Allocating capital to a venture portfolio over time

Over the last five years, we have developed a more sophisticated capital allocation framework. Most credit here is due to Yacine Ghalim, who runs our Paris office and joined us from Goldman Sachs five years ago. 

Capital allocation over time is a major driver of venture fund return. Sure, ours is a business of power laws and the most important driver of return is initial company selection. But making sure that capital is funneled to the best companies over time, ignoring the false positives of fast external fundraising or traction that doesn't really show product-market fit, is a major driver of absolute return at the end of the fund lifetime.

So here's how we do it. 

Portfolio company developments are continually shared on their own #portfolio-[company-name] Slack channel. Every quarter we run a portfolio review day, where we update each other of each company's latest status and revised outlook.

Following these updates, each member of the investment team estimates an expected enterprise value at exit for each portfolio company. This EV at exit is a multiplier of probabilities and set enterprise value ranges: write-off, under €100 million, €100 - 250 million, €250 - 500 million, over €500 million. 

The input sheet per fund (on Google spreadsheets) looks like this:

The expected enterprise values at exit are aggregated across team members for the entire fund and result in several analyses.

The first is the quarterly change in percentage and value terms - seeing which companies are moving up and down. 

The second is the relative ranking of the companies in our portfolio, which displays as a candlestick chart showing the average EV at exit as well as the range across team members. This variance also shows you the amount of consensus in the team. As the fund matures, the relative ranking displays the well-known power law of venture outcomes. 

The third analysis looks at "buckets" of companies according to several criteria: absolute EV at exit, probability of getting above €250 million, probability of write-off, time in portfolio. 

It also looks at the marginal investment opportunity - what the last valuation was, what a current valuation would be, and what the likely cash-on-cash multiple of additional capital deployed into the company would be. 

This estimated multiple is the money shot: it provides  clear guidance on where capital should be deployed and directly informs the investment manager's approach on whether we should do our pro rata, whether we should try to invest more than pro rata, or whether we should attempt to limit additional cash into the business. 

Like most of venture, capital allocation is not a purely rational endeavor. But having a joint framework and common understanding of what makes a good investment decision over time helps the team more quickly make the right decision.

Our job is to take risk - and the best way to do this is by being permissive in the team. Each initial investment decision does not require unanimity in our partnership. We encourage everyone to follow their gut (though we do keep each other intellectually honest). 

However, our follow-on decisions do require unanimity - and this is where the capital allocation framework is a great help in fully aligning the whole team behind the best companies.