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Even If You're "Good", Diversification Matters

May 15, 2012

I privately received a couple of interesting comments on my diversification post:

One of RSCM's angel advisors wrote, "I would think most smart people get it intellectually, but many are stuck in the mindset that they have a particular talent to pick winners."

One of my Facebook friends commented, "VC seems to be a game of getting a reputation as a professional die thrower."

I pretty much agree with both of these statements. However, even if you believe someone has mad skillz at die-rolling, you may still be better off backing an unskilled roller. Diversification is that powerful! To illustrate, consider another question:

Suppose I offered you a choice between the following two options:

(a) You give me $1M today and I give you somewhere between $3M and $3.67M with 99.99% certainty in 4 years.

(b) You give me $1M today and a "professional" rolls a standard six-sided die.  If it comes up a 6, I give you $20M in 4 years. Otherwise, you lose the $1M. But this guy is so good, he never rolls a 1 or 2.

The professional's chance of rolling a 6 is 25% because of his skill at avoiding 1s and 2s. So option (b) has an expected value of $5M. Option (a) only has an expected value of $3.33M. Therefore, the professional has a 50% edge. But he still has a 75% chance of losing all your money.I'm pretty sure that if half their wealth were on the line, even the richest players would chose (a).  Those of you who read the original post probably realize that option (a) is actually an unskilled roller making 10,000 rolls.  Therefore:

Diversifying across unskilled rolls can be more attractive than betting once on a skilled roller.

Of course, 1 roll versus 10,000 hardly seems fair.  I just wanted to establish the fact that diversification can be more attractive than skill in principle.  Now we can move on to understanding the tradeoff.To visualize diversification versus skill, I've prepared two graphs (using an enhanced version of my diversification spreadsheet).  Each graph presents three scenarios: (1) an unskilled roller with a standard 1 in 6 chance of rolling a 6, (2) a somewhat skilled roller who can avoid 1s so has a 1 in 5 chance of rolling a 6, and (3) our very skilled roller who can avoid 1s and 2s so has a 1 in 4 chance of rolling a 6.First, let's look at how the chance of at least getting your money back varies by the number of rolls and the skill of the roller:

The way to interpret this chart is to focus on one of the horizontal gray lines representing a particular probability of winning your money back and see how fast the three curves shift right.  So at the 0.9 "confidence level", the very skilled roller has to make 8 rolls, the somewhat skilled roller has to make 11, and the unskilled roller has to make 13.

From the perspective of getting your money back, being very skilled "saves" you about 5 rolls at the 0.9 confidence level. Furthermore, I'm quite confident that most people would strongly prefer a 97% chance of at least getting their money back with an unskilled roller making 20 rolls to the 44% chance of getting their money back with a very skilled roller making 2 rolls, even though their expected value is higher with the skilled roller.Now let's look at the chance of winning 2.5X your money:

The sawtooth pattern stems from the fact that each win provides a 20X quantum of payoff.  So as the number of rolls increases, it periodically reaches a threshold where you need one more win, which drops the probability down suddenly.Let's look at the 0.8 confidence level.  The somewhat skilled roller has a 2 to 5 roll advantage over the unskilled roller, depending on which sawtooth we pick.  The very skilled roller has a 3 roll advantage over the unskilled roller initially, then completely dominates after 12 rolls. Similarly, the very skilled roller has a 2 to 5 roll advantage over the somewhat skilled roller, dominating after about 30 rolls.

Even here, I think a lot of people would prefer the 76% chance of achieving a 2.5X return resulting from the unskilled roller making 30 rolls to the 58% chance resulting from the very skilled roller making 3 rolls.But how does this toy model generalize to startup investing? Here's my scorecard comparison:

  • Number of Investments. When Rob Wiltbank gathered the AIPP data set on angel investing, he reported that 121 angel investors made 1,038 investments. So the mean number of investments in an angel's portfolio was between 8 and 9. This sample is probably skewed high due to the fact that it was mostly from angels in groups, who tend to be more active (at least before the advent of tools like AngelList).  Therefore, looking at 1 to 30 trials seems about right.
  • "Win" Probability. When I analyzed the subset of AIPP investments that appeared to be seed-stage, capital-efficient technology companies (a sample I generated using the methodology described in this post), I found that the top 5% of outcomes accounted for 57% of the payout. That's substantially more skewed than a 1 in 6 chance of winning 20X.  My public analysis of simulated angel investment and an internal resampling analysis of AIPP investments bear this out. You want 100s of investments to achieve reasonable confidence levels. Therefore, our toy model probably underestimates the power of diversification in this context.
  • Degree of Skill. Now, you may think that there are so many inexperienced angels out there that someone could get a 50% edge. But remember that the angels who do well are the ones that will keep investing and angels who make lots of investments will be more organized. So there will be a selection effect towards experienced angels. Also, remember that we're talking about the seed stage where the uncertainty is the highest. I've written before about how it's unlikely one could have much skill here. If you don't believe me, just read chapters 21 and 22 of Kahneman's Thinking Fast and Slow. Seed stage investment is precisely the kind of environment where expert judgement does poorly. At best, I could believe a 20% edge, which corresponds to our somewhat skilled roller.

The conclusion I think you should draw is that even if you think you or someone you know has some skill in picking seed stage technology investments, you're probably still better at focusing on diversification first.  Then try to figure out how to scale up the application of skill.

And be warned, just because someone has a bunch of successful angel investments, don't be too sure he has the magic touch. According to the Center for Venture Research, there were 318,000 active angels in the US last year. If that many people rolled a die 10 times, you'd expect over 2,000 to achieve at least a 50% hit rate purely due to chance! And you can bet that those will be the people you hear about, not the 50,000 with a 0% hit rate, also purely due to chance.

Further Reading

Enjoyed this post? Here are a few more posts that you might find just as insightful and engaging.

For Investors

Tax-Free QSBS Gains: The Best Kept Secret in Venture Capital

For venture capital investors, Qualified Business Stock (QSBS) is one of the most lucrative tax benefits hiding in plain sight. It offers investors the chance to keep more of their returns by eliminating taxes on gains.

Despite being part of the U.S. Tax Code since 1993, QSBS was unused for decades—overshadowed by shifts in capital gains rates and overlooked by even seasoned investors. But today, thanks to key legislative changes, QSBS is making waves as a game-changer for venture funds, angel investors, and entrepreneurs alike.

In this post, we’ll explore the history and mechanics of QSBS, how it can transform your tax implications, and what you need to know to take advantage of it. If you’re investing in early-stage startups, this might just be the most important tax benefit you’re not fully using—yet.

QSBS first appeared in 1993, but was largely ignored

In 1993, Congress set out to incentivize investment into U.S. small businesses. As a result, Section 1202 of the IRS Tax Code was created as part of the Revenue Reconciliation Act of 1993. The goal was to give tax breaks to investors who purchased Qualified Small Business Stock (QSBS) and held it for more than five years. Initially, the tax break offered a blended tax rate of 14% on the first $10M of qualifying gains, or gains equal to 10 times the investor’s cost basis – whichever was higher. This was achieved by exempting 50% of the gains from taxes and taxing the remaining gains at a special rate of 28%.

At the time of Section 1202’s introduction, the maximum tax rate for long-term capital gains was 28%, making the effective 14% rate on QSBS gains highly attractive. However, very shortly afterwards, Congress reduced the maximum long-term capital gain tax rate to 20%, diminishing the relative impact of the QSBS benefit. By 2003, when the maximum long-term capital gains rate was further reduced to 15%, Section 1202 became virtually irrelevant. Saving 1% was not compelling enough to justify the extra complexity and tracking required.

The 2008 financial crisis sparked a QSBS revolution

The U.S. and global economies were plunged into a deep recession in late 2008 and 2009. In response, Congress incrementally expanded the QSBS tax break over the following years. Initially, these increases were temporary, lasting for short periods and sometimes applied retroactively. It wasn’t until 2015 that QSBS, as we know it today, became a permanent fixture of the U.S. Tax Code.

Key legislative changes included:

  1. The American Recovery and Reinvestment Act of 2009: This act temporarily increased the tax-free exclusion from 50% to 75% for stock acquired after February 17, 2009.
  2. The Small Business Jobs Act of 2010: It temporarily raised the tax-free exclusion to 100% for stock acquired after September 27, 2010, although only for a short period. This act also excluded QSBS gains from Alternative Minimum Tax (AMT) calculations.
  3. The American Taxpayer Relief Act of 2012: This act retroactively reinstated the 100% tax-free exclusion and extended it forward for stock acquired through January 1, 2014.
  4. The Protecting Americans from Tax Hikes (PATH) Act of 2015: This legislation permanently codified QSBS benefits, making qualifying gains 100% tax-free federally, exempt from AMT calculations, and free from the 3.8% Medicare tax. This was the true game-changer!
QSBS is now one of the best tax breaks in U.S. history

Today, QSBS stands out as one of the most impactful tax incentives in the history of the U.S. Tax Code. However, it wasn’t until the late 2010s and early 2020s that investors began to fully recognize the economic advantages of QSBS tax gains.

Here is the current tax treatment for qualifying QSBS gains:

  • Tax-Free Federally: Gains are entirely excluded from federal income taxes.
  • Exempt from Medicare Tax: The 3.8% Medicare tax does not apply.
  • No Alternative Minimum Tax (AMT) Impact: QSBS gains are excluded from AMT calculations.
  • State Tax Benefits: Gains are tax-free in 45 out of 50 states, with exceptions in Alabama, California, Mississippi, New Jersey, and Pennsylvania.

This combination of tax benefits makes QSBS an unparalleled opportunity for investors seeking to maximize their after-tax returns.

Holding Period Requirement

To be eligible for tax-free gains, Section 1202 requires that a taxpayer must hold QSBS stock for at least five years.

Limitations on QSBS gains

Section 1202 limits the amount of tax-free gain from any individual QSBS sale to the greater of $10M or 10 times the investor’s basis in the stock. Notably, this limitation applies on a per-company basis, not per taxpayer. As a result, an investor can claim up to $10M in tax-free gains for each eligible QSBS company they invest in, with no annual or lifetime cap on the total benefit.

What makes a company qualify for QSBS?

To qualify as a Qualified Small Business (QSB), a company must meet several criteria. While we won’t cover all the details here, the primary high-level requirements pertain to:

  • Corporate structure: The company must be a U.S. C-corporation.
  • Business activity: The company must actively conduct a “qualified trade or business.” (See definition below.)
  • Asset limitation: The company must have less than $50M in aggregate gross assets immediately after the funding round in which the stock is purchased, as well as at all times prior.

What is a “qualified trade or business”?
The IRS defines it by exclusion, specifying what does not qualify. The following types of businesses are excluded:

  • Businesses providing services in fields such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage, where the principal asset is the reputation or skill of one or more employees.
  • Banking, insurance, financing, leasing, investing, or similar businesses.
  • Farming businesses, including those involved in raising or harvesting trees.
  • Businesses engaged in the production or extraction of resources for which deductions under Section 613 or 613A apply.
  • Businesses operating hotels, motels, restaurants, or similar establishments.

Almost all other types of businesses qualify, meaning that the majority of U.S.-based tech startups structured as C-corporations (which is most of them) meet the criteria for Qualified Small Business status during the early years of their operations.

Can you get the QSBS tax break by investing in VC funds?

Yes. The QSBS tax benefit extends to partnerships or LLCs treated as passthrough entities for tax purposes. This means that investors in most early-stage VC funds are eligible for tax-free QSBS gains, provided the VC firm properly tracks these gains and reflects them as QSBS gains on the K-1 tax forms issued to investors each year.

In fact, a VC fund can generate well over $10M in QSBS gains from a single investment, and 100% of that gain can still pass through to its investors tax-free. This is because each individual investor in the fund has their own $10M QSBS limit per investment (as illustrated in Example 3 below).

QSBS tax benefit examples

Example 1:

An investor purchases QSBS in a qualifying company for $200k. After holding the stock for more than five years, they sell it for $5.4M, realizing a $4.4M gain. Under Section 1202 of the U.S. Tax Code, the entire $4.4M gain is tax-free federally. Additionally, the $4.4M gain is not subject to state tax in 45 of 50 states.

Example 2:

An investor purchases QSBS in a qualifying company for $1M. After holding the stock for more than five years, they sell the stock for $25M, realizing a $24M gain. In this instance, the investor exceeds the maximum $10M QSBS tax benefit. As a result, $10M of the gain is tax-free, while the remaining $14M gain is subject to long-term capital gains taxes.

Example 3:

An investor commits capital to a VC fund, which invests $1M in QSBS stock. More than five years later, the fund sells the stock for $30M, generating a $29M gain. How much of this $29M gain will investors receive tax-free? Surprisingly, it’s likely all $29M.

Here’s why: Each individual investor in the VC fund has their own $10M tax-free limit per investment. For example, if a single investor holds a 20% stake in the fund, the IRS treats them as having invested $200k in the company (20% of $1M) and as receiving $6M in liquidity (20% of $30M). This results in a $5.8M gain for that investor—well below the $10M cap—making the entire gain tax-free under QSBS.

But wait, there’s more: Investors can offset QSBS losses with Section 1244

Section 1244 is another lesser-known part of the U.S. Tax Code relevant to QSBS. It provides a unique benefit: If your investment is part of the first $1M invested in a QSBS company and the investment results in a loss, that loss can be deducted as an ordinary loss rather than a capital loss. In practical terms, this means the loss can offset ordinary income, providing a significant tax advantage.

Losses under Section 1244 are capped at $50,000 per year for individuals and $100,000 per year for married couples filing jointly.

Section 1244 has limited relevance in the traditional VC landscape since venture capital firms are rarely involved in the initial $1M invested in a company. Even Pre-Seed stage rounds typically exceed this threshold. However, individual angel investors and VC firms that focus on smaller funding rounds (such as ours) can benefit from this additional QSBS tax advantage.

How RSCM’s strategy benefits from QSBS

Although we didn’t initially design our strategy to take advantage of QSBS when we started our firm in 2012, it turns out that our focus aligns perfectly with the type of small funding rounds the government intended to incentivize. As a result, RSCM funds and investors have benefited greatly from the tax advantages provided under Sections 1202 and 1244 of the U.S. Tax Code. On average, we estimate that more than 80% of the gains from our funds will qualify as QSBS gains, and in some cases will exceed 90%. For example, over 90% of our Fund 1 distributions have been QSBS-eligible.  

When combined with the tax benefits from Section 1244 losses, the federal tax rate for most of our funds is expected to fall within the low-to-mid single digits.

QSBS: Encouraging innovation and benefitting investors

The U.S. government introduced the QSBS tax break to stimulate investment in U.S. startups and small businesses, recognizing the vital role these companies play in innovation, job creation and overall economic growth. By reducing the tax burden on successful investments, QSBS encourages more capital to flow into early-stage companies, helping to fuel entrepreneurship and economic progress.

Although it took years for QSBS to gain traction, it is now recognized within the small business and early-stage venture investment communities as a significant advantage. QSBS has come to fulfill its intended purpose, becoming a powerful tool for investors while supporting the broader goal of a dynamic and growing economy.
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This blog post is NOT professional tax advice

This blog exists to summarize the history and benefits of the QSBS tax breaks. It should NOT be construed as a complete or exhaustive overview, nor should it be considered tax advice. There are additional criteria not mentioned in this post that can disqualify a company and its investors from receiving QSBS tax benefits. Please consult a tax professional before making any personal investment decisions.

For Investors
For Founders

Report: How Are Pre-Seed and Seed VC Firms Investing in 2024?

The venture market bottomed out from historic highs last year. Total deal volume slumped roughly 50% from 2021’s peak, exit activity hit a ten-year low, and venture fund performance dropped across the industry. These rapid changes have created a new landscape for venture capital, and it’s affected how VCs are investing.

Right Side Capital surveyed 110 Pre-Seed and Seed VCs from February 2024 to May 2024 on their investment activity and strategies in 2023 and their plans for 2024, with a focus on Pre-Seed Rounds and Seed Rounds. VCs revealed that they are optimistic about the funding landscape in 2024 and that they have high expectations for revenue levels and growth rates from portfolio companies.

Below we share what we learned.

VCs Were Active in Pre-Seed Rounds in 2023

Surveyed VCs revealed that they were fairly active in Pre-Seed investment last year. Of the VCs surveyed, 87.0% made at least one investment in round sizes of $1M to $2.5M, and 35.2% made more than five investments at this stage.

Seed Round Deal Volume Was Less Than Pre-Seed Round Deal Volume in 2023

VCs reported less deal volume in Seed Rounds in 2023 as compared to Pre-Seed Rounds during the same period. Only 12.1% of surveyed VCs made more than five investments at this stage, and 25.9% made no investments at all. The majority (62.0%) made between one and four investments at this stage.

Investment Outlook Is Optimistic in 2024

Nearly half (45.4%) of respondents plan to make five to nine new investments in 2024, which is a significant increase from 2023, and 24.1% said they planned to make 10 or more investments this year. All respondents planned to make at least one investment, which indicates a more positive outlook from 2023.

Pre-Seed Fundraising: What VCs Expect from Founders in 2024

At the Pre-Seed fundraising stage, only 46.3% of surveyed VCs will invest in a pre-revenue startup, 27.4% will invest in a startup with sub-$150K annual recurring revenue (ARR), and 14.7% require $150K – $499K in ARR. For some surveyed VCs, revenue expectations can be even higher: 11.7% said they required startups to have $500K or more in ARR.

Growth expectations are high for Pre-Seed Rounds, with 34.8% of surveyed VCs expecting startups to double year over year at this stage, and 37% expecting startups to triple year over year.

Seed Fundraising: What VCs Expect from Founders in 2024

Expectations vary a lot for startups raising their seed rounds. At this stage, 17% of surveyed VCs will invest at pre-revenue, but 24% want to see ARR of $1M or more. That’s a big change from four years ago, when $1M or more in ARR was the criteria for Series A funding.

Surveyed VCs expect aggressive growth at this stage, with 47% investing in startups that are doubling year over year and 34% investing in startups that are tripling year over year.

Most VCs Recommend 6-12 Months of Runway

The majority (53.7%) of surveyed VCs advise their portfolio companies to maintain six to twelve months of runway before raising their next round. Only 29.6% of VCs advise startups to have over 18 months of runway.

Capital Efficiency Is More Important Than Ever

VCs reported that, in this leaner landscape, they are placing a greater emphasis on capital efficiency for portfolio companies. For 81.5% of respondents, capital efficiency is more important than ever before. The survey included an option for respondents to indicate that capital efficiency was unimportant, but not a single respondent selected it.

Roughly One Third of VCs Have Changed Their Investment Thesis

We asked respondents to write in answers about how their firm’s investment thesis has changed in 2024. Below we break down the results of those write-in answers.

Summary of Investment Thesis Changes in 2024

No Change (58%) The majority respondents indicated that their investment thesis has not changed significantly from 2023.

More Focus on Specific Areas (15%) Some VCs have an increased focus on specific sectors such as health, cyber, AI, and cybersecurity. They’re putting a greater emphasis on software, particularly AI-powered applications, and avoiding certain sectors like consumer and hardware.

“Like everyone else, [we have] more interest in AI-powered applications.”

– Survey respondent

Adjustments in Investment Strategy (10%) Some VCs are shifting to smaller check sizes. They indicated more capital allocation for Pre-Seed and they are rightsizing investment amounts to achieve more significant ownership.

Greater Sensitivity to Valuations and Due Diligence (7%) VCs are more sensitive to valuations, ensuring companies have more runway, and conducting more thorough due diligence. They’re also focusing on financing risk, revenue, traction KPIs, and efficient use of capital.

“[We’re] thinking more about financing risk and making sure companies have more runway.”

– Survey respondent

Increased Sector Preferences and Deal Dynamics (5%) A small subset of VCs have a growing preference for companies with experienced founders, significant revenue, and efficient burn rates. They’re avoiding overinvested spaces like sales-enablement software and sectors that are seen as high risk for next-round funding.

“[We’re] rarely taking pre-product risk unless the team has prior operating experience.”

– Survey respondent

No Specific Answer or N/A (5%) Some responses were “N/A” or did not specify a change in investment thesis.

Final Conclusions from the RSCM 2024 VC Survey

The venture capital landscape in 2024 has adapted to a leaner and more cautious environment. Right Side Capital’s survey reveals a higher bar for revenue expectations and a greater emphasis on capital efficiency than in more bullish periods.

Despite the challenges of 2023, VCs are optimistic about 2024 and plan to increase new investment volume. Overall, VCs are adopting a resilient and forward-looking approach, emphasizing sustainability and capital efficiency to navigate the transformed economic landscape.

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