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RFS Advance Access originally published online on March 27, 2009
Review of Financial Studies 2009 22(11):4643-4680; doi:10.1093/rfs/hhp012
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© The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org.

Size and Focus of a Venture Capitalist's Portfolio

Paolo Fulghieri and Merih Sevilir
University of North Carolina

Send correspondence to Paolo Fulghieri, Kenan Flagler Business School, University of North Carolina, Chapel Hill, NC 27599; telephone: 919-962-3202. E-mail: paolo_fulghieri{at}unc.edu.

JEL Classification: G24


  Abstract

We take a portfolio approach to analyze the investment strategy of a venture capitalist (VC) and show that portfolio size and scope affect both the entrepreneurs' and the VC's incentives to exert effort. A small portfolio improves entrepreneurial incentives because it allows the VC to concentrate the limited human capital on a smaller number of startups, adding more value. A large and focused portfolio is beneficial because it allows the VC to reallocate the limited resources and human capital in the case of startup failure and allows the VC to extract greater rents from the entrepreneurs. We show that the VC finds it optimal to limit portfolio size when startups have higher payoff potential—that is, when providing strong entrepreneurial incentives is most valuable. The VC expands portfolio size only when startup fundamentals are more moderate and when he can form a sufficiently focused portfolio. Finally, we show that the VC may find it optimal to engage in portfolio management by divesting some of the startups early since this strategy allows him to extract a greater surplus.

We thank an anonymous referee, Robert McDonald (the editor), Michael Fishman, Eitan Goldman, Josh Lerner, seminar and conference participants at the American University, Georgetown University, University of Amsterdam, University of North Carolina, Darden School of Business at the University of Virginia, the FRA Conference in Las Vegas, the RICAFE Conference in Turin, and the second FIRS Conference in Shanghai for very useful comments. All errors are our own.


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