Why investing early at scale is the best opportunity in VC now.
Imagine two VC funds, each with $1B:
- VC1 invests their fund in 40 startups.
- VC2 invests their fund in 400 startups.
Which VC is more likely to have a 1X+ fund (i.e. make money)?
Which VC is more likely to have a 5X+ fund (i.e. outperform the market)?
The answer to both questions is VC2.
Here’s why larger portfolios are better for VC funds:
VCs basically have two jobs: maximizing returns and minimizing downside risk.
The conventional wisdom is that VC1 is a safer bet (e.g. less likely to 5X+ but more likely to 1X+).
But both historical and projected fund models show that investors with larger portfolios like VC2 are actually more likely to have 5X+ gains and less likely to have <1X funds.
Larger portfolio sizes generate higher peak returns and significantly reduce the risk of losses.
An AngelList study of 10,000+ investor portfolios showed a direct correlation between portfolio size and median IRR, with each additional investment adding 9 basis points.
An analysis of power laws in venture portfolio construction by Jerry Neumann also shows that positive venture returns are directly correlated with portfolio size.
Specifically, to “exceed one times your investment (that is, make money) 90% of the time, you need a portfolio of at least 34 companies. To exceed 2x 50% of the time, you need a portfolio of at least 85 companies.”
So why doesn’t every VC invest in 100+ startups per fund?
It’s way more work to run a fund with a large portfolio!
The real reason why most VCs have 20-40 companies per fund is because they’re investing over a 2-4 year period and it’s a lot of work to find more than 10 good companies per year. And more companies in the portfolio means more founders to support, more boards to manage, etc.
And you don’t get more fees for this work!
VC fees are based on fund size, so both VC1 and VC2 are making ~$200M in fees (2% a year over a ten-year fund life) even though VC2 is doing more work for better returns.
LPs have a choice. They can continue to back the same large fund managers, many of whom are losing money net of fees. Or they can invest in emerging fund managers with smaller track records but much higher likelihoods of success.
Opportunity:
Be the first investor and advisor to thousands of early-stage startups.
Most startups need just $50K-250K to get started. This is increasingly true even in hard sciences like biotech, where 30+ years of Moore’s Law-like cost reductions in genomic sequencing and cell programming are sparking a new dot-com era. Whoever invests at this stage at scale will generate outsized returns vs. other VCs and the market.
Y Combinator is the first and still dominant player in this space. YC started by investing $17K each (for 7%) in 8 startups in 2005. By 2014, the deal changed to $120K for 7% for 100+ companies per year. Now, YC’s standard deal is $500K for each of the 500+ startups per year ($250M+ annual investments).
As YC has increased their first check size and gotten more competitive (there are 10,000+ applicants each batch for <300 investments), many startups are now waiting 2+ years and raising $1M+ before joining YC. This is creating an increasingly large gap to invest pre-YC.
Larger portfolios allow for earlier, riskier investments.
Making smaller investments means you can invest earlier.
VCs with larger portfolios can participate in earlier funding rounds, getting lower valuations and more equity per dollar. A $5M+ investment is almost always Series A+. $500K can be a whole pre-seed round or lead a seed round.
Funds with this strategy can make more high-risk, high-reward bets.
When you’re only making 40 investments per fund, it’s hard to take a risk on 1-year-old Airbnb or Coinbase. But just one of those 10,000X+ investments can return many multiples of a fund by itself, even in a 400+ company portfolio. The biggest risk is missing one of the top hits of the decade.
Problem: VC performance dramatically suffers when fund sizes get over $400M.
<$400M funds generate ~20% IRR while >$400M funds actually underperform the S&P (10.3% IRR in the last 20 years). $1B+ funds have historically generated just 2.4% IRR. Institutional LPs like university endowments count on large VCs to generate outsized returns, but growth funds are not delivering.
Solution: Invest large funds in early-stage opportunities at scale.
Large VCs price themselves out of the best opportunities when they invest $1B+ in <100 startups per fund. The solution is to massively increase portfolio size, investing in the same deals ($100K-$1M per startup at seed or earlier) as smaller funds at a much larger scale (400+ startups per fund).
Challenges:
I posted a Twitter thread last month about VC fund construction, and it got 130K+ views and a few VCs telling me my strategy is “very wrong”, “naive”, “impractical”, and that I need to do “more homework”.
It takes a lot of proof to challenge conventional wisdom. This essay has already shown that both historical and projected returns are better with larger portfolio sizes up to 1,000+ companies. But traditional VCs still have specific objections to my analysis, which I address here:
Objection #1: How will you get that many startups to take your money?
VCs are used to fighting to get into “hot” deals, so they assume that it would be much harder to get into 400+ early-stage deals vs. 40+ late-stage deals.
But it’s actually the late-stage deals that are most competitive. Startups at Series B+ are highly de-risked and have many large funds fighting to invest in them, so brand and access matter a lot here.
By contrast, even the best startups in YC’s history struggled to raise seed funding. Airbnb tried to raise $150K at a $1.5M valuation and got 7 straight rejections (2 investors didn’t even respond). Coinbase set out to raise $1M in their seed round, but were only able to raise $600K, including $165K in crowdfunding.
Most early-stage startups are just looking to close their seed rounds as quickly as possible and get to work. VCs who are willing to write a check after one meeting and make 100+ investments per year at this stage and will get access to many of the best deals of the decade.
Counter: It’s actually easier to get into early-stage deals.
- You just have to act fast and take many shots on goal.
Objection #2: What about VCs with multi-fund strategies?
VCs like Sequoia Capital do both early- and late-stage investing, usually out of different funds. It’s assumed that these firms get special access to great growth-stage deals since they led earlier rounds.
A famous example of this is Seqouia’s investments in Airbnb. They originally led the seed round with $585K for 58M shares ($0.01 per share). They then followed that investment numerous times out of their growth funds, spending $279M for an additional 24M shares (avg. $11.63 per share).
Sequoia’s growth-stage investments in Airbnb are a good deal by themselves. ($ABNB is at $115 now, so that’s still a 9.9X return by itself). But this investment would not return even 1X of one of Sequoia’s big growth funds, and Sequoia has posted major losses on other investments in these funds.
Sequoia disclosed that its $8B Global Growth Fund III (c. 2018), once the largest venture fund ever collected by a US firm, had only $1.7B in realized gains and $5.8B in unrealized gains before writing their $210M in FTX investments to zero in late 2022. And public disclosures from the University of California, LPs in 20 of Sequoia’s funds, show that Sequoia is underwater on half of their other funds.
Counter: Even Sequoia would be better off focusing on early-stage investments, and you’re no Sequoia.
Objection #3: What if I have super special deal flow?
In 2015, Y Combinator announced their YC Continuity fund to invest its pro-rata in every YC company with a <$300M valuation and lead or participate in later-stage growth rounds for the best YC companies.
This year, YC ended their Continuity fund, citing that they want to focus on YC Core, their original early-stage accelerator.
YC is the ultimate VC insider – they know thousands of elite founders personally, track them all over many years, and have 7%+ pro-rata rights for all of their startups’ follow-on fundraising.
For YC to stop investing in their growth-stage companies, over the objections of their founders, shows that they believe there is more value in focusing early.
Counter: Even if you have YC’s late-stage deal flow, investing earlier in more deals will yield better overall returns.
Summary:
I would invest $1B+ in 1,000+ startups to lead or participate in the first round for these companies.
- This strategy will outperform large growth funds, who typically invest in <50 startups each.
- Larger portfolio sizes lead to higher average and peak VC returns.
- This fund will also get a great reputation for backing founders at the earliest stages.
- We all remember the first investor who believed in us.
- YC is beloved for betting early on promising founders.
- A fund that invests pre-YC at scale will be a hero for startups.
- This will create a huge network and positive feedback loop that inspires future generations of founders to take our investment.
- We all remember the first investor who believed in us.
- There is still a large gap in the market to invest in early-stage startups at scale.
- Whoever fills this gap will make outsized returns vs. other VCs and the market.