# Portfolio Construction How to model portfolio construction in the venture fund models ## 10 minutes on modeling a venture fund portfolio [10 minutes on modeling a venture fund portfolio](https://www.youtube.com/watch?v=JUr6xa7-a4I) Portfolio construction is the process of setting check sizes, follow-on reserves, and assumptions about valuations, ownership, and dilution over time that defines a fund's investment strategy and shapes their expectation of returns. At its core, portfolio construction involves a set of choices given a fund's total capital available to invest: - Does the check size strategy allow the fund to get enough ownership to drive a return for the fund's investment? - Given the expectation on failure rates, does the check size strategy and reserve strategy lead to a diversified or concentrated portfolio? - Should the fund reserve capital for follow-ons? Reserving for follow-ons reduces the number of initial investments but can lead to concentrating capital into (hopefully) winners. - Should you invest the same check size across investments, or vary the check sizes by conviction? - What do you need to get access to the best deals — and does that match your check size? The result should give you enough shots to hit a winner. Invest in enough companies (30-100) to catch the [power law](https://reactionwheel.net/2015/06/power-laws-in-venture.html) of venture returns. Top funds win on (1) volume of large exits and (2) size of the largest exits. Concentrated portfolios risk getting enough opportunities to invest in a large exit; diversified portfolios increase the odds of getting a large exit, but too much diversification leads to too small investments to get a fund-returner. ### Fund size, check size, and investments Fund strategies often don't align with the math of deployable capital. Common failures: - A $10mm fund (deployable $8mm) writing $1mm first checks — too few investments. - A $20mm fund reserving 70% for follow-ons — struggles to deploy reserves into meaningful proratas. Follow-on budgeting depends on (a) projected cap tables for portfolio companies (drives your [prorata strategy](https://www.hemrock.com/docs/proratas/)) and (b) graduation rates (drives how many follow-ons you can do across stages). **Misalignment between strategy and math is the most common portfolio-construction problem.** In the end, about 50% of startups will get from seed to series A. Pace matters a lot, but the eventual final graduation rate always seems to end up around 50%. ### Check size and fund strategy Your check size dictates your fund strategy | [Charles Hudson (Precursor Ventures)](https://www.youtube.com/watch?v=xr5hPLujCCA) Charles Hudson: ["your check size dictates your investment strategy"](https://www.youtube.com/watch?v=xr5hPLujCCA). A $50k fund will struggle to get into Series B. A $250k lead-investor strategy will struggle to win deals. A $1.5mm early-stage fund needs the team, process, and experience to lead. Check size and strategy need to match. ### Check size and target ownership Eniac's [Seed Fund Portfolio Construction for Dummies](https://www.eniac.vc/writings/seed-fund-portfolio-construction-for-dummies): > The classic mistake here is new managers pick an amount like 250K or 750K when they should be pegging initial checks to a target ownership. At the end of the day, the percentage you own of a portfolio company when it exits is what's important, not the amount you put in. ... Part of the rationale for [our target](https://www.eniac.vc/writings/seed-fund-portfolio-construction-for-dummies) ownership range [of 10-15%] is that if we maintain ownership in the 10% range when the company is worth $1B, an exit at that time can return the whole fund. ## How to model portfolio construction Portfolio construction drives capital deployment and exit proceeds, both timing and amount. Hemrock's [venture capital models](https://www.hemrock.com/investors) span simple to detailed: - [Fund Economics Tool](https://www.hemrock.com/venture-fund-model-overall/) — simplest. Fund-level performance, no per-period cash flows, average gross multiple on invested capital. - [Venture Capital Model, Quarterly Forecast](https://www.hemrock.com/venture-fund-model-quarterly/) — detailed initial and follow-on strategy per exit outcome, with up to three portfolio scenarios. - [Venture Capital Model](https://www.hemrock.com/venture-fund-model/) — quarterly, with graduation rates, follow-ons, proratas, valuation increases, dilution, and per-stage exit proceeds. Detailed expected-value math per stage. The method used to create a portfolio construction varies between the models, and is detailed at [Entering your investment strategy](https://www.hemrock.com/docs/investment-strategy) ## More detail isn't always better The right level of detail depends on your situation. Building your first model for first-LP conversations on Fund I? A complicated forecast of a 4x gross isn't what LPs care about at that stage. Deeper in the process, or raising Fund II or III, detail becomes more valuable — and you're better positioned to build and defend it. ## Scenarios capture variability Returns in venture are highly variable. Scenarios and range-based inputs are valuable. Use discrete scenarios (best/worst/medium) or range-based simulation with probability distributions.