Investing in early-stage companies carries a very high risk. While on average investors can expect 20% to 30% annual returns to their portfolios, single companies may yield anything from total loss to astronomical multiples. Thus, in order to get to the expected returns, diversification of portfolio is crucial. In this article we take a look at some of my diversification strategies.
Why to Diverse?
When you invest in publicly listed shares, you can expect on average 7% to 8% returns in the long run; even if the stocks are picked randomly. And even in the worst-case scenario, picking listed shares randomly would not be likely to end up losing all your funds.
In investing in early-stage companies the situation is different as there is no efficient market setting the price. Instead, there are more companies looking for funding than receiving it. And a great number of those companies are not based on such an idea and such a team that could really make a great business nor a great investment case. So if you are shooting money at random in different startups you are more likely to lose your money than to get the average returns.
I have a good deal flow, I invest time in due diligence and developing the company after the investment. The deal flow means that I can see a good number of good opportunities and have some benchmarks between the quality of startups and terms proposed for the investment. The time invested in due diligence should reduce the number of bad investment decisions. And finally, working hands-on with the companies should help them in avoiding some pitfalls and developing faster.
Still, after all these elements, I know that I am not capable of picking only sure winners. But with these elements I should be able to build a portfolio that is statistically expected to bring good returns, once the portfolio is large enough.
A Portfolio of 20ish Companies
The key to the diversification of an early-stage investment portfolio is to have a large enough number of companies in the portfolio. However, while the diversification would be better with more companies in the portfolio, adding additional companies in the portfolio would limit the possibilities of working hands-on with the companies and increase the administrative work as well.
In an attempt to create a balance between sufficient diversification and manageable portfolio, I have set a target of some 20 companies in my portfolio. Twenty companies give sufficient diversification and let you use on average one day in a month per company.
Of course, the time allocation is not this straightforward: As I tend to invest in a very early stage, and there are more elements I can help the company in early stage, I tend to use more time with the early-stage companies working with them on a weekly to monthly basis. The more mature ones I work more on "as needed" -basis, with need usually arising in connection to funding round or potential exit.
Different Verticals
Investing in different verticals helps to reduce the vertical related risk, such as the market risk, political risk and an appearance of a dominant player into the market.
A good example of the political risk realizing happened to my portfolio company OneClinic: One of their solutions is an ERP for social and healthcare sector. Once the social and healthcare reform in Finland was expected, many clients put their investments on hold. And once the reform fell through, the customers were uncertain what to expect in the future, so their investments very largely kept at the bare minimum.
As I have chosen to invest only in B2B, I have some limitations on diversification across verticals. However, even within B2B there are a lot of different verticals represented, enabling me to build a portfolio ranging from MarkTech to Logistics, FinTech to LegalTech and IT to raw materials.
Geographic Diversification
A single startup ecosystem has certain key strengths, which are often reflected in what kind of startups it produces. For example, Finnish startup ecosystem has been largely impacted by Nokia and Assembly, which can be seen still today in the tech and game startups arising.
Geographic diversification helps to bring more different types of startups into the portfolio. Also, it helps to diversify political risk as well. However, investing in foreign startups requires building an international deal flow and understanding both the business culture as well as fundamentals of early-stage investing in that region.
So far I have made most of my investments in Finland. The foreign ones are from Estonia, where I have a decent deal flow and a network of trusted angel investors. While I would like to have more international diversification and while I am looking for companies in Nordics and Baltics, I have noticed that there is still some work to be done in building the required networks.
Timing
As most of the returns come through exits, maximizing returns means maximizing exit proceeds. And while the value of the company depends primarily on the company, better exits generally happen when M&A market is very active. On the other hand, exiting a company in a downturn is harder as there is less purchaser and is thus likely to bring lower proceeds.
In order to counter the timing issues, I try to build an open-ended portfolio. In practice, this means that I bring a couple of new investments into my portfolio every year, and hopefully exiting some as well. As I do not have a fixed investment period I am not forced to exit at any point, given more flexibility towards the timing of the exit.
One should note that most of the VCs have closed-end funds; meaning that by the end of their funds lifetime they are forced to exit their investments. This is important for both the founders and previous investors of the company to note, as this may force an exit for them as well.
Diversification in Tickets
This may not be considered as diversification in traditional sense, but finally I would like to point out one element of my investment strategy: Diversification of tickets.
With all the due diligence you do, you still only have an outside view of the company before you make your first investment. However, if you do a follow-up investment, you now have an insiders' view of the company; especially if you are a hands-on investor. Thus, in a follow-up investment you have a better understanding of the case and, thus, lesser risk in your investment (at least in theory).
Depending on the phase of the company I invest typically 20% to 50% of what I allocate to that specific company in the first round. This leaves me prepared to do one to three follow-up investments to the company.
While I set aside funds for the follow-up investments, that does not mean that I would automatically invest in the upcoming rounds. Instead, every round I go through whether the company meets my investment criteria or not. In many cases, if the business is good, I work with the founders beforehand such terms for the round that I like to accept both as an existing investor and as a new investor. This helps the company in fundraising as well.
Besides your own returns, leaving capital for follow-on investments is important for future funding rounds. External investors are more likely to invest in a company where the existing investors are also investing, preferably more than their pro-rata -share. So if you do your investments with all-in mentality, you are not only taking additional risk, you are also making the company appear less fundable.
Point of View
Portfolio diversification helps to get towards good returns on a balanced portfolio. However, adding more companies into the portfolio reduces time available on working with the companies. Vertical and geographic diversifications help to protect against market and political risks but impose some limitations on portfolio building. Running an open-ended portfolio helps to tackle timing issues. Finally, investing tickets over multiple rounds gives the investor an opportunity to utilize inside view of the company in investment decisions; hopefully resulting in better investments.