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Every Venture Deal is a 1 in 10,000 Bet

Institutional Investor came out with an article last week that I've been emailed several dozen times now - because it validates the strategy we've been working on at Hatcher+ for the past three years.  If you've not yet read it, the conclusion of the article is, if your venture portfolio consists of less than 500 companies, you're using luck, rather than math, as the basis for portfolio construction. However, there's one thing the article didn't mention - and that is, when you include an unblinking analysis of the early-stage selection process, venture capital isn't a 1 in 500 game, it's a 1 in 10,000 game.

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Hatcher+ Proprietary Research:  Effect of Portfolio Size (number of investments) on Return Multiple (i.e. 2x)

Let's start by discussing an important piece of the equation that unfortunately gets very little attention when discussing venture outcomes - the selection ratio.  Or as we like to call it at Hatcher+, the "quality threshold".

Over three years, we've interviewed over a hundred and fifty VC firms, CVCs, and family offices about their selection ratio, simply by asking them how many deals, out of a hundred inbound business plans, do you put money in?  We did this because we wanted to understand what kind of dynamics are in play on the front end of the deal funnel - before any capital gets invested - and come up with a point for determining when we might be over-selecting, so we could avoid doing that.

For generalist investors, what we discovered is: most professional investors invest in approximately 1 out of every 100 deals they see.  There were some folks that had lower ratios, and a number of folks that had good reasons to adopt a higher ratio (if you're a highly-specialised medical device accelerator, your deal flow is going to be much smaller than that of generalist investors such as Plug and Play, or YC) - but for the most part, 1 in 100 seemed, to us, to be a useful place to draw the line.

Okay, so 1 in 100 startups get money.  How do we get from 1 in 100 - to 1 in 10,000?   

Let's turn to the second part of the equation - those "power curve effect" companies responsible for returning the fund, and then some.  In his book "Zero to One", Peter Thiel states "The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined."

This is especially true for smaller-scale funds.  But the even bigger secret lurking in that statement is that larger portfolios have a statistically better change at seeing those power curve effects.  Our data and research partner CB Insights believes that the likelihood that a venture-funded, seed stage startup makes it to unicorn status is around 1 in 100.  Dan has done a similar analysis using 20 years of data and a ten year clock, and determined that this "1 in 100" number is pretty accurate.       

Many of the excellent research articles published by venture researcher Michael Jackson, and others, back up this assertion.  Dave McClure, founder of 500 Startups and Practical Capital, calls this phenomenon the "large portfolio effect".  Most recently, Kamal Hassan, Monisha Varadan, and Claudia Zeisberger of INSEAD, stated it in the clearest terms possible:

"CIOs simply need to acknowledge that VC math is different from public markets math. The importance of low-probability, excess-return-generating investments means that proper diversification requires a portfolio of at least 500 startups."

So let's put the numbers together:  1/100 (selection ratio) * 1/100 (power curve plays) = 1 in 10,000.  QED: If your deal horizon stretches from the earliest stages of investing in startups through to IPO, the odds are 1 in 10,000 that the foundation-stage business plan you're currently leafing through will have a billion dollar IPO.  Which, in broad terms, translates to five in five hundred bets, post the selection process.  

Now, I know what you're thinking - it's possible that these numbers are wrong, or inflated.  So let's assume the number is 80% lower - say 1 in 2,000.  Does that really change anything?  Does reducing the number by that amount make it significantly more likely that a 20 company portfolio is going to deliver returns?

Not really.  The researchers at Institutional Investor, CB Insights, INSEAD - and Hatcher+ - have it right.  Size matters.  More and more analysts and researchers are figuring out the (venture) math: when it comes to early-stage venture investing, constructing large portfolios is the only way to generate resilient portfolios, and solid, predictable returns.

Note: Constructing and managing deal flow and large-scale venture portfolios is not a trivial exercise.  The good news is, we've proved it's possible.  At Hatcher+, we've spent three years and millions of dollars building the data models, systems, deal origination partnerships, and technologies that are needed to make this happen.  Over the past 18 months, we've looked at over 10,000 deals and invested in... yes, you guessed it... 108 companies, or roughly 1% of the deals shared by our deal origination and venture investor partners.

The even better news: we've decided to allow anyone that wants to to partner with us, and use our technology to execute this strategy - for free.  And if you don't have the deal flow and fund management support, we can supply that too.  Call us and we'll get you set up.

*The title probably should have read "Every *Early Stage* Venture Deal..." but you get the idea...

Sharp
John Sharp
Hatcher+

John is a serial entrepreneur and investor, and the Founding Partner of Hatcher+, a next-generation, data-driven venture firm that utilises a massive global database in combination with AI and machine learning-based technologies to identify early-stage opportunities in partnership with leading accelerators and investors worldwide.