Portfolio Construction

Portfolio construction is the process of setting check sizes, follow-on reserves, and assumptions about valuations, ownership, and dilution over time that defines a fund's investment strategy and shapes their expecation of returns. At it's core, portfolio construction involves a set of choices given a fund's total capital available to invest:

• Does the check size strategy allow the fund to get enough ownership to drive a return the fund investment?
• Given the expecation on failure rates, does the check size strategy and reserve strategy lead to a diversifed or concentrated portfolio?
• Should the fund reserve capital for follow-ons? Reserving for follow-ons reduces the number of initial investments but can lead to concentrating capital into (hopefully) winners.
• Should you invest the same check size across investments, or vary the check sizes by conviction?
• What do you need to get access to the best deals — and does that match your check size?

The result should give you enough shots to hit a winner. Invest in enough companies (30-100) to catch the power law of venture returns.

Top funds win on (1) volume of large exits and (2) size of the largest exits. Concentrated portfolios risk getting enough opportunities to invest in a large exit; diversified portfolios increase the odds of getting a large exit, but too much diversifcation leads to too small investments to get a fund-returner.

Fund size, check size, and investments

Fund strategies often don't align with the math of deployable capital. Common failures:

• A $10mm fund (deployable $8mm) writing $1mm first checks — too few investments.
• A $20mm fund reserving 70% for follow-ons — struggles to deploy reserves into meaningful proratas.

Follow-on budgeting depends on (a) projected cap tables for portfolio companies (drives your prorata strategy) and (b) graduation rates (drives how many follow-ons you can do across stages). Misalignment between strategy and math is the most common portfolio-construction problem.

In the end, about 50% of startups will get from seed to series A.

Pace matters a lot, but the eventual final graduation rate always seems to end up around 50% pic.twitter.com/Uk9Pym8PzX

— Peter Walker (@PeterJ_Walker) December 5, 2024

Check size and fund strategy

Charles Hudson: "your check size dictates your investment strategy". A $50k fund will struggle to get into Series B. A $250k lead-investor strategy will struggle to win deals. A $1.5mm early-stage fund needs the team, process, and experience to lead. Check size and strategy need to match.

Check size and target ownership

Eniac's Seed Fund Portfolio Construction for Dummies:

The classic mistake here is new managers pick an amount like 250K or 750K when they should be pegging initial checks to a target ownership. At the end of the day, the percentage you own of a portfolio company when it exits is what's important, not the amount you put in. ... Part of the rationale for [our target] ownership range [of 10-15%] is that if we maintain ownership in the 10% range when the company is worth $1B, an exit at that time can return the whole fund.

Accounting for dilution and reserves for proratas, what ownership % do you need at exit for a fund-returner? The Venture Capital Method and the Venture Valuation Tool can help work the math.

How to model portfolio construction

Portfolio construction drives capital deployment and exit proceeds, both timing and amount. Hemrock's venture capital models span simple to detailed:

• Fund Economics Tool — simplest. Fund-level performance, no per-period cash flows, average gross multiple on invested capital.
• Venture Capital Model, Quarterly Forecast — detailed initial and follow-on strategy per exit outcome, with up to three portfolio scenarios.
• Venture Capital Model — quarterly, with graduation rates, follow-ons, proratas, valuation increases, dilution, and per-stage exit proceeds. Detailed expected-value math per stage.

The method used to create a portfolio construction varies between the models, and is detailed at Entering your investment strategy

More detail isn't always better

The right level of detail depends on your situation.

Building your first model for first-LP conversations on Fund I? A complicated forecast of a 4x gross isn't what LPs care about at that stage. Deeper in the process, or raising Fund II or III, detail becomes more valuable — and you're better positioned to build and defend it.

Scenarios capture variability

Returns in venture are highly variable. Scenarios and range-based inputs are valuable. Use discrete scenarios (best/worst/medium) or range-based simulation with probability distributions.