1confirmation Partners: Three Counterintuitive Lessons in Crypto VC Investment

Written by: Richard Chen, Partner at 1confirmation

Compiled by: TechFlow

*Original title: *Three counterintuitive lessons from a crypto investoooor*

In my first article, I will outline three counterintuitive lessons I have learned as a cryptocurrency venture capitalist over the past few years. In the future, I will cover more hot topics in the articles, such as politics.

1: Building a portfolio is more important than picking the right assets

This lesson is the most counterintuitive, but from a data perspective, it is quite simple: If you only invest 0.5% of your capital in an asset that returns 100 times, you still won't break even. Since venture capital returns follow a power-law distribution, winners with 100x returns are rare, so whenever you encounter one, you must make that investment more valuable. Concentrated investment > prayer-like diversification.

A VC collecting a bunch of pretty logos on their fund's portfolio page does not mean their returns are actually impressive, but this highlights the importance of portfolio construction, which is why I find it puzzling that a fund of over $400 million is still writing seed round checks.

Some people believe that small initial investments are meant to get a "shot" at the opportunity and are prepared to double down on winners in subsequent rounds. But what actually happens is that larger funds will enter later with a stronger position and capture almost all the shares (i.e., the later you invest, the more zero-sum the opportunity becomes). Moreover, if you are not a major investor in the seed round, you are unlikely to get your proportional share, and ownership will be significantly diluted (I have seen an example of 90% dilution).

If you take this lesson to its logical extreme (i.e., picking the right company doesn't matter at all), then the optimal portfolio structure is to dollar-cost average 100% of your dollars into ETH ------ this is what is known as Beta investing.

But to be honest, an unspoken secret in cryptocurrency venture capital is that at the beginning of the last cycle, most funds did not perform better than DCA (Dollar Cost Averaging) in ETH.

Assuming a reasonable cost basis for ETH is $200, if you dollar-cost averaged into ETH from 2018 to 2020, today your fund's TVPI (Total Value to Paid-In) would be 15 times.

Many people would cite a famous study by AngelList as a counterexample, which shows that, on average, funds that make more investments tend to have better returns. But I believe cryptocurrency is different. Because the equivalent benchmark returns in the public market (e.g., DCA into ETH) are already high, you need to focus on asymmetric returns to have a chance to outperform the majority.

Otherwise, over time, the average return of cryptocurrency venture capital will be lower than simply buying ETH. And in the long run, it is very difficult to outperform ETH's performance.

Therefore, for every new investment, you should consider "Will this outperform my ETH bags, and can I break even?" and make high-confidence investments.

2: The "hype" of a funding round has almost no correlation with the final outcome before product-market fit

When you look at who the biggest winners were in the last cycle, you will find that they were almost never the hot deals at the seed stage.

• DeFi: Uniswap may have been a hot topic in the market, but Aave, back when it was called ETHLend, could be bought by any retail investor for just a few cents on the open market. In fact, before DeFi Summer, all Ethereum DeFi projects were not attractive enough as investment targets (while new BitMEX competitors were the super hot topics).

• NFTs: When DeFi became extremely popular with liquidity mining Degen yields, SuperRare Cryptoart was still completely overlooked. The floor prices for XCOPY and Pak pieces were still in single-digit ETH.

• L1s: Ironically, Solana is one of the few "VC chains" and was not a hot deal at the time (unlike Dfinity, Oasis, Algorand, ThunderToken, NEAR, etc.), yet it has now become the best-performing Alt L1 investment.

This is why strict control over valuations at the seed stage is crucial. I see more and more venture capital firms entering seed rounds for products valued at $60 million to $100 million. The only reasonable exception I can think of is L1s, due to their high TAM (Total Addressable Market) ceiling. But beyond that, you can even buy publicly traded tokens with potential at prices cheaper than those seed rounds.

However, after product-market fit, the situation is completely the opposite: the best investments are in the most obvious winners. This is because humans naturally find it difficult to internalize the feeling of exponential growth ------ we tend to underestimate how much winners can actually win and become monopolists.

The $100 million valuation before OpenSea's Series A seemed high at the time, but considering their transaction volume growth rate, it quickly became a cheap value target.

This is a good example of dialectics (extreme opposing truths). The best risk-return investments are either cheap pre-IPO companies or expensive post-IPO companies, with no distinction between the two.

3: It's hard to pick winners in crowded spaces of popular narratives

One trend I have observed over the past year is that Web2 founders tend to build the hottest Web3 narratives, which are also the most crowded spaces.

Many venture capital firms point out that this is a sign of great talent entering the cryptocurrency space, but I believe it represents more that talented individuals from good schools are entering this space, rather than necessarily a good match between talented founders and the market.

Cryptocurrency may be different from other industries; historically, almost all the most successful cryptocurrency projects have been founded by individuals without Ivy League/Silicon Valley pedigrees.

I have some concerns about investments with obvious ideas:

• These ideas attract mercenary founders who are solely profit-driven. These founders are good at replicating already successful concepts (e.g., Ethereum DeFi to other L1 chains, existing web2 SaaS products for web3 DAOs) and actively marketing their products. But inevitably, as cryptocurrency rotates to the next hot narrative, the size of these founders will shrink. For example, we are currently seeing Ethereum DeFi tokens drop 70-80% from their historical highs, while DeFi on other chains has become the new hot narrative. Among the Ethereum DeFi projects launched during the DeFi Summer of 2020, those mercenary founders have turned to angel investing, while those missionary founders with product vision continue to build and innovate.

• A good way to measure the difference between mercenary and missionary founders is to walk through the thought maze with them ------ to see if the founders can discuss all their previous methods and how they are now doing better. If a venture capital firm knows much more about a field than the founders do, that is a dangerous signal.

• The competition for these ideas is intense. When a dozen projects are trying to build the same thing (like Solana lending protocols), it becomes harder to pick winners. Each category largely remains a winner-takes-all or duopoly business. If you take a concentrated investment approach (as per point 1 above), then due to conflicts of interest, you cannot make prayer-like diversified investments in its competitors.

• These ideas have high pre-product valuations. The lowest valuations I currently see for X chains are pre-product valuations of $40-60 million, sometimes reaching $100-200 million. This risk/reward may be good for traders looking for quick presale to token issuance, but it is not for venture capitalists seeking asymmetric investment returns.

I cannot provide a complete conclusion, so I will end this article with a hot topic. Funds that show their paper gains to raise large capital from LPs will underperform ETH once their paper gains are realized.