Commentary: Go broad, go early: Why scale and diversification are the answer to venture market turbulence

The latest data remove any lingering doubt: The technology venture capital market is in the grip of a deep and drawn-out downturn.

In the third quarter of 2022, global venture funding plummeted to $74.5 billion, falling 34% quarter-on-quarter and hitting a nine-quarter low, according to research firm CB Insights. The third quarter also saw the number of $100 million-plus mega-fundraising rounds slump by an eye-watering 44%.

This was hardly unexpected and confirmed a number of headline trends: The later-stage venture bubble has burst, valuations are being dramatically reset, IPOs have ground to a halt and free-flowing check-writing, induced by a fear or missing out, or FOMO, is now a distant memory. But there are glimmers of good news too, primarily in the early stage market.

According to CB Insights, median valuations declined across all stages between the second and third quarters of 2022, apart from Series A, which was up by a meager 1%. Compared with 2021 as a whole, seed/angel median valuations were up by 29% in the third quarter of 2022. And when that same quarter is compared with 2020, median valuations for seed/angel stage startups were up a remarkable 66%.

In large part, this spike in seed/angel valuations reflects the growing interest of later-stage VC funds that have moved earlier in the company lifecycle in search of deal flow. This is something we've seen firsthand at Techstars, where I've had a number of conversations with tier one investors, keen for access to pre-seed companies as the late-stage market grew frothier. And despite these increases, the vast majority of pre-seed and seed investments are still made at reasonable valuations, and have remained relatively insulated from the crunch that saw later-stage and public market valuations fall precipitously.

For the foreseeable future, as the economic backdrop turns stormier and less predictable, pre-seed investing looks like a relatively safe bet.

The upside from a $100 million-plus company invested at pre-seed is potentially genuinely huge, which is not the case when you buy into a round expensively at growth stage, when the lion's share of upside has already been captured.

Furthermore when cash runways are shorter and resources tighter in a downturn, startups are more likely to be financially rigorous, and reach profitability sooner, which often results in small yet significant exits. And for most pre-seed and angel investors, generating 2x returns means they are doing a solid job.

Yet, none of this means pre-seed is easy to do. Quite the reverse. Whereas growth stage investors have any number of milestones and metrics to check off in their due diligence, pre-seed is akin to flying a plane through heavy clouds without instruments. It is unfortunately common for novice angel investors to lose on every single one of their investments.

So what then is the best way to invest in pre-seed? The answer is a two-fold approach: scale and hyper-diversification.

The traditional venture industry is built on scarcity and the idea that – thanks to their expertise, insights and network – VCs are uniquely able to sift through thousands of also-rans to unearth the outliers, meaning companies that will produce the next 50x-100x returns. In this venture model, not only is volatility extreme, but because VC funds make relatively large investments in individual companies, the majority have highly concentrated portfolios of, at most, a few dozen investments.

If you were to design optimal portfolio construction from scratch, you would build an extremely large portfolio. The key reason for this is the statistical upside of a power law, which, in venture capital, means that a relatively small number of investments represent most of the industry's total return.

This concept of a power law in VC is generally poorly understood, which is why so many funds are focused on scarcity. In fact, the optimal venture portfolio construction should be as close to infinity, in terms of the number of positions, as you can get.

For pre-seed and seed-stage investing in particular, assuming a rigorous and consistent quality filter and focus on strong business fundamentals are in place, then the more you invest, the higher the expected performance. In other words, placing more bets increases the odds that you get bigger and better outcomes.

This is far more straightforward. By covering as many verticals as possible, from aerospace to Web3, across multiple geographies, from mature markets in the U.S. such as the West Coast to rising regions like the Middle East and Africa, investors are exposed to the widest range of innovation globally, which in turn increases the odds of catching the next tech giant, and spotting the next innovation trends early.

There has never been a better moment to invest in pre-seed technology, which is flourishing all over the world. But it's undeniably hard to do and deliver consistent returns, especially as a solo GP or boutique firm. After all, who has the time, patience, and resilience to source and perform due diligence on 300-plus investments a year? You'd need an entire team – a fairly large one at that – and deep coffers as pre-seed investment exit horizons are usually seven to 10 years.

That's why it's time for a new approach for the pre-seed category – one that combines the upsides of both index investing and venture capital. A broadly diversified pre-seed portfolio can offer the same downside protection and stable returns that draw retail investors to index investing in the public markets.

We have arrived at an inflection point where existing models need to be rethought and, if necessary, discarded. The investor-as-magician approach to venture capital rarely works with entrepreneurs who are just getting started. LPs should observe this mantra instead: Go big, go broad, and above all, go early.

Maelle Gavet is CEO of the investment firm Techstars. She is based in New York City. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.