Venture capitalists pride themselves on original, outside-the-square thinking. So it's a tad ironic that so many players gravitate towards a boilerplate approach to portfolio construction that has earned the scornful nickname of "spray and pray." "Spread your bets widely," the thinking goes, "to boost your odds of catching a unicorn, averaging up along the way, and bagging some bragging rights."
Going along for the ride with a unicorn is a very good thing. The evidence and common sense show, though, that the spray and pray model designed to boost the odds of catching a unicorn may actually be counterproductive when it comes to boosting overall fund returns.
Here are 6 reasons why leaning into a conviction approach to venture capital makes sense:
1) Fewer Investments Means You Don't Need A Unicorn to Return The Fund
A common refrain in venture is that the potential returns on an individual investment should be enough to return the entire fund. If that's the case, isn't increasing the number of investments in the portfolio counterproductive? All things equal, a 30-investment portfolio has better odds of catching a unicorn than one with, say, 15 investments, but the higher conviction portfolio only needs a 15X investment to return the fund while the lower conviction portfolio is so diluted that it needs a 30X investment to return the fund.
All things are not equal, though. First, the spray and pray VC is more reliant on a unicorn to pick up the slack for the rest of the portfolio. Second, as I'll unpack, I think she is also less likely to land unicorns on a deal-by-deal basis because her strategy is less selective, involves less time on research and due diligence, and/or she spends less time supporting founders than their peers who invest with greater conviction.
2) Conviction Strategies Are More Selective
One of the strongest arguments for investing with conviction is also the most obvious: VCs with a conviction approach are more selective. A recent article in Institutional Investor suggested that a well crafted venture fund should have something like 60 to 210 individual investments. In practice, that's the equivalent of a fund making a new investment every week or two, a torrid pace that doesn't inspire much confidence around standards or time spent on research and due diligence.
Most VCs aren't oblivious to this challenge -- that's why they allocate so much capital to follow-ons and sometimes entirely separate growth-stage funds to average up on their early-stage winners -- but they're also setting aside all that capital to follow-on with startups that they were less choosy about in the first place.
I'm reminded of when, back when was I managed portfolios of high-conviction growth stocks, I would be asked about my process for portfolio management and selling troubled stocks. Having good frameworks in place for managing positions and dealing with troubled investments was important, much like in venture, but a better use of time and focus was getting quality investments into the portfolio in the first place.
3) Conviction Strategies Leave More Time for Due Diligence
Tales of VCs who make home run investments off the back of a single meeting sound romantic but that's not how things work at venture firms with a sound, repeatable process. High-performing investors spend a great deal of time on due diligence -- getting to know founders, studying products and markets, etc. -- and with very good reason.
A study done on 539 active angel investors, who are as close a proxy to VCs as researchers can get this kind of data on, found that investors who did more than the median amount of due diligence had much bigger average exits (5.9X total return multiple) than the investors who were in the bottom half of how much time they spent doing homework on new opportunities (1.1X total return multiple). High-diligence investors also had fewer donuts with only 45% of their investments delivering less than 1X returns compared to 65% for the low diligence investors.
The point here is straightforward: A typical spray and pray VC will have less time to put towards up-front analysis and diligence on individual deals because they're stretching their time and capital across more deals than a conviction VC.
4) Focused Funds Have More Time to Support Founders
Managing a successful venture fund isn't just about finding, selecting, and getting in on winning deals. VCs also need to engage with founders on everything from mentoring to monitoring to making connections. The perspective and experience they bring are valuable so it probably will not shock you that the evidence is clear that angels -- again, the best available proxy for VCs -- who engage more often with their founders post-investment have lower loss rates and higher average returns.
The difference in the amount of time that VCs can dedicate towards engaging with founders and portfolio companies is a direct output of their strategy. Consider two scenarios.
A conviction VC with 10 active portfolio companies who is able to spend 30% of her time supporting founders. She's able to spend about 60 hours a year supporting her typical founder.
A spray and pray VC with active 40 portfolio companies who, because she spends much more time chasing, reviewing, and negotiating deals, is able to only spend 15% of her time on supporting founders. She's able to spend only about 8 hours a year supporting her typical founder, which is less than she spent watching Ted Lasso.
Sum it up and our hypothetical conviction VC is able to spend 8X the time supporting her average founder than the our hypothetical spray and pray VC. Which VC do you think founders would prefer to have their backs?
5) Other Power Law Markets Say the Same Thing
Venture capital is a power law industry but it's not the only one. Consider public equities. A study by JP Morgan found that only around 10% of all stocks in the Russell 3000 were "megawinners" that outperformed the benchmark by more than 500%. The loss rate in the stock market is also very high. The same study found that more than 40% of stocks in the Russell 3000 experienced a catastrophic loss of 70% or more from their highs that they never recovered.
And what do studies on portfolio construction of public equities say about concentration? Study after study after study show that managers with more concentrated portfolios outperform their peer averages, probably because the concentrated managers are more selective, able to spend more time on due diligence, and are able to better engage with their portfolio companies. Sound familiar?
6) More Ownership
Ownership is a simple but important concept to keep in mind when it comes to portfolio construction. The fewer investments a fund makes, the bigger the checks it can cut. The bigger the check, the greater the ownership. The greater the ownership, the more control investors have and the more of an outsized win the fund is able to claim.
Pushbacks and Exceptions
Some investors will push back on many of the above points. For example, mature venture firms with large teams can throw more at research, due diligence, and founder support. Having a large group of partners also means the individual VCs are able to be more selective on a personal level.
In theory, big teams are good. In practice, though, multiple studies on venture fund performance suggest that smaller and first-time funds deliver better overall performance than their larger, more mature competitors. Put another way, even if a firm has a big team and vast resources to throw at their process, there isn't clear evidence that it actually helps. If anything, the ultimate performance data points the opposite way:
One exception to keep in mind on the number of portfolio companies in a fund is the degree of focus and breadth of the fund's strategy. Focus is a good thing as it allows VCs to build some domain expertise, which makes for more efficient and effective deal sourcing and analysis, but there's such thing as too much of a good thing.
Consider a fund with a very narrow strategy -- e.g. seed-stage US marijuana infrastructure -- where the partners might know the space cold but the Fund is not as selective as a strategy with a wider opportunity set. The performance of this hypothetical fund will also have much more to do with how seed-stage US marijuana infrastructure investments work out as a group rather than the individual investments made by the fund because the strategy is so narrowly focused. Essentially, LPs would be paying for active management for a fund whose performance will be akin to an index on its very narrow strategy.
Some investors will push back here making the 'ownership percentage' argument. The idea is that you want to own the largest ownership percentage you can in your winners to maximize returns. While true at the position level that logic is missing the big picture: It's not the percentage of the startup you own that matters, it's the percentage of the investment in your fund.
Let's imagine we have 2 funds who are both invested in a fictional winner, Unico, and did so at the same valuation. Fund A owns 20% of Unico but only 1% of its fund is invested in Unico while Fund B owns only 1% of Unico but has 5% of its fund in Unico. It's true that Fund A has a bigger win in dollar terms but investors in Fund B end up with a much higher percentage return from the win because that fund had a higher percentage weighting behind Unico.
Something else: Readers who know this space well are probably familiar with the phenomenon in Monte Carlo simulations where the expected median performance of a hypothetical venture fund increases along with the number of investments. The reason is because of power laws and the odds of catching super-high-returning, right-tail outcomes increasing with more fund investments. With respect, though, the fundamental premise of these studies is broken because they treat deal-by-deal outcomes as random when strong evidence suggests that real-world factors like fund size, fund number, time spent on due diligence, and time spent engaging with portfolio companies all play major roles in fund and deal performance.
One Last Thing
I appreciate that there's more than one way to skin a cat in investing and that there are many venture firms who do not take a conviction approach and have done extremely well. I wish them, their LPs, and their portfolio companies all the best. I also appreciate that investing with conviction doesn't suit everyone's temperament or risk tolerance.
It's just that, at a time when venture funds are getting bigger and extreme diversification is very popular in many circles, I thought it was worth stepping back, reviewing the evidence, and appreciating that a conviction approach to venture investing might be extremely underrated.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any fund managed by Seaplane Ventures. An offering to invest in the Seaplane Venture Fund will be made only by the private placement memorandum, subscription agreement, and other relevant documentation of any such fund and should be read in their entirety.