Importance of diversification in venture portfolios: R=n*p

Read an excellent article today by Clint Korver of @uluventures on the importance of diversification in venture portfolio construction. Sharing some key highlights that I found really interesting:

  1. Venture returns (R) are driven by 2 main factors — # of investments in a fund (n) AND probability (p) of an investment being an outlier return-generator. [UPDATED] in discussions with a few readers, I realized that a 3rd factor, ownership % in the winners (o), is also a key determinant in eventual returns (this was missed out in the original referenced article). Therefore, have updated the equation to R=f(n, p, o). To optimize R, ’n’, ‘p’ AND ‘o’ need to be optimized for.
  2. Excellent chart on “chance of an outlier” — x axis has # of investments vs y axis has chance of at least one outlier for a specific portfolio size. Successful VCs need at least one outlier to have a well performing fund.

3. Summary from the chart in below table — to quote “Even the Superstar investor, who is 50 percent better than the top tier VCs, only has a coin flip of a chance of an outlier with a small, concentrated portfolio of only 10 companies.”

4. Interesting that @uluventures has chosen 50 as optimal portfolio size. This is really big, given just 2 investment partners. Strictly by data, assuming they are “top-tier” in terms of picking ability, they believe they have 90% prob. of having at least one portfolio outlier.

5. While 50 is still a huge portfolio, given failure rate of companies, incoming follow-on investors as well as organically graduating to the next stage, @uluventures can still smartly manage their workloads. This has been my experience as well at Operators Studio.

6. Whatever your “picking ability” might be, it’s just a smart choice for any venture fund to adequately diversify. While large firms do it organically by having multiple investment partners to do a sizable # of deals, smaller venture teams would need to do it more consciously.

7. Side-note: loved the reference to @AlignedPartners and their strategy of taking relatively lower risk profile bets (capital efficient, less dependency on external capital, more ownerships for everyone on exit). Resonated a lot with my approach for Operators Studio.

Overall, am a believer in thesis-driven diversification that is done consciously and thoughtfully, especially at the angel and seed stage (where I operate). Of course, if a venture investor can marry diversification (n) with top-notch picking-ability (p), [UPDATED] as well as maintain high ‘o’ in the winners by doubling-down on them, magic happens!

[UPDATED] Remember the brain tattoo R=f(n, p, o)

Would love to hear your thoughts and experiences on diversification of early stage venture portfolios. Are you a believer in diversification? Or do you focus on “being focused”? When does diversification become “spray-and-pray”? How should an angel/ seed investor go about balancing ’n’, ‘p’ and ‘o’ simultaneously?

Source: Picking winners is a myth, but the PowerLaw is not

Author: Soumitra Sharma

Operator-Angel I Product Leader I US-India corridor I Believer in Power Laws I Love building & learning

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