Why invest in YC demo day
Backing 3+ YC startups per batch pays off big for YC demo day investors. Credit: My First Million Podcast.
Assumptions
1. Binary outcomes—each investment either becomes a success (unicorn) or does not.
2. Historically, each YC batch has an average 5.0% unicorn rate .
3. Average valuations at YC demo day are $20,000,000 post-money. This implies a 50.0x multiple needed to achieve $1B+ outcome.
Inputs
$
Objective: Optimize portfolio size and check amounts using the Kelly Criterion
Analysis using Kelly Criterion
Invest in approximately 32 companies (out of 100 total companies in the batch), with an average check size of ~$31,000.
Investment Scenarios
| Filtering Level | No. of Investments | Check Size |
|---|---|---|
| 0% | 32 | $31,000 |
| 25% | 21 | $48,000 |
| 50% | 12 | $83,000 |
| 75% | 5 | $200,000 |
| 90% | 2 | $500,000 |
Investment Allocation
Write ~32 checks of $31,000
Total deployment: $1,000,000
Explanation
The Unicorn Ratio is a framework for deciding how many companies to invest in a given YC batch. There are two different ways of thinking about this problem: the Kelly Criterion and Binomial Distribution.
Kelly Criterion
Where:
- = what fraction of your money to put into each investment
- = chance of success (goes up as you get better at picking companies)
- = how many times your money multiplies if you succeed (like 50x)
- = how many companies to invest in
Understanding the Kelly Criterion
- The Kelly Criterion helps determine the optimal fraction of your capital to invest in each opportunity, balancing potential returns against risk.
- When applied to startup investing, it suggests both how many companies to invest in (portfolio size) and how much to invest in each one (check size).
- The formula accounts for your ability to pick winners (through the 'p' term) and the potential return multiple (through the 'b' term).
Binomial Distribution
Where:
- = your chance of finding at least one unicorn
- = how many companies you invest in
- = chance that any single investment becomes a unicorn
Understanding the Probability Curve
- The "knee" represents the point where adding more investments starts giving you significantly less benefit.
- Before this point, each new investment significantly improves your chances of success.
- After this point, you need many more investments to achieve similar improvements in probability.
- Mathematically, this point is identified using the second derivative of the probability curve, which measures the rate at which returns are diminishing.
Limitations
- These calculations assume you have an accurate assessment of how good you are at picking companies (i.e. how much filtering you can do).
- Historical unicorn rate may not predict future outcomes.
- Sometimes you might want to invest different amounts in different companies. The price and dynamics of each deal is unique.
- Be aware of your conversion rate (# investments selected / # meetings booked). Reputation with founders is important.
- VC returns follow a power law distribution where non-unicorn outcomes (acquisitions, smaller exits) can still meaningfully impact portfolio returns.
Disclaimer:
The Unicorn Ratio is a framework that provides probabilistic estimates for portfolio construction. This should not be considered or used as investment advice.