The rapidly evolving COVID-19 pandemic continues to create unprecedented challenges politically, socially, and economically, all of which can be seen reflected in significant volatility in the global public markets. However, over the past few months we have witnessed something entirely different on our platform. We have seen by far the best activity since we founded SeedInvest eight years ago: our investor network is highly active and growing more than ever, and we are on pace for the best quarter we’ve ever had by nearly all measures. Evidently there is a continued appetite for startup investments, despite the present public market uncertainty. For those potentially looking to rebalance a portion of their portfolios, what are some strategies, both timely and timeless, for building a diversified venture capital portfolio?
While exciting, investing in startups is not without its risks. It’s commonly accepted that the majority of your returns will be concentrated in just a select few startups, while the majority of your startup portfolio investments will return at best what you invested (and more often than not even less than that). If you invest in too few startups, you are statistically less likely to be invested in one of the few “winners” whose outsized returns are crucial to offsetting the myriad losses you are almost guaranteed to experience across the majority of your portfolio. This is a critical concept for those looking to add early stage startups to their investment portfolio, as building a large, diversified portfolio is one of the most effective hedges against such losses.
Early Stage Companies Can Be More Nimble
Early stage companies are typically more nimble and less affected by market cycles, as small businesses are better suited to pivoting their business model during a crisis, or other periods of big macroeconomic change. The COVID-19 crisis has already resulted in potentially lasting changes to the way we work, the most obvious being the dramatic increase in remote working. This is not necessarily a hindrance for agile, more tech-enabled startups. They can more easily pivot to allow employees to work effectively from home, regardless of how distributed the workforce is, which cannot always be said for companies in more traditional sectors.
Another advantage of being an early stage startup is the larger range of exit strategies available to them. Conversely, later stage companies may be more exclusively focused on an IPO. In the near future, later stage companies may begin to feel increased pressure in a bear market with depressed valuations–hardly the ideal time to go public. Further, mid to late stage companies may have higher burn rates, such as the highly visible “unicorn” startup, WeWork, which burned through $1.4B in Q4 2019. WeWork’s future is uncertain, especially with more companies looking to accommodate the increasing need for employees to work remotely, highlighting that later stage companies often need to be well-financed to endure. Diversifying into early stage companies is one strategy for building a robust portfolio for the long term, helping to prepare for an unpredictable socioeconomic climate.
Diversification Across Sectors
Beyond diversifying across company size and business model, one should also consider investing in startups across a variety of industries and sectors. Each industry has a different risk and reward profile, as well as a different tolerance of economic climates. Cast your mind back to a few years ago–who could have predicted the near collapse of the restaurant and hospitality sector, or the healthtech and e-commerce boom, all a byproduct of the crisis we are living through right now? Sectors perform at different paces the majority of the time, so ensuring you have a diversified, well-balanced selection will help bolster your portfolio’s resilience.
Diversification Across Geographies
As with different industries, differing geographies will similarly either benefit or suffer from big macro events at different paces, so one strategy for diversification is to broaden the geographical span. Additionally, the increase of remote work eliminating geography as a constraint to a company’s talent pool could be a game-changer for businesses, as fewer startups will be reliant on traditional VC hubs. Smaller tech hubs are increasingly competing against Silicon Valley, historically the epicenter of the startup tech ecosystem. Companies based in secondary or tertiary markets may start getting access to a broader talent pool as employees leave Silicon Valley. We are already witnessing this geographical shift, with exciting startups emerging from unlikely locations: UIPath ($7bn unicorn) from Bucharest, Supercell ($9bn exit) from Helsinki, Farfetch ($7bn IPO) from Lisbon. Being in a traditional VC hub is no longer a prerequisite to creating the next unicorn startup, and COVID-19 may well accelerate this trend.
Diversification Through Diversity
There is a much-needed conversation occurring these days about systemic racism, including in the business world. In addition to being a moral issue, a lack of diversity within a company may also impact the bottom line. A McKinsey report found that “ethnic and cultural diversity on executive teams continues to correlate strongly with company financial performance, [which supports] the argument that there is value in promoting ethnic/cultural diversity in [top company] teams around the world.” Additionally, First Round Capital found that teams with at least one female co-founder performed 63% better than male-only teams, while racially diverse teams performed 35% better than their industry peers.
However, a recent study of VC-backed deals found that 77% of founders were white, just 1% percent of VC-backed founders were black, while women-founded startups received only 9% percent of investments. While we still have a long way to go, we are proud that 12% of SeedInvest’s portfolio companies over the past two and a half years have been led by diverse founders. Early stage investing is just as much about who you are investing in as the idea, the potential market opportunity, business fundamentals, or technology, and so investors serve themselves well by being mindful of the entrepreneurs they are supporting.
This post was written by Alice Hankin on July 2, 2020
Early-Stage Startup Investments: Strategies for Diversification