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📊 LP Strategy – Why You Should Take an Index Approach to Startup Investing

Investing in early stage startups is incredibly risky. According to a Harvard University study of 2,000 venture backed startups, it's estimated that 75% failed to produce any returns to investors. Only 1%-2.5% of venture backed companies ever become unicorns, companies worth over $1B. According to a study by CB Insights, only 0.07% of venture-backed startups have reached decacorn status, meaning only 1 out of every 1,400 venture-backed startups will become a $10B business.

So what does this mean for you as a prospective investor (or LP) looking to invest in early stage startups via syndicates?

Well it means a lot, but the most obvious take away is that picking unicorns and decacorns is extremely hard, and odds are that any single startup investment will return you near zero capital backed. By creating a diversified portfolio of high risk investments, early stage VCs more or less accept that the majority of their portfolio companies will fail or return 0-1x capital back, but the few that make it will become massive winners, providing outlier returns of 100-500x+ invested capital and return the fund, potentially many times over.

Per the chart below (source AngelList), 5 years after closing a round, the median startup investment is flat. Furthermore based on their data, “early-stage venture investments up to the 90th percentile net out to zero return…Any positive returns in a venture portfolio are a function of the outlier returns of investments in the top decile.”

Even within those fund returners, outliers are not created equal – Peter Thiel made an estimated 2,200x on his investment in Facebook; eBay is estimated to have returned Benchmark Capital 750x on its initial investment. Accel’s investment in Facebook is estimated to have returned them over 500x. Sequoia Capital’s investment in WhatsApp is estimated to have returned them over 300x.

The distribution curve is known as power law, or the Pareto distribution. Power law is a phenomenon that describes the distribution of returns in venture capital investing. Put simply, the power law states that a small number of investments in a venture capital portfolio will generate the vast majority of returns.

I’ve seen a similar distribution in my own personal portfolio, where I’ve invested in one company that’s share price is up over 150x and a handful valued at 10-20x initial entry share price with the majority of them valued at near 1x. There’s a ton of nuance in this data – for one, my personal startup portfolio is only ~5 years old, meaning the power law distribution has yet to have taken it’s true effect as many of them, specifically the current 10-20x markups today may become 100-200x+ markups in five years or they may return nothing (yes nothing e.g. Katerra, Quibi, Theranos), but in any case you get the point. The odds are that any single one of my investments will return 0-1x capital, and if I were told have a concentrated portfolio of early stage startups, I would have almost certainly missed the 150x+ investment outlier that is driving my power law returns today.

In fact, out of the 355 personal investments I’ve made on this fund admin platform, if you take out my top 10 investments, my portfolio would be almost flat as opposed to the 30.2% IRR it’s showing.

If you’re reading this, you may have heard of this “power law” phenomenon before (perhaps so many times that I just lost you by throwing out such an well-known concept in this community as though it were a novel thought), but the reason I’m writing a whole post about this is because despite some investor awareness, it’s extremely common for new LPs in my syndicate to create concentrated early stage portfolios of 2-15 investments and expect that one will be that 100x-500x+ fund returner. Let me tell you, as an LP investing in early stage deals via syndicates, this is very difficult and quite frankly a bad strategy for most that will likely leave you resentful of the asset class.

Warren Buffet famously stated that he is a strong advocate of concentration. So does Peter Lynch, so does Charlie Munger, so does Joel Greenblatt… And even prominent VC investor Peter Thiel suggests that investors should only invest in “seven or eight promising companies from which you think you can get a 10x return.” They can’t all be wrong? Sure if you’re investing in late stage businesses with access to financials, management and other diligence materials, yes, this can be a winning strategy. But unfortunately you don’t have that as an LP in syndicates.

What you do have is limited information. No/limited access to management, no data room access, etc. No meaningful diligence can be done (for most of us) from the LP side. I believe because of this, adopting the Warren Buffet concentration strategy would be imprudent in such a risky asset class with minimal data transparency. That doesn’t mean it can’t be done, but for the vast majority of LPs, it probably works out.

And while I evidenced this near the top of this post, there’s a lot more data to support this. AngelList put together a distribution of returns on 10 investments out of the universe of 1,808 investments in their database prior to the Series C. This is what they found. The black line is market returns, which is what you would get from writing an equal-sized check into all of the potential AngelList investments.

“The most frequently observed outcome from a 10-investment portfolio, the peak of the curve, is slightly positive performance [slightly above capital back], well under the market return. This is a consequence of the power-law returns of venture capital: the typical manager fails to pick any outsize winners in their 10 chances, whereas the market portfolio is assured of selecting all of the return-driving winners.” If this is the chart at ten investments, the distribution of returns will only look more skewed for a portfolio of fewer companies, meaning more investors will massively underperform AngelList’s market returns by concentrating further. Their data concluded that “

So with this data in mind, what should you do as a syndicate LP?

• First, if you’re new to VC investing and new to joining my syndicate or others, I wouldn’t invest a single dollar before evaluating a large number of deals - spend some time backing GPs, reading their memo’s, resources and just learning. (We’ll create a much larger guide on how to best prepare for startup investing, but that’s for a different post)

• Almost every new startup investor (myself included) is overly excited that they have the chance to invest alongside the best VC’s in the business when they first get started, thinking their first investments will include that 100x+ investment. While startup investing is exciting – I remember the feeling all too well – it is very easy to invest far too much too early, thinking this is your only opportunity to access great businesses early. While some may think I’m projecting here - there are 6,000+ LPs in the Calm Ventures syndicate, and it’s an extremely common pattern, which is why most LPs burn out in a year or two (they overinvest).

• Once you’re at the stage of deploying, I would have a good sense of how much capital you're comfortable investing in startups. As a general rule of thumb, new investors should not allocate more than 5% of their portfolio to VC, so talk to your financial advisor, but 1-5% is common as a starting framework.

• Divide how much you’re going to invest in startups by a large number (well over 50), and that’s how much you’ll invest in each startup as a syndicate LP. That figure could be 60 or it could be 100 (as for me, I’m at well over 300 personally), but the important thing is you have an exact dollar amount that you will commit per deal you opt to invest in and you have enough shots on goal to create a highly diversified portfolio of early stage companies, leaving yourself room for power law to take hold.

• Per the data, investing in 10 deals will likely leave you with barely 1x capital back on median because your exposure to investing in the 100-500x+ company is extremely limited.

• It’s important to do this exercise pen to paper with exact figures because if you don’t I’m nearly positive you’ll end up investing more than you want to (or can afford to) too early and end up with a very concentrated early stage venture portfolio, very cash poor or burnt out.

So should you even start investing in startups given the risk and effort?

Well, let’s look at the data. As of April 2023, “the AngelList platform has generated returns, net of fees, of 26.5% per year for investors (LPs) dating back to 2013. One might presume, then, that the typical AngelList startup investment returns 26.5% per year, with some variance. As such, investing in lots of startups (i.e., having a larger total portfolio) could be a good approach because it might lower the variance of returns in the portfolio.” Additionally, venture is a high-risk/high-reward asset class with returns uncorrelated to returns from other asset classes with the return potential for venture is among the highest of all asset classes.

To Conclude:

1. While investing in startups can be lucrative, your diversification strategy will play a meaningful role in your returns.

2. While a fund GP may take a different (or more concentrated strategy) because of their access to management, data, perceived competitive advantages, etc. the data suggests as a whole LPs are not served best with this approach, and I agree.

3. If you decide to create a concentrated portfolio, you can create an outlier portfolio, but this strategy for most LPs will result to below market returns.

4. Create a financial plan to determine exactly how much you can afford to invest in startups (using 1-5% of worth as a guideline, but ask your financial advisory). Divide your pooled capital by a very large number (well over 50) to drive you closer to market returns, as it will increase your chance of getting that portfolio outlier that can return your entire invested capital multiple times over.

5. Alternatively, if you want exposure to the asset class in a diversified way but don’t want to put in the effort, a good option is to invest in Rolling Fund from a GP you trust (Alex at Riverside Ventures & I at Calm Ventures both have fund products, which we link to below).

6. As a whole, getting small exposure to this asset class has the ability to provide LPs with strong return, but it is a high-risk/high-reward asset class with returns uncorrelated to returns from other asset classes. Return potential for venture is among the highest of all asset classes.

We’d love to hear other thoughts on this, so feel free to drop us a reply whether you agree with us or not!

Riverside Ventures Fund Here 

Calm Ventures Rolling Fund Here

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✍️ Written by Zachary and Alex