By Noah Jessop
This is one of my favorite questions to ask people pondering an investment in crypto. Facebook’s Series B round is an easy bet in retrospect, but at the time, just five years after the dot-com bust, a $475M pre-money valuation was an incredibly steep price for a nascent website for college kids.
Especially considering that previous market leader Friendster had faded into irrelevance — in large part due to the rise of MySpace which was acquired in 2005 for a mere $580M — not much of a premium on Facebook’s new valuation. Despite the lack of evidence that social media would be profitable, smart investors chose to have their capital locked up, with a strong probability that user tastes could change along the way. And the path to success was not smooth, Facebook faced class-action lawsuits, user revolts, and political pressure right up until the investment finally became liquid in an IPO six years later. The investors were handsomely rewarded for their vision of the spectacular things that could happen if things went right.
This cherry-picked example obviously had the benefit of hindsight, but the point holds. In 2006, an investment in Facebook was very expensive and a little insane. Huge amounts of faith were required. As of my writing, Facebook’s market capitalization is just over $545B. Three orders of magnitude increase over a 10-ish year time span — Give or take dilution and how much you sold along the way.
Today, we see similarly expensive/crazy opportunities in crypto. A browser, Brave, promises to create a new business model for content and has earned a valuation similar to Facebook’s Series B. Projects, not companies, are now threatening to disrupt file storage, lending, computing, and dozens of other industries and are rewarded with sky-high valuations. Will they pan out?
We are at the “Series B” moment for Bitcoin, and maybe even Crypto as a whole. This is the hopes-and-dreams round. This isn’t value investing. This isn’t about price. This is about what you have to believe at this moment about logarithmic growth in the future.
But the key difference here in crypto is that it’s liquid all the way. We could find three orders of magnitude growth here — but with a few 80% corrections along the way. Some will sell in these moments of despair.
Luminaries like Warren Buffet have predicted that Bitcoin trading will come to bad end.
As Naval Ravikant of AngelList says — Buffett is actually the wrong oracle here. Where Buffett (and his mentor Benjamin Graham) are relevant in this world is not about price, but about “Mr. Market.” We may constantly have our beliefs questioned by the irrational, euphoric, moody depths of the public markets.
But if you could go back to 2006 — how much, as a % of your risk capital activities, would you have invested in Facebook?
Would you rather bet the same amount across ten spins?
We’ll come back to these questions.
The crypto markets have gotten so large, so quickly that everyone involved in tech or finance is making commentary. And it’s becoming evident now that many existing projects may be overvalued for the real value they provide to society. In many cases, well intentioned teams are working very hard, they’re just very, very early in their journey, similar to a certain social network circa 2006.
But these current market prices are based on a future hope — a hope that these projects go on to be the durable platform in their category.
In the case of massive, winner-takes-all markets, all entrants are valued for the chance they win, but likely all of them cannot coexist together.
Are there still projects and opportunities that are dramatically undervalued? Certainly.
Is the risk/reward profile of these investments favorable? It’s currently unknowable.
But much of our focus and attention during bubble worries focuses around the froth around the edges. These are the stories of excess that grab us: the people who take out second mortgages and the like. For the record, I believe this is a bad strategy that will likely end in tears.
But something important is buried in all this clamor and media airtime: bet sizing.
The roulette table is filled with highly speculative, potentially lucrative opportunities, available nightly in Las Vegas and many other parts of the world.
But the risk profile is truly known — thus it would be deeply (knowably) imprudent to take a mortgage to “put it all on red.”
When the probability function is hidden — and you only see accolades of outlandish success, it seems only reasonable that people err in their decisions of bet size. Now just add high volatility, FOMO, and a few hundred highly-incentivized promoters to the mix.
Bet sizing is a delicate mix: what you are willing to lose, what your beliefs of the probability distribution of outcomes, and what you believe could become meaningful.
For a dedicated venture fund, it’s a bit easier to calculate these. A large enough portfolio provides risk-adjustment for losses. It’s also fairly easy to understand what “meaningful” means: large enough to return the closed-ended fund itself (or multiples thereof).
We still grapple with sizing investments within these constraints for pure equity: if we believe in a founder and their company enough to participate in their round — why not lead the investment if we are able to?
Where much of the trouble will come with crypto is not in prices paid — but in incorrectly sized bets by market participants.
This many come in many forms — too little diversification across many crypto assets. Overconfidence in what worst case scenarios may look like. Too much capital at stake per participant.
For those that have gone “Crypto Native” — the bet sizing changes a few variables to constants. Fiat (locally issued government currency) is for food, shelter, basic luxuries — and the rest is goes into the new economy. If you are going to hold for 5–10+ years, a little bubble and volatility doesn’t matter too much.
Could we currently have runaway prices of assets (in USD) that could have wild corrections? Yes.
Is investor enthusiasm currently extremely high? Yes.
But where we might look to the dot-com bubble for inspiration and understanding, there is a new factor in play this time around. If you see a basket of crypto as hedge against the eventual fall of the US dollar…everything becomes different. Aforementioned shelter, food, etc aside — who cares what the prices are in dollars?
But this long horizon starts to look a lot like…venture capital itself.
Patient capital able to weather the uncertainty along the way. Patient capital believing in logarithmic growth enabled by a new disruptive technology.
So stay safe out there — and size your bets wisely.