winners super early and boost returns by smart cash allocation will make or break one’s career as a VC. In the end, we are being paid for our judgment, expertise, and results. The primary goal of a first fund is to prove our worth as managers, and to collect as much data as possible to leverage for subsequent funds. Thus, collecting and analyzing data — both our own and others’ in relevant industries and markets — are essential to building better portfolio models and honing sharp, accurate judgment. Smart data analytics help us become better at projecting portfolio performance and the timing, size, and probability of future financing rounds.
4. The 20% / 80% rule in venture capital works. In a portfolio of 20 companies, an average of four will do well and drive performance, only requiring occasional involvement. Our goal is to identify the lagging companies in our portfolio that have a chance to deliver good returns provided some sound discipline and guidance. A shrewd VC’s task, then, is to roll up their sleeves and help these founders maximize the outcomes of their businesses.
5. ‘Invest before the rest of the world cares.’ I simply love this quote from Mike Maples, as it encapsulates a key component of my investing philosophy — one that has borne out superior returns. Investing ahead of the curve taps into a strength unique to specialist emerging managers: the ability and desire to fill funding gaps in underserved markets and founder classes. Though you may not have the near-unlimited capital and negotiating power of larger VC firms, you do have a deep understanding of current gaps in the funding landscape, and of your target markets’ unmet needs — insight that has immense, though underappreciated, value. This can enable focused early-stage funders from outside the dominant VC paradigm to see opportunities the bigger players can’t, giving you a competitive edge. Being early in the deals that will see strong demand from later-stage VCs, and a resulting sharp increase in valuation down the line, will also potentially limit dilution.
6. Be a ‘conviction investor.’ Related to the above, it is crucial as an emerging manager to hone one’s ability to see beyond dominant industry biases to follow one’s considered conviction in founders’ promise — focusing particularly on founding teams that might not fit the typical (over-)hyped profile. Developing an expertise in working with a particular founder persona, combined with a hands-on approach towards helping them with their most pressing needs will make your limited ability to follow on less critical, especially if your fund strategy and approach are clearly communicated in advance. In my experience, conviction-based investing and spotting trends early enables smart independent VCs to gain a stake at a lower input price, leading to higher multiples and better returns down the line.
Final Thoughts
While you can’t ‘have grand slams without a lot of strikeouts’, you can use these guidelines to optimize your strategy for above-average performance that will showcase your abilities as a fund manager. Understanding that there are many ways to succeed in venture capital and thinking carefully about your fund operational model, using both top down (i.e. expected net return and math behind it) and bottom up (what you think you can deliver) approaches; and certainly treating conventional industry wisdom with a grain of salt will substantially increase chances to raise capital from LPs and succeed in the fascinating world of venture capital.
