3 Tips VCs Use to Maximize Their Returns
Dear Startup Investor,
Buck Jordan here.
Investing is hard. It’s a job that requires patience and attention to detail. You need to be well-read and possess many other skills. This is truer for angel investing than anything else.
I know, because I’ve spent years investing in dozens of startups that do everything from 3D print rockets (Relativity Space), to building food delivery robots (Serve Robotics), and selling workforce management software for service industries (Harri). I’ve learned a lot over the years from each of these investments and each company I’ve had the opportunity to be part of in a small or big way.
Venture capital is a uniquely challenging asset class for investors because failure is a large and important part of the business.
According to LendingTree, in the U.S., 20% of small businesses fail in their first year of business and 50% fail by their fifth year in business. In contrast, failure rates for startups are estimated to be anywhere from 60% to 90%. In fact, over two-thirds of startups don’t deliver a positive return to their investors.
These are scary stats. You might even ask yourself why anyone takes the risk of investing in startups! Trust me I’ve asked myself that question many times when I’ve had portfolio companies at risk of failing. But as the famous saying goes no risk, no reward.
While the failure rate is high for startups, the ones that do succeed become enormous companies. Many of the most successful startups are crucial parts of our day-to-day lives such as Amazon, Google, Microsoft, Uber, Spotify, and many more.
The trick is knowing how to find the companies with the best potential for successes… and how to navigate the risk-reward knife blade safely.
Here are three tips that all the best venture capitalists (VCs) use to improve their chances at the good returns those successful startups deliver.
As VCs, we spend a lot of time thinking about our “portfolio construction” – how many companies we invest in and how much we invest in each. To be successful in startup investing, you need more than just a few companies in your portfolio. This way, you spread your risk out and increase your chances of having a company that could return 10x your investment (or maybe even 100x).
You need at least 20, 30, or 40-plus investments in your portfolio to increasing your “shots on goals.”
Most early stage VCs invest in at least 40 companies per fund. Many invest in as much as 60 to 70 investments per fund. Some even invest in hundreds of companies per fund.
The best VCs carefully curate high-quality investment opportunities to add to their portfolio and build a large and diversified basket of investments to maximize their odds at those 10x and 100x returns.
One of the single most powerful ways to amplify your returns in VC is to double down on your winners.
A famous example of failing to double down on winners is Peter Thiel’s investment in Facebook.
He invested $500,000 in Facebook’s seed round.
When Facebook raised its Series A a few months later, Thiel didn’t invest because he thought the company was overvalued at the time.
The result was that he missed out on billions of dollars in returns.
Still, I think he did more than fine from his initial seed investment in the company!
As you build your portfolio of startup investments, when you strike a company showing the potential to be a real outlier, make sure you double, triple, and quadruple down on it to amplify your returns!
The final strategy that top VCs use to maximize their returns is to invest patiently.
In venture capital we often talk about a concept known as “time diversity.” That essentially means you want to invest in startups over a period of several years instead of investing all your money at once.
Why is time diversity important?
Well, for one, technology advances so rapidly. Within just a few years a new technology could leapfrog another. Think about what happened to MP3 players once smartphones arrived with the launch of the iPhone in 2007. When’s the last time you saw an MP3 player?
The second reason that time diversity is important is that financial markets are cyclical and valuations can move up and down dramatically depending on many external factors. We’ve all experienced this viscerally over the last six months, where we’ve seen the stock price of many public tech companies drop 70% to 80% from their highs last year.
These price drops are now driving startups to raise at lower valuations. They’re also forcing VCs to be more disciplined. Investing over a period of years ensures you don’t only invest in startups at the peak of a financial cycle.
The best VCs use these three strategies to maximize their returns.
Keep them in mind next time you’re looking at an angel investment. Before you commit, spend some time thinking about the portfolio you want to build over the next few years.