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VAs a venture capitalist, one of the characteristics of investing that I think about the most is risk. Risk is the principal factor that all investors seek to understand before finalizing an investment. In the venture capital industry, one of the most common investment ideologies you’ll hear about is the power law. The power law is less of a “law” and more of an idea that suggests that in a large portfolio of companies, a very small number of those companies will provide the vast majority of returns. Of course, the quantity of companies in a portfolio must be large enough to ensure the power law effect is relevant. But what I often question about the power law as it pertains to early-stage venture investing is “what quantity of companies is optimal” and “is the power law a law that can (or needs to) be broken?”
There is a mountain of academic research about the power law effect in venture capital (deeper reading HERE). As such, for the sake of this post, I’m limiting the scope of this discussion to examine what it takes for a company to advance from one stage of financing to the next. More specifically, what it takes for a company to advance from pre-seed or seed-stage financing to the series A stage. Because getting to a series A is so challenging for most early-stage companies, it’s this inflection point that’s most critical to understand in the broad picture of the power law dynamic.
Some pre-seed and seed-stage venture capital firms believe the optimal number of companies to have in a portfolio should be high. High to me is greater than 40 companies in a fund. I know several firms with greater than 100 companies in a single portfolio. These types of firms make more, smaller investments ($50K to $250K) in a lot of companies and will double or triple down on their outperformers. On the other hand, there are firms who invest slightly larger amounts ($250K to $1M) in 20-40 companies and will also double down on their best companies.
Prior to starting Serac Ventures, I was a partner at a venture capital fund of funds manager for 5.5 years. In that role, I reviewed hundreds of early-stage VC fund managers’ investment strategies and had the privilege of investing in and alongside several of them. In my experience, I observed that most funds invested in a range of 20 to 60 companies per fund. If the power law were indeed a “law” then one could expect that every fund manager would invest in the same number of companies. But that’s far from what actually happens in practice because the success or failure of a single underlying portfolio company depends on various factors. For most early-stage companies the three most important factors (in my opinion) are the leadership ability of the founder, how quickly the company can achieve product/market fit, and the strength of its go-to-market and distribution strategy. I believe most early-stage investors would agree that if a pre-seed or seed-stage company can execute in these three areas, the probability of raising a Series A financing round is greatly enhanced.
Knowing this, is it too audacious to suggest that the principles of the power law don’t apply to VC firms who support early-stage companies in the three aforementioned areas? If we know upfront the catalysts for success, doesn’t it make logical sense to devote our time and resources to these areas? Herein lies the challenge for most venture capital firms. If a VC firm has a lot of companies, it can put a strain on internal resources to provide the level of support early-stage companies may need. On the other hand, if a VC firm has too few companies, they may under-diversify their portfolio and spend too much time with the wrong companies.
What complicates the story even further are founder, market, and timing dynamics. Every successful VC-backed company in history had the right founder in the right market at the right time. The combination of these three dynamics is inevitably what leads to company success. If one of these components is off (e.g. right founder, right market, wrong timing) the company has a low probability of succeeding no matter how much guidance/support they receive from their VC backers.
At Serac Ventures, we believe the optimal portfolio size falls within a range of 20-40 companies per fund. As the fund grows, we strategically add resources to support our portfolio companies. We are thrilled to announce the recent addition of Britt Hoose to the Serac team as Vice President of Operations. Britt brings a high degree of operational rigor to the firm to optimize how we support our portfolio companies as they grow.
Our goal as a firm is to maximize returns to our investors with the right combination of portfolio construction and founder support to both take advantage of the power law effect and lessen its effect at the same time. I know this sounds like a contradictory statement, and that’s intentional. From our perspective, the power law is more of a rule of thumb than a true law. And if there’s even a small chance that we at Serac Ventures can challenge it, it’s worth the effort.
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