Share 3 counter-intuitive experiences in crypto investing

Good morning, readers! This post will present three counter-intuitive lessons I've learned over the past few years as a crypto investor. Of course, I will also explore more interesting topics in future articles.

1. Building a portfolio is more important than picking the right companies.

This experience is the most counterintuitive to ours, but the mathematical logic behind it is actually quite simple. Let's say you invest 0.5% of your fund in a company that has returned 100 times. Even if that company earns that return, your fund will still not be able to make a return. Since the distribution of venture capital returns follows a power law distribution, winners with returns as high as 100 times are actually very rare. So, whenever you come across an opportunity like this, you have to make sure that your investment is more valuable. To be successful, you need to focus on commitment rather than just wishing for luck.

Not building a portfolio properly, but just having a bunch of nice company logos on a fund website doesn't necessarily mean a VC is getting a good return. This may also explain why some VC funds with over $400 million in assets are still doing seed investing.

Some believe that making a small initial investment is an opportunity to take a "goal on goal" and then plan to make a larger investment based on that. But in practice, the larger foundations enter the market in a more astute manner and reap the vast majority of the gains (i.e. the later you invest, the closer your round is to zero-sum). On top of that, if you are not the lead investor in the seed round, you may not be entitled to pro rata equity, so your ownership stake may be substantially diluted (I once saw an example where dilution was as high as 90%).

If one takes the extremes of this experience (i.e. completely ignores the importance of picking the right companies), then the optimal portfolio construction is 100% dollar cost averaging, also known as "beta". To be honest, the unspoken rule of crypto investment institutions is that most of the funds launched in the last cycle did not outperform the above portfolio construction. Assuming an average ETH USD cost of $200 from 2018 to 2020, your fund's TVPI could be 15 times today's price.

As a counterexample, many point to AngelList's famous study showing that, in general, foundations make better returns when they invest more. However, I don't think this statement holds true in the world of encryption. Since public market equivalent benchmark returns (such as investing in ETH via DCA) are already very high, you need to focus on asymmetric returns to have a chance of outperforming the market. Otherwise, over time, the average return of crypto investment institutions will be lower than that of using an ETH-only strategy. In the long run, it will not be easy to surpass ETH.

So, with every new investment, you should be thinking "is this going to outperform my ETH yield and return capital?" At the same time, you should feel confident enough to place your bet.

2. Before product market fit, there is very little correlation between the "hotness" of a funding round and the final outcome

If you look back in history, almost none of the biggest winners of the last cycle were seed round hot projects.

DeFi: Even though Uniswap was once a hot trading platform, when it was called ETHLend, Aave was priced at just pennies, buying on the open market for any retail investor. In fact, all investments in the Ethereum DeFi field are not very attractive (then BitMEX's new competitors are the sweet spot), until the arrival of the DeFi summer.

NFT : When DeFi became popular last year due to the "risk-yield farm", SuperRare's digital art market was completely ignored. The price of works of XCOPY and Pak is still at the price of a single ETH.

L1: Ironically, Solana was not one of the hottest "VC chains" at the time (unlike Dfinity, Oasis, Algorand, ThunderToken, NEAR, etc.), but ended up being the top performer alt L1 investment.

This is why it makes sense to keep a very tight grip on valuation at the seed stage. I'm seeing more and more VCs chasing $6K-$100M valuations in seed rounds as well. The only exception I can think of is L1 as the market size/upside is very high. Plus, you can even buy publicly traded tokens with market recognition for less than the FDV price of some seed rounds.

After product-market fit, however, the opposite is true: the most successful investments are usually those with the most obvious prospects for success. This is because humans are inherently hard-wired to perceive what it feels like to experience exponential growth (e.g. look at how many people dismissed COVID-19 in early 2020); we tend to underestimate the potential for winners and the possibility of becoming a monopoly. OpenSea was valued at $100 million in their Series A funding round, which might have seemed high at the time, but quickly became worth it as their deal volume grew rapidly.

This is a good example of "dialectics" (extreme relative truth). In terms of investment risk return, the best options are either cheap companies before product market fit or expensive companies after product market fit, and there is no good choice in between.

3. It is difficult to choose a good project in the hot narrative and fierce competition

Over the past year, I've noticed a trend that Web2 founders are building towards the hottest narrative and most competitive space in Web3. Many VCs see the abundance of talent entering the crypto industry as a positive sign, but I think newcomers may have good credentials but not necessarily fit the specific needs and requirements of the crypto market. Unlike other industries, in crypto, heroes come from no matter their origin. Historically, almost all of the most successful crypto projects were founded by people with no Ivy League or Silicon Valley background.

I'm a little apprehensive about some of the "obvious" ideas in investing.

These ideas attract founders who are primarily profit-seeking. These founders are good at copying what already exists (such as copying ETH DeFi to other L1 chains, copying existing web2 SaaS products into web3 DAO), and then actively marketing their products. But as the cryptocurrency hotspot shifts, the industry these founders operate in is bound to suffer some degree of decline. For example, we are seeing this now, with ETH DeFi tokens having dropped 70-80% from their all-time highs, while DeFi on other chains has become the new hotness. In the ETH DeFi project launched by the DeFi boom in 2020, the founders who focus on profit have turned to angel round investment, while the founders who focus on evangelism have always adhered to the product vision and continued to build and innovate.

A good way to tell the difference between “profit making” and “missionary” founders is to explore ideas with them. Can the founders describe in detail what others have tried and what they are doing better now? If the VC knows a lot more about a particular field than the founders, that's usually a red flag.

These ideas are highly competitive. When there are a dozen projects trying to build the same thing (such as the Solana lending protocol), choosing a good project is much more difficult. In each industry or category, there are only a few dominant companies occupying the market share. If you take a concentrated approach to investing (per #1 above), then it's not a good fit for you to invest in their competitors due to conflicts of interest.

These ideas have high valuations before the product launch. We can see that the minimum valuation of the DeFi clone to the X chain is 40-60 million US dollars, and it can even reach 100-200 million US dollars. While this can be lucrative for traders looking to make a quick profit by buying tokens during the pre-sale period and then selling them after launch, for investors looking to invest with the potential to generate handsome returns and generate excess returns to pay back For venture capitalists of funds, it may not be attractive.

I didn't come to a conclusion, so I'll end this article on a controversial note: Funds that raised large funds by showing LPs paper returns, once those paper returns turned into actual returns, performed differently. Will not be as good as Ethereum.

Author: Richard Chen

Translated by: Theseus Wu

Proofreading: jomosis1997

Typesetting: Bo

Reviewer: Suannai