Diversification in Startup Investing: How Many Investments a Portfolio Needs

By common estimates, up to nine out of ten startups fail. Anyone who puts their money into a single young company is therefore staking everything on one bet. At a masterclass in November 2024, Companisto co-founder Tamo Zwinge and business angel Ingo Weber recommended holding at least ten investments; Weber thought 20 to 30 would be closer to what’s needed. The probability math supports this advice. Even broad diversification, however, does not protect against losses.

Ingo Weber’s first investment started with a question: Would he like to invest in a film? A single film struck him as too risky. It seemed smarter to take a stake in the production company, which made lots of films. Maybe, he reasoned, one of them would turn out to be good. “Long story short, in the end none of the films were any good,” Weber recalled. “So that can happen even when you diversify.”

Weber, who had been a business angel for about 15 years at the time, told the story at the Companisto masterclass. The episode shows where diversification reaches its limits: Even many films from the same company are, in the end, a bet on a single business. Weber’s motto, nonetheless, was “Diversification is king.”

Why diversification makes such a difference with startups

Put simply, diversification means not putting all your eggs in one basket, Zwinge explained at the start of his talk. For startup investors, that means spreading their capital across several companies, whether they invest through a crowdinvesting platform or as business angels. With high-risk investments, betting everything on a single startup is “usually not a particularly good strategy,” he said.

The key is an asymmetry between losses and gains. A failed investment costs the entire stake, while a successful one can return far more than 100 percent. A few hits can therefore make up for many failures. Very successful startups can even increase in value more than a hundredfold, Zwinge said. Such outliers are rare. What’s more, the value of an early stake usually rises less than the company’s value, because later funding rounds dilute the stake.

Professionals take advantage of this asymmetry. As a rule, venture capital firms invest in a very large number of startups, because even they, however carefully they choose, never know exactly which ones will succeed. “There’s no crystal ball,” Zwinge said. It’s always a matter of probabilities, he added. Venture capitalists count on a few hits generating most of the returns; in the VC industry, this is known as the power law.

Zwinge advised investors, as a rule, to base their own planning on the industry’s typical failure rate of up to 90 percent. Another reason to do so is that failure rates are snapshots: In a young portfolio, many failures haven’t surfaced yet.

The number of investments is what counts

Within a startup portfolio, Zwinge considered the number of investments the most important lever. With startups, he said, a great deal depends on the founders and their teams. Each additional investment puts another team with a new idea in the race and spreads the risk further. The full effect comes only when the amounts invested are of similar size: Anyone who invests in 20 startups but puts half their money into one of them still depends mainly on that one company.

What the probability math shows

Zwinge illustrated the effect with a simple calculation. Suppose each startup has a 90 percent probability of failing, independently of the others. Then the probability that every single investment fails drops markedly with each additional investment:

Simplified model calculation with a 90 percent probability of failure per startup: 0.9 to the power of n, where n is the number of investments; figures are rounded. The model assumes that every startup fails with the same probability and independently of the others.

In practice, a recession or a funding drought hits many young companies at the same time, and investments in the same sector are often exposed to the same developments. When such shared risks pile up in a portfolio, the result is concentration risk: The chance that all of the investments fail is then higher than the table suggests. And if at least one investment survives, that alone doesn’t mean the portfolio will end up in the black; that depends on how big the successes turn out to be.

What the 6-3-1 rule means

Weber pointed to the 6-3-1 rule, an industry rule of thumb (the numbers vary depending on the source): Out of ten startups, six go bust, three “break even,” and one “hopefully delivers the return.” With equal amounts invested, that means six stakes are lost, three merely return their money, and the one hit has to bring in more than seven times its stake for the portfolio to make any profit at all before costs and taxes. Since that usually takes years, a slim profit would still not be a good result.

Ten investments don’t guarantee such a hit: If, according to the rule of thumb, only one startup in ten is a hit, then under the table’s simplified assumptions a portfolio of ten investments has about a 35 percent chance of ending up without one. The rule of thumb describes an average across a very large number of startups, Weber said; it is based on studies by venture capital firms that together had probably invested in hundreds or, more likely, thousands of startups. To have any chance of a return at all, he said, you therefore “absolutely have to invest in at least ten, more like 20, 30 startups.”

Zwinge showed how much capital a portfolio of 40 investments ties up on Companisto, where investments usually start at €250: 40 times €250 comes to €10,000. That is “of course still a significant amount,” he acknowledged. “But in return, you get 40 shots at a home run.” Compare that with Weber’s own track record: In total, he said, he had invested in about 40 startups, two or three of which had paid off in the 15 years to date. His first ten investments had gone completely wrong. In other words, had he stopped after ten investments, he would not have had a single hit.

Other ways investors can diversify

Across asset classes

For most investors, even their first startup investment is a step toward diversification, Zwinge said, because they usually also own shares, ETFs, or real estate. He counted combining different asset classes among the most effective strategies for spreading risk. That assumes startups make up only a small part of an investor’s wealth; personal finance guides often cite a ceiling of 5 to 10 percent. By that measure, a €10,000 startup portfolio calls for total assets in the six figures.

By sector, stage, and region

Within the startup world, investors can diversify further: by sector (such as services, health care, or technology), by company stage, from the early stage to later growth rounds, and by region. Weber added a point that, in his view, should not be overlooked: home bias. Most investors, he said, prefer to invest close to home and therefore don’t diversify enough; with startups, too, you should ask yourself which countries and regions you want to invest in.

Over several years

Nobody has to build their portfolio all at once, Zwinge said; it can grow gradually. Investors who take that approach also spread their money over time. The venture capital industry, he said, goes through periods of high and lower valuations, as well as investment trends in which young companies in certain sectors raise especially large sums, most recently in artificial intelligence, for example, and before that around blockchain. Investing continuously means automatically buying in at different valuation levels, so entry prices tend to average out. Zwinge called this cost averaging, an effect many investors know from ETF savings plans.

The term isn’t a perfect fit: With a savings plan, you buy the same security over and over, whereas with startups, you invest in a different company each time. For private equity and venture capital funds, the industry term is vintage diversification, meaning spreading money across several vintage years. The main benefit of this approach is that not all of your startup capital gets invested during a single boom.

Four questions before your first investment

Weber opened his roadmap for startup investors with a line he attributed to the boxer Mike Tyson: “Before every fight you need a strategy, but it’s usually out the window the first time you get punched in the mouth.” Having a strategy still matters, he said. For Weber, these questions came first:

Why do I want to invest? Anyone whose main goal is to make as much money as possible may not be best served by startups, Weber conceded. There are probably asset classes with a better balance of risk and return, he said. Even so, in his view, putting part of your wealth into startups can make sense. What drives him personally is something else: He is an entrepreneur and likes being close to founders and their teams, where he can contribute ideas of his own and help through his network.

Do I have enough money? Anyone who invests in startups has to make sure they won’t need the money for a long time, Weber said. When friends tell him they’d like to invest in a startup sometime, he replies, “Yeah, don’t do that.” Investing in a single startup is a mistake, he said, and so is investing in two. If you can’t or don’t want to diversify that broadly, a VC fund may be the better alternative, in his view. Such funds, too, usually tie up money for many years, and they charge management fees and often performance fees.

What do I want to focus on? Weber said he deliberately invests early, putting in between €50,000 and €100,000. At an early stage, that still gets you a meaningful stake. But if you put €50,000 into a Series A or Series B round at a valuation of €20 million or €30 million, he said, you hold only a fraction of a percent (about 0.2 percent, if you do the math), can’t easily sell that stake, and have no say. In that case, a publicly listed company may be the better choice.

Investors who put smaller amounts into startups through Companisto also have hardly any influence over an individual startup. If the startup is a limited liability company (GmbH), they invest through a special purpose vehicle (SPV), receive profit participation certificates (Genussscheine), and do not become shareholders themselves. If it is a stock corporation (AG), they are shareholders, but their voting rights are exercised on a pooled basis. Business angels who invest larger amounts can become direct shareholders in a GmbH; their votes, too, are generally pooled.

Can the monkey do better? The question alludes to a much-quoted image from the American economist Burton Malkiel: A monkey throwing darts at the stock pages of a newspaper would pick a portfolio just as good as the experts’. Beating the market is simply very hard, Weber said; even large fund companies usually fail to do so. There is no index fund for young, unlisted companies, and anyone who sets out to pick the one winner can easily overestimate their own marksmanship. The closest you can get to an index is holding many investments of your own or a broadly diversified venture capital fund. Diversification doesn’t raise the average expected return, but it makes your own result less dependent on luck with individual companies. How good that average turns out to be depends on the quality of the startups you are choosing from.

Staying the course, even when it takes years

Weber put particular weight on one more point, a quality he said he often finds lacking in business angels: staying power. Many jump in full of enthusiasm, invest here and there, and the money is gone before they know it. Then they get frustrated and give up. Yet that is precisely when the learning curve kicks in, he said, and you get the chance to break into the right networks and gain access to the good deals. Anyone who decides to invest in startups should stick with it: “It’s a strategy. You shouldn’t keep changing it; you should see it through.” Staying the course doesn’t mean trying to recoup losses by putting in more and more new money, though. It’s best to decide in advance how much money in total should go into startups.

In the discussion that followed, one investor offered an example of how much patience may be needed. At the time, he had been investing for six years, mainly in medical technology startups. He had not lost any of his investments so far, he said, but had not made any money on them yet either. During the COVID-19 pandemic, he explained, clinical trials could not go ahead because hospitals were off-limits to visitors; on top of that came delays from the postponed EU Medical Device Regulation (MDR). As a result, two or three of his investments were four to five years behind their original schedule, he said. The case also shows what it means to concentrate on a single sector: The pandemic and the MDR slowed down several of his investments at once.

Whether a startup will ever be sold or go public is an open question; if it happens, it is often only after many years. The capital is generally tied up for that long, and until then investments usually cannot be sold, or only to a limited extent. Investors should plan for this time frame from the outset.

Lessons a business angel learned the hard way

Weber spoke openly about his own mistakes. When he started out, he said, he brought plenty of enthusiasm and money but had little idea what he was doing; he was too naive in his approach and not professional enough.

He said he focuses on fields he understands: topics on the agenda of chief financial officers, meaning accounting, financial controlling, and consulting. That is “exactly the opposite of diversification,” he admitted. Now and then, he also invests because a team and a product excite him. The failure rate of these forays into unfamiliar territory is considerably higher than for companies whose business he understands, he said. His advice: Get professional help with diversification, or leave it to the professionals altogether.

When investors should be on their guard

Weber has run into certain patterns at startups again and again:

• The flattering founder: A founder assures you that you are really the only investor they want. Instead of feeling like the discoverer of the next Microsoft, Weber advises, you should ask why no one else is investing: Maybe you are, in plain English, “the only fool still willing to give the company money.” Conversely, he said, it is often a sign of a startup’s quality when several investors come on board. That doesn’t replace your own due diligence, because investors, too, are prone to herd behavior.
• The grand vision: Most founders who talk up a grand vision, such as missions to the moon or Mars in the style of Elon Musk, turn out on closer inspection to have relatively little substance to offer and little chance of realizing it, Weber said.
• The solo founder: A single founder is always a risk, he said. Starting and running a company alone is also unsatisfying; if the founder drops out, the startup is left without leadership.
• The supposed break-even: Claims like “We’re break-even” or “We just need another €50,000 or €100,000 to break even” deserve close scrutiny, he said. Often the startup had covered its costs in just a single month, or the figures had not been properly accrued (meaning revenue and expenses had not been assigned to the right period).

In Weber’s experience, one thing holds true for every startup: “Revenue comes later and costs are higher.”

The bottom line

For startup investors, diversification is the most important tool for cushioning the high risk that individual companies will fail. The more investments a portfolio holds, the less likely it is that all of them fail, and the more likely it is to include hits that can offset the failures. The speakers recommended at least ten startups (Weber favored 20 to 30), spread across sectors, stages, regions, and several years. At the masterclass, Zwinge announced a feature that Companisto investors can now find in their dashboard: A “Diversification Level” widget rates their portfolio by the number of startups they have invested in through the platform and shows how many more investments they need to reach the next level. This helps investors keep an eye on what, in Zwinge’s words, matters most. The widget does not show how the amounts are spread across startups, sectors, and years, or how the individual startups are doing.

Weber’s film investment is a reminder of where the limits lie. Diversification works only to the extent that the investments don’t depend on the same factors, and even then it does not guarantee a profit. Startup investments remain risk capital: A total loss is possible, and it can be a long wait for a possible exit. Investors should therefore commit only money they can do without for the long term, and they should be patient.

Note: This article is based on the Companisto masterclass of November 6, 2024. The speakers’ statements reflect the situation at the time and their personal views; additional explanations and sample calculations were provided by the editorial team. The probabilities in the table are the result of a simplified model calculation. This text is intended as general information; it does not constitute legal, tax, or investment advice or an offer to acquire investments. Investing in startups involves considerable risks and can result in the total loss of the capital invested. The capital is generally tied up for many years, and investments usually cannot be sold early, or only to a limited extent.