Starting a VC Fund, Episode 6: Crafting Your Portfolio Construction Model

Hi there. I'm Patrick Iwas. I'm the founder and CEO of MindMaven. We're an executive coaching firm that focuses on helping VCs as well as leaders free up at least one workday a week. And then we try to utilize that time to invest into relationships so that you can reach your fullest potential no matter what you're pursuing. And we have.

I'm Charles Hudson, managing partner at Precursor Ventures, an early stage venture capital firm that invest in founders at the earliest stage of their journey. We often invest in folks pre launch, pre traction, pre data, pre everything.

All right, so we talked about how to build a portfolio construction model, what the elements of that is, what to consider about it. Now we've built it. What are some of the things that basically come up when you do it? And I want to start with those types of meta questions that might arise from that model.

What's one of the first ones that come to mind?

I think one of the big meta questions that comes out of some combination of number of companies in portfolio whether you want to be a lead investor, whether you're going to take board seats, is portfolio size and how you're going to spend your time.

And I think how you spend your time, first of all depends on the size of your team. If you're a single GP doing this by yourself, you should assume you're going to get lots of questions about how you're going to spend your time no matter what your portfolio construction is, because you're just going to have more on your plate than someone who has two or three partners at the fund will. So I think you have to be honest about a couple of questions that come up that I would describe as meta questions. One is, what are you going to do about the companies that aren't performing?

Are you going to continue to spend time with them? Are you going to sort of cut them loose? Are you going to move them to a lower tier of service? I think you have to have it in your mind, what am I going to do with companies that aren't performing? As you can imagine, our sort of canonical 200 company portfolio, this is a much more pressing question than it is for the fund that has 10 companies.

Yes, that makes sense.

And I think it's also important to recognize that your constraints are different. If you're a small investor in a company that isn't doing well, the social cost of you breaking the contract, the social contract with the founder and engaging less, the cost is low. You're a relatively small investor. You could argue they shouldn't have high expectations for your involvement unless you've set them high. If you've decided to take a board seat at a company that isn't doing well but isn't at risk of going out of business, it's much harder to actually, on a practical basis, scale back your time, commitment and involvement with that company. Because taking a board seat is a pretty big commitment to the company and to the founders.

Absolutely. All right, what else?

I think another thing is, I think it is important to think about your strategy for follow ons and we talked about this a little bit in the previous video. This is also an area where I think you have to be realistic about what you can achieve. So I've seen people who've given me portfolio construction that says, hey, we're going to write a tiny $25,000 check up front at this company and then when they raise their next round, we're going to raise, we're going to invest a million dollars into our winners at the A. And I'm like, well, on a spreadsheet, that sounds great. Practically speaking, that's fairly hard to pull off in most cases. As a 25k investor, you're not going to have a super strong relationship with the company in most cases. And when they're thinking about allocating ownership in that next round, they're probably not thinking about you writing a check that's 40x your original check. That's one of those strategies that looks great on your spreadsheet and probably sounds awesome. It's very difficult to actually pull off in practice.

Yeah. So the model would probably look very awesome and you probably think that you're an absolute innovator. But you have to ask yourself, well, if it's so amazing, why hasn't it been done before? And truly investigate the assumptions you might not know about.

Got it.

Okay. What's the next question you have?

I think the other one that's related to this is how likely are you to get included in these follow on investments and why? So I think there's a couple of ways to think about access to follow ons. One is to just say, hey, we're going to get a pro rata rights agreement with every investment that we invest in. We're going to insist that we have the legal right to invest in every round. Then the question says becomes, so are you telling me that you wouldn't invest in a company that doesn't give you a pro rata right? Most people would say, well, no, we'll probably still make the investment. So so there's one strategy which is we're going to rely on securing a legal right to do pro rata. And again, it's easier to get a pro rata right if you're a large investor in the round. Again, going back to our example of the 25k investor probably isn't going to easily secure a pro rata right to invest the next round. They're going to have to earn it through showing value to the founders and building relationships with them? And again, that comes back to fund size. Do you have a fun size that allows you to spend enough time with the founders you've backed to build relationships of trust with them where they think to include you in that round? And the other thing is, if you have a strategy that's very dependent on on those follow on investments in reserves dollars as a value driver in the fund, it is essential that you get pro rata in all of your follow on companies.

Exactly. Yeah, that makes a lot of sense. All right, now the next question, if I remember correctly, had one that had to do with sourcing, which of course from what I do is my favorite one. So talk to us about that one.

I think you have to have a notion for sourcing. And again, I think this comes back down to portfolio construction and strategy. And strategy I think we talked about really early on. The question is why do you win? And LPs will ask you this question in lots of different ways. But I think there's always this question, why do you win? For example, if you are a fund that specializes in artificial intelligence and you're the only AI fund, then your argument's probably we're the only people focused on this category and we think that we're going to be able to win the best deals by being the most expert, most well informed, smartest people in the room. Maybe that's possible to do at a point in time when artificial intelligence is not a mainstream investment strategy, I'd argue there's lots of strategies that sound great on paper. We're going to invest in the very best consumer Internet startup founders we can meet, I'd say. Well, that's also the stated strategy of Sequoia, Benchmark, Excel, Greylock, General Catalyst and Lightspeed very good firms. So you might have a strategy that's appealing, but the question is, can you actually execute on it? Are you positioned to win the deals that you're supposed to win based on what your strategy is?

And not only win the deals, not only win these, but win them based on what your model needs to get on top of that.

And so.

So you know, like what works in that area.

I think you have to understand the limits of your strategy. And so if your strategy is, you could have a strategy that says, hey, our goal is to get 10 to 50k checks into the hottest deals in Silicon Valley regardless of price. If it's a hot deal with, with a lot of energy and heat around it, our whole strategy is to get 10 to 50k checks in because we think it's better to have a tiny check in the hottest companies than it is to do anything else. Then your whole firm strategy has to be, and we've figured out how you win these deals. You basically drop everything and show up at the person's house until they let you in. You activate your entire network of founders. We've recruited a bunch of LPs that are high profile founders and executives in the tech ecosystem who we think have context these people and tell them to take our money. And our whole firm strategy is to basically full court press these people to get our 25 or 50k in and we will be shameless in our effort to do whatever it takes to get into the deal. And that's what we're going to do. But you've got to have a strategy around sourcing and winning that matches your strategy. You could also say, hey, we're going after founders that other people don't focus on and who don't get a lot of attention. And we're going to be a first and unambiguous supporter of these funds. Yes, we're going to write, we're going to write them a check early. We're going to have high conviction and we think that will build trust with them because this is a category of founder who's not accustomed to, to that experience.

So similar to the. Sorry, but so similar to the discussion that we had in the other video where you're saying you have to be aware of how much time you have to actually spend with your portfolio. You really have to spend the time figuring out how you can actually do this. NLP's will ask you in very specific ways of how are you going to do it? And it brings us also back to the original thing is like, well, I have a great network and.

That just doesn't cut it. You have to really think this through as part of your portfolio construction model.

Okay, so we're nearing the end of this video. Is there still another question you have?

I do think the. This is a meta question. I think this is something I found. Hold on one second.

Hello?

Yeah, I am. Yeah.

Okay, I'll go get him.

All right, guys, I think we're gonna lose Charles here, so we're going to drop off here. I think. Charles, right, you have to go take care of your little son right now.

I do. Yeah, let's do that.

And I. I hope you guys are with us, but family always comes first. So we're going to sign off, but thanks for listening.

Thanks.