Quality over Quantity – Why a small portfolio leads to big returns

Venture Capital is not only about focusing on data, statistics, and pure rationality but also about non-quantifiable variables. The latter separates the wheat from the chuff.

Quality over Quantity

Let’s start with some number-crunching!

Common knowledge suggests that 9 out of 10 startups fail. Diving into statistics, the majority of VC returns are coming from 20% of their investments, in other words from 2 out of 10 startups the VC invests in – this is often referred to as the “Pareto principle”. A minimum 12% annual return is regarded as a good VC performance, which over a standard fund lifetime of 10 years yields a 3.1x total return. To achieve this return with 2 investments while the other 8 have to be written off, these 2 investments have to return on average 15.5x.

Reality check: “Spray & Pray” is not a safe bet

That sounds of course very logical and would imply that as long as the fund volume is sprayed enough, VCs just have to pray, and statistically there will be a success as long as the two winners are real winners. Of course, reality looks different: it is much more probable that out of 10 investments 5 have to be written off, 4 yield 2-4x return and then there might be one really big winner yielding e.g. 50x.

Comparing theory to reality, it’s becoming clear that there’s more to a successful VC than pure math: According to UpWest data 50% of VCs return less than 1x to their LPs – overall, those investors are taking a pretty big risk for a minor return. On the upper end, 5% of VCs realise a return of more than 3x.

How we choose a high-conviction investment strategy of quality over quantity

At 3VC the key lies within pursuing quality over quantity: the startups we partner with, the way of sourcing exciting new opportunities, the 3VC team setup, and even our latest rebranding all have one thing in common: quality over quantity.

1: Identifying potential category leaders

Whether a specific market that we look at is a winner-takes-it-all market or not, there will be one company that will be the leader in that category. Finding that potential category leader is one key for the quality over quantity principle.

3VC will never invest in two companies in the same market competing (now or in the future) with each other hoping that one of the two then wins the race for the pole position. As part of the due diligence process, we analyse the market thoroughly and make sure we are partnering with the best team that has built the best product based on unique insight.

This is also the reason we don’t set a tight industry focus because it would sooner or later lead to competition in the portfolio, but also we want to expose ourselves to serendipity and be in a position to capitalize on structural developments that emerge.

2: Better support for founders

One big advantage of only partnering with a handful of teams every year is that we have more capacity to support these teams closely and take more time for them. Think for example about a partner sitting on 25 boards versus only sitting on 5 boards. Of course, the latter allows her/him to think much more about the business, engage more when needed, and add more value.

Does that mean that 3VC is interfering with the operations of the startups? No, definitely not! But when founders would like to get opinions, feedback, advice, or any other kind of support we want to make sure we can stand by. Startups we are excited to partner with always get the chance to speak to portfolio founders to get a feeling of how 3VC works with the teams.

3: Investing with conviction

We are in for the long term and have a conviction that every company we partner with has the potential to outgrow, otherwise, we would not invest at all. In this context, numbers play a role again, as VCs are looking for “fund returners”, investments that pay back their entire fund. However, if a fund distributes its investments equally among 100 companies, one investment needs to return 100x on the invested capital. If the fund invests in 10 companies, one company has to yield 10x to be a fund-returner. Although perceived risk seems to be higher, we would argue that every founding team we partner with is still taking a much higher risk, so interests are better aligned between investor and founders, but also a common mindset that “every investment counts” is established.

Endorsing Tradeoffs

As with everything in life, there are advantages and disadvantages to the quality over quantity approach. Certainly, the biggest tradeoff is that there are a lot of amazing entrepreneurs building very exciting companies, but we are not able to build full conviction and thus decide not to partner with these entrepreneurs. While we have to say no much more often than we would want to, we will always be interested to stay in touch, often conviction can build up over time and of course, we can be (and should be proved) wrong.

Pursuing quality over quantity certainly isn’t easy.

Quoting Steve Jobs: “Quality is more important than quantity. One home run is much better than two doubles. Quality is never an accident.”

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