This article aims to help VCs figure out how to size a venture capital fund, how many companies to include in your portfolio, and when and how to do follow-on investments. Most VCs aim to make a 3X (net) return on initial fund capital, at a ~20% net IRR. Note however, likely less than 10% of most VC funds achieve that goal.

1. Title: Determining VC Fund Porfolio and Investment Size, Reserves and Follow-on Investing
Abstract: This article aims to help VCs figure out how to size a venture capital fund, how many companies to include in
your portfolio, and when and how to do follow-on investments. Most VCs aim to make a 3X (net) return on initial fund
capital, at a ~20% net IRR. Note however, likely less than 10-20% of most VC funds achieve that goal.
Questions and Discussion Topics
● What is a good vs. bad return for a VC fund? What is a *great* return?
● Does a “concentrated” (n<20) or “diversified” (n>30-50) portfolio lead to better returns?
● What’s the “right” check size and typical % equity ownership in a company?
● Is there a standard amount to “reserve” for follow-on investments?
● When should you do (or not do) a follow-on investment?
Readings
● The Meeting that Showed Me The Truth About VCs - Tomer Dean, AudioLabs
● Venture Outcomes are Even More Skewed Than You Think - Seth Levine, Foundry Group
● No We’re Not Normal - David Coats, Correlation Ventures
● The Babe Ruth Effect in VC - Chris Dixon, A16Z
● Picking Winners is a Myth but the Power Law is Not - Clint Korver, Ulu Ventures
● 99 Problems But a Batch Ain’t One - Dave McClure, Practical Venture Capital
● Questing Conventional Wisdom of the Reserve Fund – Clint Korver, Ulu Ventures
● Three Core Principles of VC Portfolio Strategy - Alex Graham, Flywheel Visions
Sample Templates
● Venture Fund Portfolio Model
● VC Operational Budget
VC Goals: 3X and 20% (net)
How should we think about setting expectations as VC fund managers? How big a fund should you raise, and how many
companies should you invest in? What check size and valuation should you aim for, and what % equity should you aim to
own? Should you reserve capital to invest in future rounds? If so, how much? And when and how should you do follow-on
investing? These are tough questions, and the answers aren’t always obvious. Let’s try and figure out some basic rules
and fundamentals for how to make decisions on these topics.
The soundbite you often hear for VC performance targets is “3X and 20%”. This means most VC funds aim for a 3X (net)
return on initial fund capital, at a 20% net IRR or annual rate of return. While fewer than 10-20% of VC funds achieve this
goal, it’s because venture capital is such an illiquid and unpredictable asset class that the bar is set so high. Typically
investors in VC funds wait 5-10 years to get their initial investment back, and often up to 10-15 years for any substantial
returns. Since returns of 7-10% are commonly expected in more liquid investments like public stocks or index funds, VC
funds really have to outperform to be worth the risk and illiquidity. But unfortunately, most of them won’t and aren’t.
Strikeouts, Homeruns, and Unicorns
First, let’s start with looking at some data on company investments and returns. As you probably know, most companies
(and most investments) are failures. In the chart below, more than half and perhaps close to ⅔ of all venture investments
fail to return 1X the initial capital invested. Of the remaining 20-30% that generate a positive return, it appears <5-10%
achieve “homerun” returns of 10-50X+. Indeed, a homerun is what most VC funds are aiming for to “return the fund”, or
>1X overall return. But remember, VCs need to return 3X (or really 4X gross, to get 3X net). So in a typical portfolio of
20-40 companies, VCs need at least 3 or 4 companies to return 10-20X, or perhaps 1 big unicorn that returns 50-100X.
That’s pretty tough. Even if you assume you’re better than average, most VC funds have to be perceived as “top-quartile”
(top 25%) or even “top-decile” (top 10%) performers in order to be considered successful and raise future funds.

2. Concentrated or Diversified Portfolios?
Ok, so let’s start with portfolio size first: how many companies should you choose to invest in overall? Personally, my view
is most portfolios aren’t big enough and could use more diversification – hey, my first VC firm was called “500 Startups” –
what did you expect? However, there are other (successful) VCs who think more concentrated portfolios are a better way
to go. I don’t know if either answer is right for everyone, but regardless you need to decide how skilled (or lucky) you are
at picking unicorns / hitting homeruns. In the following (simplified) portfolio model, you need to guess how many company
investments are required to find at least one big outlier – and also, what exit valuation and ownership % you will have.
In the example below, we have a $20M fund size and 40 equal investments of $500K. At the time of investment, each
company is valued at $10M, so initial ownership is 5%. However, we assume (successful) companies will raise additional
capital, and after subsequent rounds and dilution, ownership at exit will be closer to 1-3%. In this model we also assume
the fund manager wasn’t lucky enough to find a unicorn, however they did get a few small, medium, and large wins of
between $100M to $750M in size. This results in a good (but not great) total return of 2.4X gross / 2.1X net, and a modest
profit of ~$5.6M for the VC fund manager(s). Not bad eh? Well if it’s just 1 partner and only takes 5-6 years… but if it was
2 or 3 partners and takes 15 years, maybe you should have been a doctor or a lawyer (or an engineer!).
Example Portfolio #1: $20M Fund, 40 Companies (a few winners, but no unicorns)

3. Ok, now let’s take a look at a portfolio that’s a little more lucky and does have 1 big unicorn. In this example, we assume
a slightly higher “unicorn win” ratio of 2%, and we have a slightly larger portfolio of 50 companies, resulting in one really
big winner that exits at $2B (and a few other winners at <$1B that are also meaningful). Note even though ownership was
only 1-2% at exit, the unicorn still “returned the fund”, and a few other medium and big winners also returned a significant
amount of the fund (but still, most investments failed and/or returned nothing). In this case, the fund resulted in a 3.7X
gross return, and a 3.2X net return – hey, look mom! I’m a top-quartile VC, maybe even top-decile? And maybe me and 1
other partner get to split $10M+ after working our butts off for 10-15 years… okay, not so bad.
Example Portfolio #2: $20M Fund, 50 Companies (a few winners, including 1 $2B unicorn)
In both of the examples above, I’ve over-simplified things – we didn’t account for any management fees or expenses, and
we didn’t reserve any capital for follow-on investing. To keep things easy, let’s assume the fund does some “recycling” of
capital – that is, we chose to re-invest some of our smaller, earlier exits… say, perhaps 20% of total. And let’s also
assume the recycled capital just about offsets the management fees and expenses (this would probably be more than
20%, but let’s keep it simple for now). This article won’t get into too much detail about recycling, however I’ll observe that
if you choose to recycle some capital, this will likely result in taking longer to make distributions to your LPs… and if you’re
lucky, you’ll generate a better return on capital. Or if you’re not lucky, then it may not.
Note that if we chose to have a more concentrated portfolio (n=20), we might have been unlucky and had zero big wins…
or we might have been lucky, and had the same or more winners, but larger ownership since we had more capital for each
company. It’s not obvious if either a more concentrated or diversified portfolio will result in better outcomes. I suggest
arguing this over beers with a few experienced VCs who have larger funds – at least that way, they might pay for the beer.
Reserves and Follow-on Investing: Double-down on Winners? Or Good Money after Bad?
So now let’s talk about reserves and follow-on investing. Most VC funds choose to “reserve” some of their capital for
follow-on investments, to be made a few years after the initial first checks have been invested. The theory here is that 1)
you may find out more about which companies are doing well (or not doing well), and may learn more about the founders
and market and business model, and 2) you may also find out if other investors are investing more capital in later rounds,
to help the company continue to survive and grow. However, it’s likely that 3) the company valuation will increase, and 4)
your ownership will be (somewhat) diluted as the company raises more capital.
Again, in theory the information you learn in #1 and #2 will offset the increase in costs and dilution in #3 and #4, at least
for some of the winning companies in your portfolio. But how will you evaluate when is the right time to make a follow-on
investment? How do you know whether the increased valuation is worth it? Should you wait for next round investors to
put money in, when there is less risk but a higher valuation? Or should you jump in earlier, when valuations are lower but
there’s still a lot of things to figure out?

4. The Relative Cost of Buying Good Equity = (Average Valuation per round) x (Success / Filter Rate to next round)
My own hack for making this decision is to look at 1) the average increase in valuation from one round to the next,
and 2) the “filter rate” of your investment selection, and/or “success rate” of the companies that make it from one round
to the next. We can think of this as the “relative cost of buying good equity” at one stage vs. another.
Let’s assume we make 10 investments at seed-stage, each @ $10M valuation. And let’s assume 4 companies do well
enough to get to a next round of investment, where they now have a $40M Series A valuation. In this scenario, valuation
increases by 4X, however only 40% of the companies make it to the next level. For simplicity, let’s presume the other 6
companies' value goes to zero (note: this may not be true, not all companies require investment to increase in value).
Then overall portfolio value has gone up by (4X x 40%) or ~1.6X. As an interim way to evaluate portfolio progress, we
would assess things are moving in a positive direction. However, in the next round there will be some dilution as new
capital comes in, and we might expect to own 20-30% less equity than previously. That would still be a win, since even
70% of 1.6 is still >1. In this scenario, we might feel like rather than investing more follow-on capital, we should have just
written a bigger check in the seed round. Follow-on capital is more expensive than earlier-stage capital.
However, if we adjust the portfolio dynamics slightly, and assume only 2 of the 10 companies make it to the next level,
then we might assess the portfolio only increased in value by (2X x 40%) or 0.8X, and with additional dilution now our
overall portfolio value has gone down. In this scenario, we might feel like we should have waited to invest more money
until the Series A, rather than at seed – our invested capital would have been worth more. In this scenario, a dollar of
follow-on capital is worth more than a dollar invested in an earlier round.
Ok, so now you can see that it depends on the relative increase in cost of equity, and the success rate of your portfolio
companies to figure out whether it makes sense to invest more or less dollars at any given round. While it may seem like
waiting to invest in later rounds is less risky, you may have to pay substantially more for equity when the valuation has
gone up, and indeed you may not get the chance to invest at all if the round is oversubscribed and you weren’t a previous
round investor. Conversely, if you put money in at earlier / riskier stages and too many companies fail, or not enough
companies get to the next round at an increased valuation, then you may have invested too much money before finding
out which companies are going to be winners.
However, reality is quite a bit more complicated than the simplified examples above. Assuming you have a finite amount
of capital to invest, there will always be trade-off scenarios to consider:
● Should I invest more capital in fewer companies to increase ownership? or less capital in more companies to
increase diversification?
● Should I invest more in earlier rounds when valuations or lower? Or in later rounds when success is more likely?
● Should I reserve more capital for winners? Or should I help companies that need capital to survive / make it to
the next round? What if I don’t follow-on, and the new round washes out early investors that didn’t participate?
● Should I invest pre-emptively in companies that seem to be winning, but before other investors have increased
valuations? Or should I wait to invest after other investors have put in more capital, but perhaps I may get
squeezed out of the subsequent round, or have my pro-rata rights cut back?
● Rather than invest follow-on capital from my existing fund, should I raise an SPV outside the fund from my LPs (or
perhaps new LPs)? Or should I raise an opportunity fund to exclusively invest in later rounds of my winners?
Here are a few suggestions I might offer:
● Play offense not defense: if possible, follow-on pre-emptively in the companies you think are winning, before other
investors double-down and increase valuations. Founders will generally appreciate your willingness to bet on
them early, before it’s obvious to everyone else.
● Don’t follow-on just because companies need the money: need is not a sign of market acceptance or progress.
Look for evidence the company is learning how to make a better product, getting more / happy customers and
retaining them, increasing revenue or reducing costs (relative to competitors).
● Don’t follow-on or just because other investors put more money in: altho it’s a good sign others are willing to
invest, evaluate the increased cost of equity and the relative progress of the company from the prior round.

5. Again it’s not easy to come up with simple one-size-fits-all answers to each of these scenarios. It may also depend on
whether you’re in a competitive financial ecosystem with many other VC funds, or in a more capital-starved geography or
industry vertical where investors have more time and leverage relative to entrepreneurs. It may depend on whether you
have investor advantages due to your experience or branding or relationships with your entrepreneurs, and if you can
depend on those advantages to get into competitive rounds or companies at lower cost. And it may depend on if you
have fiduciary obligations to your portfolio companies and/or your LPs that drive some decisions which may not always
relate to investment returns or valuations. Hey, nobody ever said this would be simple or easy!
I hope this has been a useful article to explore how to think about portfolio size and valuations, and reserves and follow-on
investing. If not, then I hope you find a few other friendly VCs running bigger funds who will help pay for those beers.
Good luck and now go make some good investments! (or at least make a lot of them… some of them might work out ;)
Dave McClure, Practical Venture Capital