The Second Quartile

As I have written about here on AVC many times, early stage venture portfolios produce a wide range of outcomes. A few investments produce the vast majority of the returns while many investments return nothing. Managing a portfolio with power law dynamics is a challenge.

At USV, we tend to make 20-25 investments per early stage fund.

The best four to five investments per fund will usually produce greater than 80% of the total returns of a fund (the top quartile). This is where you might imagine that we spend all of our time, but the truth is that these investments generally go well and while we certainly do everything we can to help these companies, they often do not demand a lot of our time. When they do require a lot of our time, it tends to be situational.

There will be roughly ten investments per fund that will return maybe 5% of the fund (the third and fourth quartile). We spend a lot of time on these investments and it is difficult work that I have written a lot about over the years. The time and money we spend on these investments is not rational but we do it anyway.

And then there is the second quartile that will produce roughly 15% of the returns of the fund.

I find that it is this cohort of investments that is the most challenging to manage. The companies in the second quartile are usually very good companies but they lack the explosive value generation characteristics of the top quartile. They tend to have a harder time attracting top talent and financing their businesses at attractive valuations. We often do insider-led rounds for companies in the second quartile as the venture industry is hard wired to invest in the top quartile, particularly the later stage/growth investor community.

But there is a lot of value in the second quartile. The exits in the second quartile tend to be in the $100mm to $500mm range which is not a small amount of value to anyone other than a VC managing a billion dollar fund. The founders and management teams that are building these companies stand to make a lot of money if they execute the opportunity well. And an early stage VC can make a lot of money too. At USV, we tend to own between low to middle teens and twenty percent of our portfolio companies at exit, so the proceeds at exit to us of an investment in the second quartile cohort can be $50mm or more. A few of those and that is the difference between a 3x fund and a 5x fund for us. So managing the second quartile is super important.

But the second quartile will try your patience and your conviction. These investments often take longer to realize. And you will have to take endless calls from friends in the VC passing on the investment for all sorts of good reasons, but always come down to “it’s just not exciting enough to us.” You will have to talk your management team off the ledge countless times. You will work harder to recruit new talent. You will put more money into them than you want to. You will struggle to get the business profitable. You will wonder if you have lost your objectivity.

And then one day, you will get an offer from a buyer to acquire the company for hundreds of millions of dollars. And then all of that effort and conviction will have been worth it.

The tech sector’s obsession with the billion dollar companies emerging from startup land is irritating to me. That narrative ignores a lot of great companies and terrific work being done by founders and management teams. And it makes it harder to build a company that isn’t in that top cohort.

I understand why the attention is focused on the big winners to the detriment of everything else. But I can assure you that is not how we operate at USV, and it is not how the best early venture capital firms operate. When you start a company, you want to find an investor who will be there with you through thick and thin. Do yourself a favor and look at how the firms you are talking to behave toward their second and third quartile portfolio companies. That will tell you all you need to know.