portfolio construction

Our Secret to Finding 100x Opportunities

In previous blog posts (here and here), I’ve delved into the mathematical model for constructing an early-stage VC portfolio designed to achieve outsized returns. In short, investing early to build a concentrated portfolio of fewer than 20 moonshot companies, each with the potential for 100x returns or more, is the way to go.

The math is straightforward—it doesn’t lie. Not adhering to this model can significantly reduce the likelihood of achieving exceptional returns.

However, simply following this model is not enough to guarantee outsized results. Don’t mistake correlation for causation! The real challenge lies in identifying, evaluating, and supporting these “100x” opportunities to help turn their vision into reality.

At TSF, we use a simple framework to evaluate whether a potential investment can meet the 100x criteria:

10x (early stage) x 10x (transformative behaviour) = 100x conviction

The first “10x” is straightforward: We invest when companies are in their earliest stages. For instance, over the past two years, all but one of TSF’s investments have been pre-revenue. This made financial analysis simple—those spreadsheets were filled with zeros!

Many of these companies are also pre-traction. While having traction isn’t a bad thing, savvy investors shouldn’t rely on it for validation. The reason is simple: traction is visible to everyone. By the time it becomes apparent, the company is often already too expensive and out of reach.

At TSF, we have a unique advantage. Before transitioning to investing, all TSF partners were engineers, product experts, successful entrepreneurs, and operators—including a “recovering CEO”—that’s me! Each partner brings distinct domain expertise, collectively creating a broad and deep perspective. This allows us to invest only when we possess the domain knowledge needed to fully evaluate an opportunity. We “open the hood” to determine whether the technology is genuinely unique, defensible, and disruptive, or whether it is easily replicable. If it’s the latter, we pass quickly. A strong, defensible tech moat is a key criterion for us. This approach means we might pass on some promising “shallow-tech” opportunities, but we’re very comfortable with that. After all, we believe the best days of shallow tech are behind us.

Maintaining a concentrated portfolio allows us to commit only to investments where we have unwavering conviction. In contrast, a large portfolio would require us to find a large number of 100x opportunities and pursue those we might not fully believe in. Frankly, I wouldn’t sleep well if we took that route. This route would also make it difficult to provide the meaningful, tailored support we’ve promised our entrepreneurs (more on that in a future post). 

When evaluating product potential, we look beyond the present. At TSF, we assess how a technology might reshape the landscape over the next decade or more. We start by understanding the intrinsic needs of the user and envision how a product could fundamentally change customer or end-user behaviour. This is crucial: if a product that addresses a massive opportunity has a strong tech moat, first-mover advantages, and the ability to change behaviour while facing few viable alternatives, it can unlock significant new value and create a defensible, category-defining business.

This often translates into substantial commercialization potential. If we can foresee how the product might evolve into adjacent markets (its second, third, or even fourth act) with almost uncapped possibilities, we achieve the “holy trinity” of tech-product-commercialization potential—forming the second 10x of our conviction.

Here’s how we describe it:

Two Small Fish Ventures invests in early-stage products, platforms, and protocols that transform user behaviour and empower businesses and individuals to unlock new, impactful value.

This thesis underpins our investment decisions and ensures that each choice we make aligns with our long-term vision for transformative innovation.

While this framework may sound simple, executing it well is extremely difficult. It requires what I call a “crystal ball” skill set that spans the full spectrum of entrepreneurial, technical, product, and operational backgrounds.

Over the past decade, we’ve built a portfolio of more than 50 companies across three funds. By employing this approach, the entrepreneurs we’ve supported have achieved numerous breakout successes. This post outlines our “secret sauce,” and we will continue to leverage it.

As you can see, early-stage VC is more art than science. To do it well requires thoughtfulness, insight, and the ability to envision the future as a superpower. It’s challenging but incredibly rewarding. I wouldn’t trade it for anything.

P.S. This blog is licensed under a Creative Commons Attribution 4.0 International License. You are free to copy, redistribute, remix, transform, and build upon the material for any purpose, even commercially, as long as appropriate credit is given.

Winning the Home Run Derby with Proper Portfolio Construction

TLDR – 20 companies in a VC portfolio is the optimal balance between risk and reward, offering a very high chance of hitting outsized returns without significant risk of losing money. This is exactly the approach we follow at Two Small Fish Ventures, as we keep our per-fund portfolio size limited to roughly 20 companies.

In my previous post, VC is a Home Run Derby with Uncapped Runs, I illustrated mathematically why early-stage venture funds’ success doesn’t hinge on minimizing failures, nor does it come from hitting singles (e.g., the number of “3x” companies). These smaller so-called “wins” are just noise.

As I said:

“Venture funds live or die by one thing: the percentage of the portfolio that becomes breakout successes — those capable of generating returns of 10x, 100x, or even 1000x.”

To drive high expected returns for VCs, finding these breakout successes is key. However, expected value alone doesn’t tell the full story. We also need to consider variance. In simple terms, even if a fund’s expected return is 5x or 10x, it doesn’t necessarily mean it’s a good investment. If the variance is too high—meaning the fund has a low probability of achieving that return and a high probability of losing money—it would still be a poor bet.

For example, imagine an investment opportunity that has a 10% chance of returning 100x and a 90% chance of losing everything. Its expected return is 10x (i.e., 10% x 100x + 90% x 0x = 10x). But despite the attractive expected return, it’s still a terrible investment due to the extremely high risk of total loss.

That said, there’s a time-tested solution to turn this kind of high-risk investment into a great one: diversification. While everyone understands the importance of diversification, the real key lies in how it’s done. By building a properly diversified portfolio, we can reduce variance while maintaining a high expected return. This post will illustrate mathematically how the right portfolio construction allows venture funds to generate outsized returns while ensuring a high probability of success.

Moonshot Capital vs. PlayItSafe Capital: A Quick Recap

Let’s start by revisiting our two hypothetical venture capital firms: Moonshot Capital and PlayItSafe Capital. Moonshot Capital swings for the fences, aiming to find the next 100x company while expecting most of the portfolio to fail. PlayItSafe Capital, on the other hand, protects downside risk (at least that’s what they think), but by avoiding bigger risks, it sacrifices the chance of finding outsized returns.

• Moonshot Capital: Out of 20 companies, 17 resulted in strikeouts (0x returns), 3 companies achieved 10x returns, and 1 company achieved a 100x return.

• PlayItSafe Capital: Out of 20 companies, 7 resulted in strikeouts (0x returns), 7 companies broke even (1x), 5 companies achieved 3x returns, and 1 company achieved a 10x return.

Here’s how their expected returns compare:

• Moonshot Capital has an expected return of 6.5x, thanks to one company yielding 100x and three companies yielding 10x (i.e. (1 x 100 + 3 x 10 +16 x 0) x $1 = $130).

• PlayItSafe Capital has a much lower expected return of 1.6x, with its highest return from one 10x company, five 3x returns, and several breakeven companies (i.e. (1 x 10 + 5 x 3 + 7 x 1 + 7 x 0) x $1 = $32).

Despite these differences in expected returns, what’s surprising is that counterintuitively, the probability of losing money (i.e., achieving an average return of less than 1x at the fund level) is quite similar for both firms.

Let’s dive into the math to see how we calculate these probabilities:

Moonshot Capital: 12.9% Probability of Losing Money

1. Expected Return :

2. Variance :

3. Standard Deviation :

4. Standard Error :

Using a normal approximation, the z-score to calculate P(X < 1) is:

Looking this up in the standard normal distribution table gives us:

P(X < 1) = 0.129 or 12.9%

PlayItSafe Capital: 11.6% Probability of Losing Money

Similarly, looking this up in the standard normal distribution table gives us (sparing you all the equations):

P(X < 1) = 0.116 or 11.6%

Shockingly, these two firms’ probabilities of losing money are essentially the same. The math does not lie!

Here’s a graphical representation of the outcomes (probability density) for Moonshot Capital and PlayItSafe Capital.

Probability Density Graphs: Comparing Moonshot and PlayItSafe

As you can see, Moonshot has higher upside potential, as the density peaks at 6x, while PlayItSafe is more concentrated around lower returns. Since their downside risks are more or less the same while PlayItSafe’s approach significantly limits its upside, counterintuitively PlayItSafe is far riskier from the risk-reward perspective.

Proper Portfolio Construction: How Portfolio Size Affects Returns

To further optimize Moonshot’s strategy, we will explore how different portfolio sizes affect the balance between risk and reward. Below, I’ve analyzed the outcomes (i.e. portfolio size sensitivity) for Moonshot Capital across portfolio sizes of n = 5, n = 10, n = 20, and n = 30.

The graph below shows the probability density curves for Moonshot Capital with varying portfolio sizes:

As you can see, smaller portfolios (n = 5, n = 10) exhibit higher variance, with a greater spread of potential outcomes. Larger portfolios (n = 20, n = 30) reduce the variance but also diminish the likelihood of hitting outsized returns.

Why 20 is the Optimal Portfolio Size

1. Why 20 is Optimal:

At n = 20, Moonshot Capital strikes an ideal balance. The risk of losing money, i.e. P (X < 1), remains manageable at 12.9%, while the probability of outsized returns remains high: 62.1% chance of hitting a return higher than 5x. This suggests that Moonshot’s high-risk, high-reward approach pays off without exposing the fund to unnecessary risk.

2. Why Bigger Isn’t Always Better (n = 30):

When the portfolio size increases to n = 30, we see a significant drop-off in the likelihood of outsized returns. The probability of achieving a return higher than 5x drops significantly from 62.1% at n = 20 to 41.9% at n = 30, and counterintuitively, the risk of losing money starts to increase. This suggests that larger portfolios can dilute the impact of the big wins that drive fund returns. It also mathematically explains why “spray-and-pray” does not work for early-stage investments.

3. The Pitfalls of Small Portfolios (n = 5 and n = 10):

At smaller portfolio sizes, such as n = 5 or n = 10, the variance increases significantly, making the portfolio’s returns more unpredictable. For example, at n = 5, the probability of losing money is significantly higher, and the risk of extreme outcomes becomes more pronounced. At n = 10, the flat-curve suggests that the variance is very high. This high variance means the returns are volatile and difficult to predict, increasing risk.

Conclusion: How to Win the Home Run Derby With Uncapped Runs

The key takeaway here is that Moonshot Capital’s strategy of swinging for the fences doesn’t mean taking on excessive risk. With 20 companies in the portfolio, Moonshot is the optimal between risk and reward, offering a very high chance of hitting outsized returns without significant risk of losing money.

While n=20 is optimal, n=10 is also pretty good, but n=30 is significantly worse. So, a ‘concentrated’ approach – but not ‘n=5 concentrated’ – is far better than ‘spray and pray,’ if you have to pick between the two.

This is exactly the approach we follow at Two Small Fish Ventures. We don’t write a cheque unless we have that magical “100x conviction.” We also keep our per-fund portfolio size limited to roughly 20 companies. This blog post mathematically breaks down one of our many secret sauces for our success.

Don’t tell anyone.

P.S. This blog is licensed under a Creative Commons Attribution 4.0 International License. You are free to copy, redistribute, remix, transform, and build upon the material for any purpose, even commercially, as long as appropriate credit is given.

VC is a Home Run Derby with Uncapped Runs

There’s an old saying that goes, “Know the rules of the game, and you’ll play better than anyone else.” Let’s take baseball as our example. Aiming for a home run often means accepting a higher number of strikeouts. Consider the legendary Babe Ruth: he was a leader in both home runs and strikeouts, a testament to the high-risk, high-reward strategy of swinging for the fences.

Yet, aiming solely for home runs isn’t always the best approach. After all, the game’s objective is to score the most runs, not just to hit the most home runs. Scoring involves hitting the ball, running the bases, and safely returning to home base. Sometimes, it’s more strategic to aim for a base hit, like a single, which offers a much higher chance of advancing runners on base and scoring.

The dynamics change entirely in a home run derby contest, where players have five minutes to hit as many home runs as possible. Here, only home runs count, so players focus on hitting just hard enough to clear the fence, rendering singles pointless.

Imagine if the derby rules also rewarded the home run’s distance, adding extra runs for every foot the ball travels beyond the fence. For context, the centre field is typically about 400 feet from home plate. So, a 420-foot home run, clearing the centre field by 20 feet, would count as a 20-run homer. This rule would drastically alter players’ strategies. Not only would they swing for the fences with every at-bat, but they would also hit as hard as possible, aiming for the longest possible home runs to maximize their scores, even if it reduced their overall chances of hitting a home run.

This scenario mirrors early-stage venture capital, where I liken it to a home run derby with uncapped runs. The potential upside of investments is enormous, offering returns of 100x, 1000x, or more, while the downside is limited to the initial investment. Unlike in a derby, where physical limits cap the maximum score, the VC world is truly without bounds, with numerous instances of investments yielding thousandfold returns.

This distinct dynamic makes assessing VCs fundamentally different from evaluating other asset classes, where protecting the downside is crucial. In the VC realm, the potential for nearly limitless returns makes losses inconsequential, provided VCs invest in early-stage companies with the potential for exponential growth. The risk-reward equation in venture capital is thus highly asymmetrical, favouring bold bets on moonshot startups.

For illustration, let’s consider two hypothetical venture capital firms: Moonshot Capital and PlayItSafe Capital.

Moonshot Capital approaches the game like a home run derby with uncapped runs. They aim for approximately 20 companies in their portfolio, expecting that around 20% will be their home runs—or “value drivers”—capable of generating returns from 10x to 100x or more. 

Imagine they invest $1 in each of 20 companies. One yields a 100x return, three bring in 10x, and the remaining are strikeouts. The outcome would be:

(1 x 100 + 3 x 10 +16 x 0) x $1 = $130

Their $20 investment becomes $130 (or 6.5x), a gain of $110, despite 17 out of 20 companies being strikeouts. Yes, you are correct. 85% of the portfolio companies failed!

PlayItSafe Capital, on the other hand, prioritizes downside protection, ensuring none of the portfolio fails but also avoiding riskier bets. In the end, one company generates one “10x” return, five companies return 3x, and the remainder is equally split between breakeven and failing.

(1 x 10 + 5 x 3 + 7 x 1 + 7 x 0) x $1 = $32

Despite several “successes” and very few “losses,” the fund’s return of $12 pales in comparison to Moonshot Capital’s. Even increasing the number of companies generating a 3x return to 10 with no loss (which is almost impossible to achieve for early-stage VCs) only yields a $29 gain from a total investment of $20:

(1 x 10 + 10 x 3 + 9 x 1) x $1 = $49

No one should invest in the early-stage VC asset class with the expectation of such a paltry return.

As illustrated, success isn’t about minimizing failures, nor is it about the number of “3x” companies or even the number of “unicorn logos” in the portfolio, as how early when the investment was made to these unicorns is crucial as well. One needs to invest in a unicorn when it was a baby-unicorn, not after it became a unicorn.

In summary:

Venture funds live or die by one thing: the percentage of the portfolio that becomes “value drivers”, i.e. those capable of generating returns of 10x, 100x, or even 1000x.

At Two Small Fish Ventures, we are the IRL version of Moonshot Capital. Every investment is made with the belief that $1 could turn into $100. We know that, in the end, only about 20% of our portfolio will become significant value drivers. Yet, with each investment, we truly believe these early-stage companies have the potential to become world-class giants and category creators when we invest. 

This is what venture capital is all about: not only is it exhilarating to be at the forefront of technology, but it’s also a great way to generate wealth and, more importantly, play a role in supporting moonshots that have a chance to change how the world operates.

P.S. This is Part 1 of this series. You can read Part 2, “Winning the Home Run Derby with Proper Portfolio Construction” here.

This blog is licensed under a Creative Commons Attribution 4.0 International License. You are free to copy, redistribute, remix, transform, and build upon the material for any purpose, even commercially, as long as appropriate credit is given.