In his Medium post, Matt H. Lerner, founder of Startup Core Strengths, considers the calculations behind risk and return in venture capital. Using a Monte Carlo simulation, he finds that ceteris paribus, a larger portfolio yields markedly better return multiples than smaller ones.
This is chiefly due to the power law characterizing VC returns, which implies that a small number of portfolio companies bring in a large portion of total returns. Simply put, the more companies you have, the more likely it is that you find an outlier that ends up becoming a unicorn and yields a gargantuan multiple.
Of course, VCs do not choose their firms randomly, and some of the top ones highly benefit from their brand and connections which certainly boost the probability of success for all of their respective portfolio companies. The above still holds true, and we at Gorilla Capital have since 2012 been vocal advocates of the large portfolio approach.
The diversification benefits from having 70+ active companies in total in our Funds I & II mean that our success is actually not even contingent on finding the occasional unicorn. Instead, the bulk of the solid returns is generated from a large number of successful, earlier-stage exits. However, should a portfolio company show potential to reach a billioneuro IPO, we certainly support them on their path – our approach doesn’t force any artificial ceiling on companies.
There are some understandable reasons behind LPs preferring managers that practice unicorn-hunting over this more sensible strategy. First, venture capital is seen as an asset class with a high level of risk correlated with a high level of reward. LPs might feel as though they can get solid returns with a sounder risk level from other assets. Second, the irrational optimism characterizing the entire venture capital industry is strongly present when funds are pitching to LPs: the dramatic, emotional and overoptimistic style often entices more than a more cynical one.
At Gorilla, our mission is thus to show that a larger portfolio size of companies is also able to generate sizeable returns for investors. We are essentially hedging our downside without limiting our upside in the slightest. The success of our previous funds applying this strategy serves as empirical proof: the general VC wisdom of unicorn-hunting can and should be challenged.
A Tale of Two Squirrels: The Not So Simple Math on Venture Portfolio Size: https://medium.com/@matthlerner/a-tale-of-two-squirrels-the-not-so-simple-mathon-venture-portfolio-size-b33a2de51003
In his article for Soaked by Slush, Christian Owens, co-founder and CEO of the scaleup Paddle raises the concern that the metrics currently used to quantify European tech success are due for a change. The overemphasis on unicorns leads to a tunnel vision in which only the gigantic exits are valued, and the numerous smaller ones neglected. The author argues that the overall health of the European startup ecosystem rests on the hundreds and thousands of small businesses becoming successful and scaling up only when solid foundations are built, instead of seeking aggressive growth via big funding rounds.
Our team at Gorilla Capital fully endorses this view. In our opinion, start-ups often try to jump the growth curve, and end up trying to scale a product which hasn’t yet had time to morph into its final version. This behaviour is often due to the phenomenon mentioned above. If a billion-euro valuation is seen as the holy grail, many companies adopt a mindset of aggressive early-stage growth without taking the time to ponder whether their product is ready to be scaled.
That is why we actually seek “camels” instead of unicorns. These are the companies that are capital efficient, have solid unit economics, and focus on building sustainable growth. Admittedly, the initial growth rate may be slower than that of an aspiring unicorn, but these companies are more robust and resilient than their peers.
In good times, the camels thrive, but even under uncertainty, they survive, unlike the aspiring unicorns that jumped the growth curve with high valuations and wind up with downs rounds when the overall economic climate worsens and the bubble bursts.
Stop talking about unicorns: The way we measure European tech success needs to change:
Stop talking about unicorns: The way we measure European tech success needs to change: https://www.slush.org/article/stop-talking-about-unicorns-european-techsuccess-needs-change/
Money is
always a consequence, not the root cause. You work – you get paid. You sell –
customer pays. You roll the dice and get lucky – you get rich. You have a
business (plan) that works – you get funding.
But getting
funding is not the end goal, not even for a startup. The end goal is to be able
to pay all that funding back, and some more. To reach that you need to have a
business that works. For getting there, you need the right strategy. The
strategy should be all about your business: who is your customer, what is your
offering, how you plan to win etc.
The journey
from where you are today to where you need to be one day is typically so long
that you may need to top up some fuel on the way. Funding is your fuel, helping
you to get where you need to go. But it’s just a means to an end, not the
reason your startup exists and definitely not your Northern Star. It should not
be the driver for your thinking and activities, do not let “what do I need to do to get funded” to
mislead you.
No, but this is still more of an “exception” rather than “the norm”. Some investors who have a similar kind of basic philosophy (model is more of a “scalable Angel” rather than “VC”)
https://www.kimaventures.com/ (the only European on this list) http://rightsidecapital.com/ (we owe a lot to these guys for setting up a role model we have taken full advantage of. Big thanks to Kevin & al for the inspiration and openly sharing their thinking) https://svangel.com/ (building on the heritage of the original SuperAngel Ron Conway, they have the longest track record to demonstrate the strategy works) https://500.co/ (the most vocal on this list. For them investing is just one of the things they do) There certainly are more but most investors with this strategy tend to prefer a low public profile, they focus on their business rather than PR.
