August 15, 2017

Venture capital economics with public market liquidity

by Tushar Jain

Traditional venture capital firms typically invest in the equity of young, fast-growing, technology startups. Each individual investment is risky: 75% of venture-backed companies fail to return invested capital to their investors. Venture capitalists rely on the fact that the winning investments will return enough to cover the losses from the losing investments and more.

A venture fund might make 20 investments. 15 of them will probably return nothing. 3 or 4 may return 5-10x. And 1 or 2 may return 20-30x. This hypothetical fund will return 2-4x despite the fact that 75% of investments returned 0x.

This strategy of portfolio composition is known as “venture capital economics”. Big returns on a few investments in the portfolio drive the returns for the whole portfolio.

Traditional venture funds’ investments are illiquid. Once a venture investment is made, the fund will not realize a return until the company sells or IPOs. Because of this, limited partners, who commit capital to venture funds, have to commit for 7-13 years. Only select few investors can afford to think on that time-scale.

A venture fund cannot change its mind about an investment once it’s been made due to the same illiquidity constraints. There is no way for a venture fund to liquidate or reduce their investment even if presented with new information.

Typically venture funds won’t invest in direct competitors to a portfolio company to avoid conflicts of interest (this decouples at the latest stages of private investment, but typically not series A/B/C). This means that venture firms will invest in only one company within a competitive space, even if the space is big enough for multiple successful companies. Venture investors must choose either Uber or Lyft. Facebook or Linkedin. Pandora or Spotify. Postmates or Doordash. This is risky in that it doesn’t accommodate diversification as a way of hedging risk.

Generally speaking, Multicoin Capital gets the best of both worlds: venture capital economics but with public market liquidity. We experience venture capital economics as we invest in promising protocols while they are young and aim for outsized returns on every investment. But most of the assets Multicoin Capital invests in are liquid. This means that we reserve the ability to change our minds about a given investment.

If we thought an investment could be 10x, and we discover while we’re up 2x that upside is capped at 2.5x, we can take our profits and move on. On the other hand, if an investment is down 50%, we can sell and get half our invested capital back. Many venture funds attempt to do this by salvaging the companies, but this is usually a laborious process. When we choose to cut our losses, we can do so overnight with minimal headache.

Most importantly, Multicoin Capital can invest in competing protocols rather than having to pick a single winner in a competitive space. This significantly lowers risk for investors. It is generally easier to spot trends than it is to pick specific winners. For example, there are many smart contract platforms today: Ethereum, NEO, Stratis, Lisk, Aeternity, Tezos, EOS, and more. Although Ethereum is the market leader today, there are strong cases to be made that smart contract platforms will not be winner-take-all platforms or that Ethereum could be unseated by a competitor. So there is real opportunity in investing in smaller platforms at 1/100th the price of Ethereum’s $30B network value.

Historically, investing in technology trends meant investing in illiquid assets. This creates risk because capital is locked up as the technology evolves and the market changes. Cryptoassets offer a unique and novel investment profile, one that combines venture-style upside potential, but with lower risk and shorter commitment due to asset liquidity. Or in other words, venture capital economics with public market liquidity.

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