Investing Frameworks
How to allocate capital in the Venture Capital model
Introduction
Lithium’s core value proposition is enabling our community to invest in early-stage crypto projects. Traditionally, this has been reserved for institutions who have, for years — milked returns not from sensible and prudent investments, but rather getting in at the ground floor before other, later investors enter at a higher valuation. This is the classic Venture Capital model which hasn’t been updated since 1946 when J.H. Whitney & Co launched their vehicle to finance entrepreneurs who were cut off from traditional funding markets.
The approach still fills the same void. In essence, venture funding exists to provide short-term capital to facilitate innovation. These funds are almost always the first money through the door, which means the risk-reward metrics are vastly different when compared to backing more established companies who already have a product-market fit or real revenue.
The Statistics
In 2021, $612 billion was invested industry-wide, representing a massive 108% increase from the prior year. This hot money provided by LPs is constantly chasing the next unicorn, and a steady stream of cheap equity has enabled the massive growth of the industry.
What’s interesting about the VC market is its success rates. There are several studies focused on defining failure rates across venture-funded startups, with Harvard Business School estimating that up to 75% of start-ups fail within the first 18 months. The general ‘working assumption’ of a professional manager within a venture fund is for every 10 investments a fund makes, the rough expected return may look akin to:
- 4 will fail completely and the value goes to zero
- 3–4 will break even or experience down rounds
- 1–2 will be massive successes and generate almost all the fund's total performance
Picking winners is hard. The numbers are vastly skewed against you, and even the best-looking start-ups can fail for a plethora of reasons. Because our model is to democratize venture investing — opening the dark art up to a wider community, this article is to challenge your thinking and understand how different approaches may lead to personal success or failure in early-stage allocation.
Investment Approaches
Everyone has a slightly different approach and widely different investment appetites. What works for one person may work against another, however, what seems to be constant is the prevalence of a couple of approaches the majority (those in the middle of the bell curve) seem to take.
- Pick and choose
The first camp is picking and choosing which projects to invest in based on personal preferences, tokenomics, vesting schedules, team etc. They only look to invest in 2 or 3 projects they feel are best placed to succeed, ignoring the others and allocating large amounts of capital to these select projects.
The benefit of this method is that IF you can pick a winner and have a large position — you’ll make many multiples of your investment, however as we now know the statistics behind the VC model of investing, there has to be a large element of luck when looking for the 2/10 startup that takes off immediately. Within the context of the aforementioned, the downside becomes more apparent — statistically, you’re unlikely to hit a real winner without access to non-public information.
2. A portfolio approach
The second camp — one that I personally fit into, is more of a portfolio approach. Rather than picking a few projects, this cohort leans on equal weighting allocations and investing in each. It takes a certain acceptance of the statistics to allow this to play out, and a willingness to accept drawdowns.
The chances of hitting 1 or 2 large winners increases significantly at the expense of some upside if you were lucky enough to buy only the most successful projects. The actual execution of this strategy requires a solid process and conviction in the approach as it demands you invest in each and every IDO with smaller size, for example.
A thought experiment
Imagine a small, closed ‘economy’, where you as an investor have a bankroll of $1,000 to allocate into 10 different IDOs on a launchpad. There are no other variables, and clearly, you have no idea which projects will be successful. How would you choose to allocate this capital across opportunities with imperfect information?
I would personally look to put $100 in each of the projects and commit to the long run — accepting the reality that picking winners is hard, and letting the probabilities play out over a time horizon. An understanding of expected returns is crucial to building a strategy, and I consider a consistent approach to be the most likely way to generate success.
