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The Power of Portfolio Investing for Early Stage VCs



For early stage venture capital firms, investing broadly across a wide range of promising startups is crucial for maximizing potential returns. The nature of early stage investing is inherently high risk, with most companies failing and only a small percentage becoming homeruns that drive outsized returns. As a result, having a diversified portfolio approach is vital to help mitigate the risks while still capturing the upside of big winners.



The Importance of Quantity Over Quality (At First)


When investing at the earliest stages, it's nearly impossible to accurately predict which companies will become massive successes. Even the most promising ideas and rockstar founders still face innumerable challenges and pivots before achieving product-market fit and scaling their businesses. As legendary investor Marc Andreessen put it, "When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins." Rather than trying to pick just a few perceived "winners," top early stage investors understand that casting a wide net and making many smaller bets increases the odds of getting exposure to those relatively rare massive successes. High quantities of investments act as a portfolio diversification strategy against the binary risk of each individual company failing or succeeding.

For example, look at the early portfolios of firms like Sequoia Capital or Andreessen Horowitz. They have made hundreds of seed and Series A investments, knowing that the distribution curve of outcomes means only 10-20% may become billion dollar companies, but those winners more than compensate for the many failures or mediocre performers.


The Power Law Distribution


Venture returns exhibit what's known as a power law distribution, where a small number of companies drive the vast majority of returns. Research shows that 65% of returns come from just 6% of deals, while two-thirds of investments just return capital or modestly underperform. Amplifying this dynamic is the incredible scale and upside potential of the biggest tech startup successes. Firms who get exposure to those massive, category-defining companies tend see outsize portfolio returns that more than make up for many duds. Just look at Sequoia's investments in companies like Apple, Google, Nvidia, and more recently, Airbnb and Zoom. This distribution underscores why diversification through quantity is so crucial in early stage tech. By maximizing the number of quality investments, VCs increase their chances of capturing those precious few outsized hits that can return an entire fund and then some.


Picking Winners Is Extremely Difficult


Even for the most experienced and savvy investors, predicting startup success is incredibly challenging, especially in highly technical fields or paradigm-shifting new markets. There are countless examples of companies that were passed over by leading VCs, only to go on and become massive successes. Take video conferencing platform Zoom, which achieved a $9 billion valuation after its 2019 IPO. Almost every major VC firm passed on investing in the seed or Series A rounds. Or look at Roblox, the gaming platform juggernaut valued over $25 billion. Very few investors foresaw its potential in the earliest days.

The early stories of Airbnb, Uber, Facebook, and many other iconic tech companies are filled with investors dismissing or passing on rounds that in hindsight proved to be massively impactful misses. This constant struggle to spot the biggest winners at the earliest stages is why portfolio diversification is so crucial for early stage investors.


The Winners Can Generate Incredible Multiples


While the failure rate of startups is undoubtedly high, the upside payoff from investing in a huge winner can be stratospheric. Compounding growth of successful tech companies over many years results in valuations and exit multiples that are truly game-changing. For instance, Union Square Ventures' $4.68 million seed investment in Twitter yielded over $315 million after the company went public. Sequoia invested $12.5 million in WhatsApp across several rounds, which then sold to Facebook for $22 billion just a few years later. Stories like these illustrate why having broad exposure across hundreds of companies is so powerful - a single huge winner can more than compensate for a portfolio filled with failures and underperformers.


Early Portfolio Construction Is Key


For early stage VCs, a thoughtful and disciplined portfolio construction strategy centered around making many smaller, broadly diversified investments is critical. Having exposure to hundreds of companies greatly enhances the chances of capturing those few massive outlier successes that generate outsize fund returns. Trying to pick just a handful of "winners" is extremely difficult, even for the most experienced investors. The risks are simply too high and the batting average too low. As Marc Andreessen once said, "No matter how brilliant your logic or rationale, you are still guessing." Top early stage firms increase their odds by taking an industrialized approach, meeting with thousands of companies each year and aiming to deploy smaller amounts of capital across a large, diverse portfolio. Most funds target making anywhere from 100-300 or more seed or Series A investments per fund cycle. The goal is to get access to as many quality opportunities as possible, knowing that the distribution curve means only a small percentage will become homeruns but those successes will drive the majority of returns. Disciplined follow-on investing in the most promising companies as they scale further concentrates the portfolio over time.


Why Doesn't Everyone Do This?


If broad diversification is so powerful, why don't all VCs employ this strategy? There are a few key constraints:


  • Staffing: Having enough investment professionals to actively source, evaluate, and conduct due diligence on thousands of companies per year is extremely resource intensive. Most firms don't have teams large enough to handle that volume.

  • Capital Constraints: Making hundreds of small investments requires having very large fund sizes or concentrating a smaller fund into a narrower investment strategy or stage. Smaller funds of $50-100 million may only have capital for 20-30 investments.

  • Deal Access: The best deals are highly competitive, especially at the Series A level and above where more established brand name firms have an edge. Less reputable or emerging fund managers may lack deal flow.


Despite these hurdles, funds that can execute a high volume, diversified approach position themselves to capture outsize returns over the long run. By embracing the power of portfolio diversification, they maximize their chances of getting exposure to those elusive blockbuster companies that take portfolios into the stratosphere.

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