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Early Stage Return Probabilities Are Inverting

 The idea of power laws dominates the venture capital narrative. The best investors are not optimizing for batting average, but rather slugging percentage. They want home runs, even grand slams if possible, regardless if they continuously strike out over and over again on their other investments. In fact, many people would argue that the natural trade-off to hitting a lot of home runs is that you have to strike out often too.


AngelList, the venture capital software platform, wrote a great blog post two years ago that outlined the math behind power laws.


Abe Othman wrote:

“Using AngelList’s curated data we show that the returns of early-stage investments follow a fairly extreme power law distribution, with enormous positive outliers skewing portfolio performance. The prominence of these huge winners suggests that an indexing strategy of investing in the entire early-stage venture universe will outperform roughly three-quarters of early-stage venture capital funds.”


The blog post then went on to construct hypothetical portfolios and compare the returns across each scenario. Here is a visual and description:

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“The black vertical line represents the market return, which is what you would get from writing an equal-sized check into all of the potential AngelList investments. All of the probability density to the left of that vertical line represent hypothetical portfolios that underperformed the market return. The most frequently observed outcome from a 10-investment portfolio, the peak of the curve, is slightly positive performance, well under the market return. This is a consequence of the power-law returns of venture capital: the typical manager fails to pick any outsize winners in their 10 chances, whereas the market portfolio is assured of selecting all of the return-driving winners.


On the other hand, all of the probability density to the right of that line represents hypothetical portfolios that outperformed the market. It is important to note that the tail of return multipliers does not stop at the 5x shown on the plot but instead keeps going. Our experiments indicate that portfolios also showed a heavy right tail, just like their underlying investments. We found that the best simulated 10-investment portfolio from 50,000 random draws generally has around a 19x multiplier, far off the chart.”


So the traditional venture capital market is driven by power laws, which naturally leads to lots of strike outs if you want home runs. In a normal portfolio, an early stage investor may expect 50% or more of their investments to ultimately be worth $0.


These distributions in normal portfolios may follow a generalized belief like this:

  • 50% of investments are worth $0
  • 25% of investments are worth 1x (get money back)
  • 15% of investments are 2-4x
  • 9% of investments are 4x-10x
  • 1% of investments are 10x or more


Each portfolio is different, but these numbers generally line up with investor expectations from the investors that I talk to regularly. But why exactly am I pointing this out?

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The early stage crypto market is very different than the traditional early stage venture capital market. One key structural difference is that the average time to liquidity for a venture capital equity deal is about 7 years, but the average time to liquidity for a venture capital token deal is under 18 months. That shorter path to liquidity means the world of difference in a high attrition market like startups.

So how does this play out in investor portfolios?


Well….the distribution of outcomes is basically inverse for token investors. It looks something like this:

  • 1% of investments are worth $0
  • 9% of investments are worth 1x (get money back)
  • 15% of investments are 2-4x
  • 25% of investments are 4-10x
  • 50% of investments are 10x or more


Think about this for a second. For early stage investors, they have gone from 50% chance of complete loss of capital in equity deals to approximately 1% chance of complete loss of capital in token deals. That significant decrease in risk is enough to bring billions of dollars into the new market, but it isn’t the only driver.

Given that early stage investing in a power law game, these early investors are used to hitting 10x or more very rarely (about 1% of the time on average). But with token deals, 50% or more of the time they are seeing 10x or more on their investments if they focus on the early stage.


I’m not here to judge whether the difference in returns is sustainable or good for the market. The obvious difference in risk and probability of return is enough to highlight why billions of dollars are flowing into the early stage crypto markets. Add in the fact that there is more democratized access, greater levels of transparency, and it is easier to build an index of opportunities.


Anyone who is applying the legacy understanding of early stage equity investing to this new world is missing one of the most important changes — the likelihood of success, and the subsequent increase in probability of outsized returns, skews the risk-reward for every investor to the point where they have a hard time ignoring the opportunity.

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Now with that said, majority of these new investment opportunities have a hard time outlasting the industry benchmark (Bitcoin) over 3 or 5 year periods. So that tells us that most of the asymmetry is captured in the earliest, illiquid investment stages. The investors that are buying majority of these opportunities in the liquid market, and missed the first or second round of investment funding, have had a really tough time keeping pace with the benchmark that continues to grow at 150% compound annual growth rate for more than a decade.


Investing is a difficult game. Understanding where asymmetry lies is important. But also understanding the trade-offs and risks are key too. The average person is going to struggle to get access to the best early stage deals, both in the legacy equity and new token world. The best investors in the world are going to use their capital base, access, and risk tolerance to continue seeking out the ultimate asymmetry.


Stay educated my friends. Know the various opportunities in the market. Optimize for the thing that you have an unique edge. Sometimes that edge can simply be having a longer time horizon than your peers. Hope you have a great start to your day. Talk to you tomorrow.

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