Strategies for Building a (10x) Startup Portfolio
Ventures Done Right Is Not Gambling
Reflecting on the boom of the Swedish and European venture ecosystems, and the corresponding lack of consensus or research surrounding the topic of portfolio construction, we have set out to share with you an insider’s perspectives on the peculiarities of building a coherent portfolio in our industry. Having researched and compiled data from numerous specialised sources (Dealroom, Pitchbook, Capshare, EIF reports, Nordic 9, and our own proprietary database of 2 400 startups), we were able to construct and render a picture of a hypothetical startup ecosystem mimicking that of Sweden, with over 5 000 startups created over 5 years and 15 000+ simulated investment rounds occurring over a 20 year period that both matches real world observations and high level market statistics. We then chose to iterate 1 000 randomly constructed portfolios for each strategy, thereby forecasting performance metrics.
Why is this important? Not only is portfolio construction and allocation strategy a necessary condition for consistently good returns, it also lays out the basis for acting professionally within an opaque market that otherwise can be prone to “gambling”, speculative, destructive or inflationary behaviours. It turns luck of the draw into persistently higher performance at lower risks.
As a preamble to this article and should you want to dig deeper into the characteristics of the startup market and venture investors, I invite you to explore other articles in the series describing the highly skewed distribution of startup performances, key success factors for becoming a top tier investor and biases affecting your performance as an investor.
How to Optimise your Startup Portfolio
Let’s deep dive into some statistical analysis integrating a few, very key, behavioural observations. Based on our simulated startup ecosystem, the models we have developed allow us to comparatively assess investment styles and portfolio efficiencies. We look at stages of investing, the level of access to deals (proxy for screening ability and reputation of the investor) according to the startups’ ranking in the market, timing of investments, follow-ons, portfolio size and ticket sizes in order to randomly simulate and replicate investors behaviour in the market. Which strategy fits your investment style?
Exhibit A: The Early-Stage Venture Capitalist
Early stage ventures investing has been — on average — notoriously difficult for lack of properly applied strategies, immature ecosystems and entry-level investors, as well as sub-par availability of funding at different stages. It has also been a haven for those select few that have positioned themselves as the very best in the industry.
Lets look at the difference in metrics between a random early stage venture capitalist’s portfolio and that of a reputable player in the industry. Typically such funds deploy around 100 MEUR (or approx. 1 BnSEK) over the lifetime of the fund and target portfolio sizes of 20 to 40 companies, sometimes diversified across industries and geographies. While allocation strategies may vary, across stages, seed investors will look to take a lead in those early rounds following up in Series A and Series B in order to strengthen their positions in the winning few.
One fundamental differentiator being the access to, and winning of, highest quality deals in the market, top tier seed VCs can expect 10 whole percentage points higher returns… yearly. As well as to achieve multiples 50% higher than the competition. Take note that higher performing investors seek higher risks (and variance) when selecting assets, but also enjoy lower downsides on an aggregate portfolio level.
Exhibit B: The Angels
Many of the more successful angels have a great reputation in the industry from deals previously made, get early access within their vertical and typically have high level networks within tech and their own segment. Angels take higher levels of risk over often smaller sized portfolios and therefore concentrate their wealth in few assets with little diversification across industries, stages and geographies. For the superstar Angel, this is where you reach the 5x, 10x, 50x… 100x or more multiples. Either through luck, skill or proprietary networks.
What most debuting angels lack however is reach, scale or resources, failing to efficiently address many of the biases and qualitative aspects of successful ventures investing (Read the 4 Success Factors in VC). And what happens then? Well you end up facing unnecessary risks other investors have entirely eliminated from the equation… and investing becomes entirely up to luck again.
We encourage more professionals to become angels because their contribution, properly channeled, is invaluable. And more angels to professionalise their approach. Joining a network of angels or affiliated venture firm, or dedicating more time to your angel activities are the ways to go. And its more fun:).
Exhibit C: Spray and Pray
The definition of “spray and pray” is that you make lots of bets and count on the few that “make it” to bring home the returns. Most famously, Dave McClure, Founder @ 500 Startups, defended the idea that due to the skewed distribution of startup performances you should invest broadly across the market, building a large, diversified, portfolio. And statistically speaking he isn’t entirely wrong, it does reduce overall risk… Except that in practice this strategy overlooks the fundamental fact that top tier entrepreneurs are picky about their investors and require a level of personal interaction, expertise and dedication that is rarely met by a spray-and-pray investor. Simply put, properly engaging with and managing a wide portfolio of startups takes a tremendous amount of resources, and the best entrepreneurs want your full attention in order to allow you access in entry level and follow on rounds.
The J12 Way — Seeking Consistently Higher Returns and Better Risks
Putting our money where our mouth is, I wanted to share with you our own performance benchmark. In terms of allocation, we believe in sharing the risks and opportunities with our partnering Angels at the earliest stages, because such a collaboration has proven to be extremely value adding. Properly executed, the result is a well diversified multistage portfolio with comparatively low risks, high ownership stakes and higher upside due to early and high levels of engagement.
So What About My 10x Portfolio?
The simple truth is that I can’t promise you a realistic allocation model that would deliver these types of returns, again and again, over extended periods of time. Which is not to say it doesn’t happen sporadically. A few talented angels and VCs have achieved this feat. Most recently our friends at Creandum (first institutional investors in the likes of Spotify, iZettle and Cint) delivered a fantastic 13x multiple on their portfolio in fund II over a 10–12 year period.
Together with our Angels in DHS Venture Partners, our initial fund, we’re well on our way towards delivering similar results.
Toying with the idea of a perfect startup portfolio, this is what it would look like if you were given the gift of near-perfect foresight.
What does it take to persistently remain at this level of excellence? Probably a bit of luck as well…
Key Takeaways:
- Aim for a portfolio size that fits your level of resources: you want a large portfolio, but without compromising on your ability to analyse, engage and add value in each individual startup.
- Spray and Pray or “average investor” portfolios are not attractive when accounting for behavioural factors.
- Most capital should be allocated in follow-on rounds to reduce risk.
- Well constructed portfolios have consistently higher risk/reward profiles.
- Account for behavioural biases and be self-critical: the best startups pick the best investors, not the other way around.
- Performance is highly correlated to your ability to access, pick and win the very best deals.
- Investing in top tier companies is competitive: behave as a top tier investor!
What does your own allocation strategy look like? Fill in this form and we’ll get back to you with your own expected portfolio metrics.
Questions? Ideas? Open to discuss our findings and assumptions with any data scientists, VC professionals and enthusiasts in the crowd! Give us a shout, j12ventures.com.
