The Portfolio Effect: Battery’s Tom Crotty on Why VCs Should Back at Least 25 Companies in Every Fund

Tom Crotty, managing general partner of Battery Ventures, told me yesterday that his firm believes that  that “between 25 and 30 deals provides the proper portfolio effect.” I’d never heard a VC mention the ideal portfolio size with such specificity, so I asked what he meant.

“If you build a portfolio of less than 20 deals, and especially if you are an early-stage investor where the industry mortality rate is somewhere in the 50% range and maybe higher, you better be damn lucky on the winners and get more than one with strategic ‘exit’ premiums of 7x or more,” he said. “You’d probably need three deals returning at that level to be successful. And deals with that level of return profile are very hard to come by in this day and age. For example if you have 16 companies, it’s highly likely that eight will be goose eggs. The other eight will need to have very strong return multiples to achieve greater than 2x return on the fund.”

Sounds straightforward enough, but would your portfolio effect still require 25 companies if you ran a small operation?  After all, Battery is investing out of a pair of funds that total $1 billion and has 12 general partners. Most early-stage venture firms do not.

Crotty pointed out that Battery’s first fund, a $34 million vehicle closed in 1984, backed 30 companies. Battery Ventures III, closed in 1994, backed 22 companies with $85 million. Meanwhile, its 2004 fund, which closed with $450 million, bought stakes in 35 companies.

He also said that more firms could invest in more companies by recycling their fees. “If you have $100 million, you could build a portfolio of 20 companies, particularly if you invested up to the 100 percent of the fund. Many people don’t do that. They invest the fund size less the amount of fees.” Subtract the typical $20 million to $25 million in fees that a firm might over the life of the fund, and a firm could easily put another three to five more chips on the table, he suggested. (Crotty didn’t say so, but obviously this approach is only plausible if you’ve already made some money in the business and can afford not to draw management fees all along but rather take them when you start getting some exits.)

As for the manpower question, Crotty said that each Battery GP completes one to two deals each year, though none will sit on more than seven boards at one time. If adding new investments means hiring or promoting someone new, so be it. “We want to ensure deep focus on each investment without having the GPs get so stretched they can’t stay on top of their companies.” Battery winds up overstaffing, he said, adding that its GPs all take less salary than firms with comparable capital under management, “but the formula works to ensure quality and focus and greater returns through the carry side.”

Could you do today what you did in 1984 –invest across 30 deals with $35 million, I wondered? “You couldn’t,” said Crotty, “but I also don’t think you can be very competitive with a fund that small any more.”

Scale “absolutely helps in this business,” he conceded. “But small funds can achieve a fair amount of diversity. You have to work at it.”