Portfolio Size Matters

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What do the world’s largest and most successful venture firms have in common? Ycombinator, Sequoia, Accel and other well known and high performing venture capital funds use a common strategy: They invest in a LOT of startups.

Ycombinator is the largest startup investor globally by volume, investing in upwards of 1,000 startups per year!


The Power Law.

What’s that?

The Power Law says that a small part of a group receives the most results. For example, the top 1% of musicians earn 77% of all recorded music income.1 The top 1% of authors earn about 40% of all book sales revenue​.

Even in language, the power law is at work. The most commonly used words are used exponentially more than less popular words. Below is a chart for word usage in a multitude of different languages displayed logarithmically and named after its author, George Zipf. The words on the left of the chart are used much more than other words in that language. In English the most used words include “the”, “be”, “to”, “of”, and “and”.3 For those that are interested, the least used words include “genipap”, “gossypol” and “witenagemot”.4

So what does this have to do with investing in startups?

A small percentage of startup investments returns the vast majority of venture return on investment. Going back to Ycombinator, they were the first investor in Airbnb, investing USD20,000 in return for a 6% stake. When Airbnb IPO’d for USD47 billion they owned approximately 3.3% worth around USD155 million and a ROI of almost 8,000%!5. You can imagine that this investment most likely made up the majority of their returns for this fund.

Ycombinator and other investors, including Accelerating Asia Ventures use the power law to maximize return to their funds. Here’s a typical expected return outcome breakdown for early stage startup investments6:

In this distribution, 75% of the portfolio will either be a complete failure (zero return) or return some capital, but still at a large loss (-50% ROI). Another 18% will return 3x, which may seem pretty good, but usually VC funds are targeting a 3x return for the ENTIRE FUND. So with 75% of the investments at a loss and 18% at 3x, a fund needs the remaining 7% of “large win” and “unicorn” investments to get the total return up to 3x+.

Let’s look at some examples of how a larger portfolio can increase our chances of getting there.

Here’s the same distribution as above with a small portfolio of 15 startup investments:

With only 15 companies it’s unlikely that we will get a “large win” or a “unicorn” so the odds are that we'll have a poor outcome.

What if we bump things up and invest in 30 companies?

With 30 investments we have a greater chance of catching s “large win” but the odds are still low and it’s unlikely we’ll catch a “unicorn”. Our expected returns are at least positive, but they are still way below the target of 3x for the fund.

Let’s bump things up and invest in 100 startups:

OK, now we’re starting to capture some “unicorns” and it makes a big difference, as does capturing more “large wins”. We’re getting closer to our target of 3x and most investors would be satisfied with a 2.42x return.

Here’s another chart showing monte carlo simulations on tens of thousands of investment portfolios7:

As we move from 0 to 50 investments there is a dramatic improvement in investment returns (MOIC means “Multiple on Invested Capital”, a VC way to say ROI). From 50-100 investments we see an increased rate of return but at a lower slope and the returns continue to increase, but an an increasingly lower rate as we go from 100 to 300 investments where returns stabilize.

So what are the key takeaways?

  1. Venture funds should invest in at least 100 startups per fund.
  2. Angels and smaller startup investors like family offices are unlikely to have a good ROI in the industry without scale. They’d be better off investing in venture funds. The larger ones already do.

If you’d like to learn more about Accelerating Asia Ventures and join our investor community you can do so here. We invest in early stage startups in South and Southeast Asia, the fastest growing economies in the world. Our Fund II is investing in at least 125 startups over the next few years. You can also connect with me on LinkedIn here.

PS - the image for this article was generated with the prompt “please generate an abstract image with the concept of the power law long tail”

1 https://untappedsound.com/how-do-musicians-really-make-money/

2 https://publishingstate.com/how-book-authors-make-money-money/2023/

3 https://web.archive.org/web/20130616200847/http://www.duboislc.org/EducationWatch/First100Words.html

4 https://www.businessinsider.com/words-people-know-the-least-2014-6

5 https://news.crunchbase.com/startups/y-combinator-biggest-startups-gone-public-airbnb-doordash/

6 https://500hats.com/99-vc-problems-but-a-batch-ain-t-one-why-portfolio-size-matters-for-returns-16cf556d4af0

7 https://www.linkedin.com/pulse/modelling-suggests-venture-investors-should-have-bigger-steve-crossan/

This blog was originally posted on Craig’s Substack

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