Optimizing portfolio construction involves considering factors such as shots on goal, ownership percentage, and follow-on investment strategy.
Successful venture investors have a diverse portfolio of companies with the potential for substantial returns.
Managing reserves and making prudent follow-on investment decisions are essential to maximize returns and maintain alignment with founders' objectives.
Deep dives
Portfolio Construction and Management
Portfolio construction and management are crucial topics for venture capitalists and founders alike. Building a portfolio is necessary to achieve the desired returns on investment. However, the approach to portfolio construction may vary depending on factors such as fund size, stage, and check size. To optimize portfolio construction, venture capitalists need to consider factors like the number of shots on goal, ownership percentage, and follow-on investment strategy. It is important to have a bottom-up approach and assess each investment's potential to contribute significantly to the fund's returns. Additionally, venture funds must strike a balance between risk diversification and focusing resources on high-potential companies.
Returns and Outcomes
Venture capital funds aim for significant returns on investment, typically targeting a threefold or higher multiple of the initial capital. However, the distribution of returns across funds is wide, with a small number of companies driving the majority of the fund's returns. While a medium venture fund return may not be competitive with private equity, top-performing venture firms can achieve outlier outcomes. Factors such as time, market cycles, and investment quality influence the success of a fund. Successful venture investors often have a diverse portfolio of companies with the potential for substantial returns.
Reserves and Follow-on Investment
Reserves play a crucial role in venture capital fund management, especially when deciding on follow-on investments for portfolio companies. The amount allocated to reserves varies among funds, with some reserving one-third of the fund for future investments and others reserving up to two-thirds. The decision on follow-on investments is influenced by factors like the fund's size, stage, and ability to play offense or defense. Funds often aim to double down on companies showing strong potential, but managers should be cautious about the company's fundamentals and the ability of additional capital to positively impact the trajectory. Managing reserves requires balancing the desire to support companies with the need for diversification and opportunity costs.
Challenges and Considerations
Venture capitalists face various challenges when managing portfolios and making follow-on investment decisions. It is important to differentiate between companies showing high potential and those that require additional capital due to possible strategic acquisitions or growth opportunities. Managers should carefully evaluate certain factors such as unit economics, market dynamics, and a company's ability to achieve its milestones. The decision to invest more capital should be driven by strong conviction and a clear understanding of how the new funds will contribute to the company's success. Managing reserves and making prudent follow-on investment decisions are essential to maximize returns and maintain alignment with founders' objectives.
Investing in a diverse range of companies
When it comes to investing in startups, it is important for funds to have a sufficient number of opportunities to put their capital to work. Some funds may only invest in 15 to 20 seed-stage companies, but this may not be enough in the long run. It is more prudent to have closer to 25 or even 25 to 40 opportunities to follow into. Though not all investments will be equal, having a larger pool of potential companies ensures a better chance of success.
The importance of correlation and bias in investing
Investing in a specific region, also known as having a geographic bias, can be a strategy that works well if the chosen region has a strong ecosystem for growth. However, it is essential to avoid being overly biased towards local companies and neglecting opportunities elsewhere. Diversity in both geography and company types is important for investors. While having a correlation with a specific region or sector can be advantageous, too much bias can limit exposure to other valuable opportunities. Balancing bias and diversification is crucial.
We continue our VC Fundamentals series with Portfolio Construction & Management — how do you build and manage a fund's portfolio as a whole, beyond each individual portfolio company and investment decision? We brought in two of the very best people in the world to help us dissect this topic: Jaclyn Hester & Lindel Eakman of Foundry Group. Jaclyn and Lindel have been early and longtime LPs in some of the best venture funds in the world: USV, True, Spark — and of course Foundry — and now also sit on the GP side of the table at Foundry. Tune in for a master class on how the best VC managers think about generating and optimizing fund performance.
