Diversifying Your Startup Portfolio, Part II

In a previous post, we delved into the importance of diversification in a start-up portfolio. We looked at ‘The Babe Ruth Effect’ and the number of different positions that should be taken to properly diversify an early stage investment portfolio. Startup investors must be aware that they are going to encounter more losses than wins. Success of a portfolio is based on those few home runs, which drive the overall return. However, there is a degree of nuance and some pitfalls that are worth noting in order to diversify successfully.

‘The Babe Ruth Effect’ Redux

VC portfolio data from Horsley Bridge Partners revealed that “~6% of investments representing 4.5% of dollars invested generated ~60% of the total returns,” demonstrating that the majority of their returns came from a small number of winners in their portfolio. Diversification amongst many different companies allows VC firms to cast their nets wide enough to snag some of these ‘home runs’ and realize lucrative returns from their portfolios. However, to do so, individual funds often raise hundreds of millions, if not billions, of dollars in order to have enough investment dollars to properly diversify.

From a perspective of number of positions, let’s take a more modest approach and assume a VC raises $350M for a fund focused on early stage investment. The average amount invested in any particular deal varies greatly by sector and opportunity, but for simplicities sake, let’s assume this fund focuses only on Series A funding rounds of roughly $7.5M each, on average. By the time the capital from this fund is exhausted, the firm would have taken approximately 47 different positions, close to our 50 number discussed in the first post.

Diversifying Across Startups? It’ll Cost You

As an early stage investor, your investment focus is very likely limited to 10 companies or less. As such, the chance “hitting a home run” is much lower compared to the truly diversified investment funds we discussed above. With only ten placements, the 6% of your investments that are successes, representing that large portion of return, is 0.6 of a placement… in other words, potentially non-existent. The larger the number of placements, the lower the unsystematic risk, increasing the chances of reaching median returns for early stage investment.

That being said, the previously stated rule of thumb suggests 15 startup investments as the low end of the acceptable diversification spectrum. If the minimum dollar amount for traditional early stage investment begins at $25,000, this means an individual’s portfolio would require $375,000 of start up capital to reach the low end of suggested positions, and up to $1,250,000 for the ideal diversification level.

Though this simplifies what is involved with early stage investment, it is understandable that not everyone has access to this much capital, especially considering that early stage investments should only represent a portion of your overall investment portfolio. Remember our 5-15% number? On the highest end, your portfolio value would have to hold $25M in assets.

The Parallels: Public Market Diversification

Investors experience diversification hurdles in practically every investment asset class, including the public market. Though stocks trade at lower dollar amounts, it can be difficult to assess risk and evaluate the number of opportunities to achieve proper diversification. When you take into account transaction fees, account fees, commissions, and other return-eroding metrics, it can be too costly to justify a properly diversified stock portfolio.

To overcome this difficulty, investment products like mutual funds and ETFs were introduced to the market. In pooling capital, investment managers realize economies of scale, applying the same strategy to the entirety of the fund. This allows investors to reach proper diversification levels without the in depth due diligence process that was previously required, and with a lower minimum investment amount required to justify purchasing these instruments.

Additionally, this approach provides access to asset classes that were previously reserved solely for institutional and high net worth investors, such as Asset Backed Securities or other capital-intensive fixed income instruments. Here at Crowdfunder we thought, why not apply this to early stage investment? This led to the launch of our newest product offering: the Crowdfunder VC Index Fund.

The first truly diversified early stage investment fund, we invest in 15 startup companies a month, looking to cap this fund at roughly 1,000 portfolio companies. We add a critical layer in evaluating and completing the same due diligence processes described above, similar to a mutual fund or portfolio manager. Additionally, we provide early stage investment diversification with much less capital commitment. To top that off, our team only pursues deals that are already backed by the world’s most prestigious VC firms. Our Index tracks early stage investments of VCs to evaluate which are generating the most success. We then invest in startups at the exact same terms as these home run hitters.

[SOURCES] Average VC Capital Raise / Fund Size
http://www.kauffmanfellows.org/journal_posts/vc-adaptations-for-seed-investments/
Average VC Series A Investment Size
https://www.cbinsights.com/blog/early-stage-tech-report-february-2016/

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