Liquid Venture Capital

Executive Summary
September 2022 Venture capital has delivered great historical returns but is illiquid and hard to access.
Fortunately, innovation does not occur only at venture-backed startups. We replicate
Kai Wu venture capital returns using liquid small-cap public equities and find the underlying
Founder & Chief Investment Officer innovation premium also exists at large innovative firms. We also show that crypto
[email protected] tokens can provide a liquid complement to blockchain venture equity.

Introduction Venture Glut

Cradle of Innovation Venture capital is especially favored by elite institutional
Venture capital plays a leading role in the story of American investors. This is largely due to the influence of David
innovation. Venture capital was instrumental in the birth of Swensen, the late CIO of Yale University, who popularized a
legendary Silicon Valley firms such as Apple and Google. model favoring illiquid alternatives like venture capital.
Venture-backed firms ushered in the information revolution,
cementing America's status as the hub of global innovation. Yaleʼs 24% venture capital allocation is the crown jewel of
the endowment world. Other institutions, most notably
Investors in venture capital funds have been very generously Yaleʼs multi-billion dollar peers, have also built huge venture
rewarded. Since 1995, an index of venture capital funds has allocations. This overweight to venture capital (and other
returned +17.5% per year, trouncing the stock market. The alternatives) has been a key driver of their outperformance
performance of top quartile venture funds has been even relative to smaller institutions over the past few decades.
more astronomical (~40% per year).
Exhibit 2
Exhibit 1 Educational Endowment Allocations
Venture Capital Returns 🚀

Source: Cambridge Associates, S&P, Sparkline. Cambridge Associates index Source: Yale, NACUBO-TIAA, Sparkline. Yale and NACUBO-TIAA data are as of
return is a pooled horizon internal rate of return, net of fees, expenses and FY2020 and FY2021, respectively. Averages are for the 720 higher education
carried interest. See important backtest disclosure. As of 12/31/2021. endowments and foundations in the NACUBO-TIAA study.

This impressive track record fueled the meteoric rise of the However, the ongoing tech stock implosion has le many
$2 trillion venture industry. In 2021, US venture funds raised investors overexposed. As the tide goes out, the drawbacks
a record $139 billion across 1,000 funds. In just the first half of large illiquid allocations are glaring. Venture funds o en
of 2022, despite a collapse in tech stocks, these managers lock capital for a decade or more, creating headaches for
have already raked in $122 billion. investors trying to adjust to volatile market conditions.

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Making matters worse, venture managers are notoriously With this in mind, letʼs start with a simple example. Exhibit 3
slow to write down their portfolio positions in downturns. shows DoorDashʼs path to its initial public offering (IPO).
While early-stage technology stocks are down 60 to 80%, Founded in 2013, its 2014 Series A led by Sequoia Capital
many venture funds have yet to implement markdowns. valued it at $72 million. From here, it raised $2.5 billion in
Stale prices relative to a shrinking denominator exacerbates venture funding over several years. Its final venture round
the overallocation. valued it at $16 billion, six months before its $32 billion IPO.

Allocators are not the only ones stuffed to the gills. Venture Exhibit 3
managers have been raising increasingly massive funds at DoorDash Example
an accelerating pace (i.e., every 1.6 years). These funds have
been raised faster than they can be deployed, with the
global industry now sitting on $539 billion in dry powder.
With more capital than opportunities, it may take years to
work through this glut.

Venture capital has been a great boon to investors, but the

current glut is forcing investors to reexamine its role in their
portfolios. While venture investing is o en seen as a mostly
qualitative endeavor, we will show that its broad properties
can be replicated using quantitative methods.

Replicating Venture
Source: Sparkline.
Venture Data 🤓 While DoorDash is an idealized example, it is generally true
Our first goal is to show that the returns of the venture index that valuations tend to increase with each successive stage
can be replicated using liquid public equities. This not only of financing. However, given their high failure rate, only
helps us unpack the source of venture returns but also offers around 50% of startups make it to each successive funding
a potentially valuable tool for investors seeking venture-like round (e.g., only ~⅛ make it to Series D).
exposure in a liquid and accessible vehicle.
Exhibit 4
We start by assembling a database of venture deals. Venture Good Work (If You Can Get It)
traditionally consists of a series of financing rounds, starting
with Series A. Investments before Series A are called angel or
seed rounds. These are generally the purview of founders,
friends and family, or smaller venture firms.

Our analysis excludes angel and seed deals. While there are
of course great opportunities at these very early stages, the
venture index is dollar-weighted and thus driven by large
institutional funds. Large funds tend to invest in later-stage
startups, as smaller seed checks do not move the needle.

Ignoring seed deals helps reduce noise. Compared to public

stocks, private firms have much less reliable data as they are
not subject to standard regulatory and financial disclosures.
Deal terms are o en undisclosed and survivorship bias is a
big concern, especially in the high-turnover startup world. Source: Sparkline. Data from 12/31/2017 to 8/31/2022.

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This underscores the famous “power law.” Most startups fail Venture capital is largely a relationship game. Venture firms
but the few that succeed can produce generational returns. source deals through their personal networks and invest
Exhibit 5 shows the valuations of private venture-backed alongside like-minded funds. Startups partner with investors
“decacorns” (i.e., $10 billion firms). The top ten are more based, among other things, on relationships and industry
valuable than the other 48. This power law exists not only for connections. Such network effects are a major reason for the
decacorns but also the startup world in general. rise of Silicon Valley as an innovation hub.

Exhibit 5 The next exhibit maps out the startup ecosystem from the
Decacorn Power Law 🦄 perspective of investor networks. Venture funds o en have
specific investment focuses and tend to do deals with other
funds that share their theses. This causes clusters to emerge
around themes such as life sciences, crypto, and China.

Exhibit 7
Venture Investor Networks

Source: CB Insights, Sparkline. As of 8/31/2022.

We also have data on the investors leading and participating

in each financing round. The next table shows the most
active venture investors by deals led over the past few years.

Exhibit 6
Top Dealmakers

Source: Sparkline. Links based on number of shared investors. Node size

proportional to network centrality. Data from 12/31/2019 to 8/31/2022.

Factor Exposure
Now that we have a handle on the data, letʼs study the three
basic characteristics of venture-backed startups.

Source: Sparkline. Based on deals led from 12/31/2019 to 8/31/2022.

👶 Young: Startups are by definition young companies. The
next exhibit shows the age distribution of venture-backed
private firms on a logarithmic scale. For comparison, we also
We see the impact of prolific new entrants into the space.
show the age distribution of publicly listed US companies.
Tiger Global and Coatue are so-called “crossover funds” that
recently expanded from liquid markets into private equities.
Meanwhile, the So bank Vision Fund doled out a staggering
$100 billion to startups like WeWork. These fundsʼ aggressive
deployment played a big role in the recent valuation run-up.

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Exhibit 8 Venture-backed private firms tend to have smaller equity

Age Comparison capitalizations than public firms. However, there is huge
dispersion. For example, SpaceX is valued at $127 billion,
which would make it the 58th largest US stock if listed today
(bigger than AT&T, Goldman, and Netflix). Conversely, there
are over 800 US stocks with market caps under $1 billion.

While the power law is conventional wisdom in venture, it is

actually more pronounced in the stock market. The average
startup valuation is $290M against a median of only $70M,
but this ratio is even more extreme in stocks ($14.5B v. $2B).
This reflects the rise of the superstar firms from Monopolies
Are Distorting the Stock Market (Sep 2020). Apple is a $2.5
trillion company that alone comprises 7.3% of the S&P 500!

Source: S&P, Sparkline. As of 8/31/2022.

🚀 Fast-Growing: The third salient characteristic is fast
growth. The startup world is “up or out.” Companies either
The median venture-backed startup is 8 years old, compared grow and are rewarded with richer valuations or they die.
to 34 years old for public firms. Startups generally wait until Given their low hit rate, venture funds need their winners to
they reach a certain maturity before listing on an exchange, be home runs in order to earn a decent return at the fund
a period which has lengthened over the past few decades level. Most venture investors wonʼt even consider startups
(the median age of US firms at IPO rose from 7.9 to 10.8). without significant growth potential.

Of course, there are many exceptions. The oldest 20 percent Thematic Exposure
of venture-backed startups are around the same age as the
youngest 20 percent of public firms. In particular, the recent “The myth is that venture capitalists invest in good
SPAC boom has brought a lot of startups to the public people and good ideas. The reality is that they invest in
markets much sooner in their lifecycle. good industries.”

🐜 Small: A related characteristic is company size. Exhibit 9 🏭 Bob Zider

compares the valuations of US venture-backed private firms
Venture firms donʼt just blindly finance all high-growth
and public companies (again on a logarithmic scale).
startups. Instead, they tend to focus on firms innovating in
specific technological domains (e.g., PCs, internet, crypto).
Exhibit 9
Size Comparison
One simple way to classify companies is by industry. The
next exhibit compares the GICS industry exposure of the
Cambridge Associates US Venture Capital Index to that of
the Nasdaq Composite.

Source: S&P, Sparkline. As of 8/31/2022.

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Exhibit 10 Our model produces intuitive results. For example, it

Industry Comparison correctly associates terms like “NFT” and “smart contract”
with the blockchain. The model also successfully deciphers
multi-word phrases like “carbon neutral” and acronyms like
RPA (“robotic process automation”).

Now that our model speaks “startup jargon,” weʼll have it

analyze the relationship among startups based on their
business descriptions. We use machine learning to build the
market map below, which identifies startups with exposure
to each of these four themes. Bubble size is proportional to
total venture funding.

Exhibit 12
NLP Startup Market Map

Source: Cambridge Associates, Nasdaq, Sparkline. As of 6/30/2021.

Both venture capital and Nasdaq have around 42% in tech.

However, this comparison is not very revealing. In Value
Investing Is Short Tech Disruption (Aug 2020), we argued
that investors should not conflate tech and innovation. A er
all, not all tech companies are disruptive (e.g., IBM), and
disruptive firms exist in all industries (e.g., Tesla, Amazon).

We believe that unstructured data can provide a more

granular way to classify firms by technological theme. Our
last paper, Investing in Innovation (Apr 2022), clustered
technologies by applying natural language processing (NLP)
to patent abstracts. This section applies a similar technique
to the business descriptions in our startup database.

The algorithm starts by learning the relationship among

concepts mentioned in the business descriptions. Exhibit 11 Source: Sparkline. Bubble size is proportional to the square root of total
funding raised. As of 8/31/2022.
lists terms associated with four popular themes: blockchain,
climate tech, artificial intelligence, and metaverse.
The position of each startup is based on the similarity of its
Exhibit 11 business description to those of other startups. For example,
Robo-VC 🤖 the model puts Fireblocks and Copper, which are both
crypto custody platforms, near each other.

Proximity also matters at the theme level. The model places

metaverse and blockchain startups nearby due to their
shared association with blockchain gaming and NFTs. On
the other hand, climate tech and artificial intelligence form
distinct clusters.

We now have a way to cluster firms innovating in similar

technologies. Next, we explore how venture investment in
each technology cluster evolves over time. We construct
Source: Sparkline. As of 8/31/2022.

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rolling one-year windows based on deal announcement Exhibit 14

dates and calculate the share of deals (and dollars) venture Venture as a Leading Indicator
firms direct at each theme.

Exhibit 13
History of Venture Investment

Source: USPTO, Sparkline. As of 12/31/2021.

In Investing in Innovation (Apr 2022), we built a simple

model to identify technologies trending in patent data. We
showed the first few columns of Exhibit 15, which lists the
Source: Sparkline. Rolling 1-year sum. As of 8/31/2022. top trending technologies. We now reproduce the table with
the same technologies but add three new columns in gray.
In the dot-com bubble, venture capital firms threw money at
internet companies. Next, Blackberry and iPhone ushered in Exhibit 15
the mobile age. Then, Facebookʼs success sparked a wave of Top Venture Bets
investment into social networks. Artificial intelligence grew
steadily over the past decade, while blockchain burst on the
scene a few years ago. Climate tech investment faded a er
an initial burst but is now seeing a resurgence.

Our venture database complements the patent data from

Investing in Innovation (Apr 2022) well. Patents have a much
longer history and are more relevant for larger firms. On the
other hand, venture data is more timely and offers insight
into small-firm and non-patented innovation (e.g., trade
secrets and open source). Source: Sparkline. Data include patents and venture deals announced from
12/31/2019 to 12/31/2021. VC funding only includes deals where the exact
We see the more timely nature of venture investment in the dollar amount is known (i.e., actual money raised may be higher).

following case study of blockchain technology. Venture

funds were ramping up investment in blockchain startups Venture firms are extremely bullish on blockchain. They are
years before blockchains appeared in the patent corpus. also bullish on quantum computing and 3D printing, albeit
from a much lower base. They are continuing to invest in the
established sectors of autonomous vehicles, AI, robotics,
and Internet of Things (IoT). However, venture investment in
virtual reality and cloud computing has cooled off.

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Replicating Venture 🦄🦄 Exhibit 16

Examples of Current Holdings
“[T]he results push against the view that private equity
adds value relative to passive portfolios of similarly
selected public equities.”
🎓 Erik Stafford, Harvard Business School professor
Private equity replication has gained some attention the
past several years. While buyout funds have historically beat
the market, they are illiquid, opaque, and expensive. Some
have argued that public stocks can be used to replicate the
returns of buyout funds with more investor-friendly terms.

Researchers, such as Verdad (2015) and Stafford (2015), have

found that private equity buyout funds tend to target small, Source: Sparkline. As of 8/31/2022.
cheap, and levered firms. They build portfolios of public
stocks with these characteristics. They find these portfolios Letʼs next explore the portfolio's thematic composition using
are able to reproduce the returns of the private equity index. the technologies from Exhibit 15. The portfolioʼs thematic
exposure closely matches the level of venture funding. The
We replicate venture capital using a similar approach but two series have a robust 85% correlation.
target stocks with a different set of characteristics. As we
showed, venture funds tend to invest in firms that are: Exhibit 17
1. 👶 Young Thematic Composition
2. 🐜 Small
3. 🚀 Fast-growing
4. 🧬 Innovative
Our replication strategy buys liquid public stocks with these
four characteristics. We select stocks that are in the US
small-cap index (e.g., Russell 2000), bottom half of age, and
top half of growth (defined using a composite of multiple
growth metrics).

For innovation, we follow the methodology introduced in

Investing in Innovation (Apr 2022). First, we build a rotating
list of the ten technologies receiving the greatest increase in
venture capital investment each period. Next, we use NLP on
10-K business descriptions to identify the public companies
investing in these trending technologies. Source: Sparkline. As of 8/31/2022.

We apply a market-cap weighting scheme to mirror the The big exception is that the portfolio is relatively light on
construction of the S&P 500 and Cambridge Associates US blockchain. As we will show later, very few crypto companies
Venture Capital indexes. Our replication strategy currently are publicly listed. Investors seeking blockchain exposure
holds 81 stocks. Some examples are shown below. should instead consider venture capital or crypto tokens.

The next table compares the factor exposures of our venture

replication to that of the S&P 500 and US venture capital. We
show basic descriptive statistics in blue, fundamentals in
red, and intangible value factors in green.

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Exhibit 18 Exhibit 19
Portfolio Characteristics Venture Replication Strategy

Source: S&P, Sparkline. Calculations are weighted averages with weights

equal to position size. Venture Capital Index is market value weighted Source: Cambridge Associates, S&P, Sparkline. Cambridge Associates index
(larger firms get more weight). Metrics in red utilize analyst estimates. EPS is return is a pooled horizon internal rate of return, net of fees, expenses and
earnings per share and R&D is research and development. *PhDs scaled by carried interest. Liquid venture replication assumes 0.5% bps of annual
billions (e.g., # PhD employees per $1 billion market cap). As of 8/31/2022. expenses. See important backtest disclosure. As of 12/31/2021.

The replication holds smaller, younger, faster-growing, and The total cumulative return and general contours of the
more intangible-intensive companies than the S&P 500. replication closely match those of the venture index. The
These firms tend to be more expensive and less profitable. annual return correlation is a solid 72%. While the quarterly
Compared to the venture capital index, the replication holds volatility of the replication is much higher, this is largely an
larger and more mature firms. But, as we will see, these artifact of the way private market performance is calculated
mismatches do not make a huge difference in returns. (discussed in the next section).

We next apply our portfolio construction rules back through

time. The strategy buys a monthly-rebalanced portfolio of Venture Capital Risk
stocks with exposure to the four factors. Exhibit 19 compares
its performance to the Cambridge Associates US Venture Nowcasting Venture ⌚
Capital Index. We add a 0.5% annual expense ratio to the The past year witnessed a sharp reversal of the 2020 stock
replication since the venture capital index is net of fees. market surge. Many once high-flying tech stocks, such as
Affirm and Coinbase, are down 70 to 85% from last yearʼs
highs. With all this carnage in the stock market, one would
expect venture funds to be down similarly.

However, venture funds are notoriously slow to mark down

their holdings in market declines. Managers are incentivized
to drag their feet in order to report smoother performance
(and the illusion of lower risk). Startups are similarly loath to
do “down rounds” (i.e., new financing at lower valuations).
Of the 1,495 US venture deals in the first half of the year, only
4.9% have been down rounds – a historical low!

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Exhibit 20 Even putting aside the reporting delay, the venture index
No Down Rounds lags the public markets. Venture funds were conservative
marking up their books in the 2020 venture boom and are
being similarly slow with write-downs in the bust.

Cambridge Associates recently published the (preliminary)

Q1 2022 returns for its US Venture Capital Index. The index
declined 3.98%. In contrast, our liquid replication fell 12% in
Q1 2022 and tumbled 21% in Q2 2022. Even a er rebounding
the next two months, it is down 31% from its high.

From its peak, the venture index is down only 4% compared

to 31% for the liquid replication. It is likely that the industry
will continue to slowplay in the hopes the market turns and
they never have to realize bad marks. But the longer public
Source: Pitchbook. Data for 2022 is for the partial year as of 6/30/2022.
markets stay low, the less viable this approach will be.

This inertia is problematic for allocators since it obscures the Unpacking Venture
true valuation of their private investments. Fortunately, due
In Investing in Innovation (Apr 2022), we argued that
to our replicationʼs tight correlation to the venture index, we
investors in innovation funds, such as ARKK, are actually
can use it as a proxy for the true value of venture portfolios.
buying a bundle of factor exposures. This bundle includes
not only innovation but also other unwanted factors such as
The following exhibit plots the returns of the liquid venture
“low profitability” and “high price-to-book.”
replication, venture capital index, and S&P 500 on a monthly
frequency. The venture index exhibits a “stair step” pattern
Now that we have created a liquid surrogate for venture
as it only reports quarterly. It is also released with a few
capital, we can unbundle the sources of its returns using
months lag, so the most recent datapoint is from 3/31/2022.
regression analysis. The next exhibit shows its exposure to
the Fama-French factors widely used in the industry.
Exhibit 21
Nowcasting Venture
Exhibit 22
Venture Factor Exposures

Source: S&P, Ken French, Sparkline. As of 7/31/2022.

Venture capital is exposed to the overall stock market with a

Source: Cambridge Associates, S&P, Sparkline. Cambridge Associates index bias toward small, expensive, and unprofitable companies.
return is a pooled horizon internal rate of return, net of fees, expenses and
Research shows that expensive and unprofitable stocks tend
carried interest. Liquid venture replication assumes 0.5% bps of annual
expenses. See important backtest disclosure. S&P 500 and liquid venture to underperform over the long run. Moreover, all six factors
replication as of 8/31/2022. Venture index as of 3/31/2022. are commoditized “betas” that mainly contribute noise.

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We can remove these unwanted factors to isolate the pure

innovation driving venture returns. We decompose our
Sleeping Giants 💤
liquid venture strategyʼs returns into three categories. First, “Large corporations welcome innovation … in the same
we carve out the market factor. Second, we combine the way the dinosaurs welcomed large meteors.”
remaining five style factors into a single bucket. Finally, we 🦖 Scott Adams
consider the residual returns to be pure innovation.
It is a popular myth that innovation only occurs at startups,
Total Return = Market + Style Factors + Pure Innovation as large firms are too bureaucratic and risk averse. However,
this overlooks the innovative legacy of large industrial labs,
The next exhibit decomposes the liquid venture strategyʼs
universities, and government agencies. The information age
historical total return into the three components.
owes much to researchers at large organizations, such as
PARC, Bell Labs, IBM Research, ARPA and CERN.
Exhibit 23
Decomposing Venture Returns
Even today, many of the largest companies are carrying on
this tradition. Big firms have virtually unlimited resources
and the customers to predictably monetize breakthroughs.
Last year, companies in the S&P 500 spent a combined $487
billion on R&D. Google and Facebook are at the forefront of
artificial intelligence research, while Tesla is a trailblazer in
electric vehicle and battery technology.

In order to assess the performance of innovation at large

firms, we build a companion strategy to our liquid venture
replication. However, this time we select stocks from the
large-cap instead of small-cap universe (i.e., Russell 1000 v.
Russell 2000). We also relax the age constraint.

Source: S&P, Ken French, Sparkline. We use rolling 3-year regressions on the Exhibit 24
FF5 model (+momentum). Total Return = Stock Market + Style Factors + Pure
Innovation. Style Factors are the ex-market Fama-French factors. Pure
Super-Sizing Innovation 🍟
Innovation is the residual. Total return assumes 0.5% bps of annual
expenses, which are attributed to the market factor. See important backtest Early-Stage Large-Cap
disclosure. As of 7/31/2022. Innovation Stocks Innovation Stocks
(“Venture Replication”) (“Sleeping Giants”)
Pure innovation is the driving force behind the liquid
venture strategyʼs impressive historical returns. Not only is it 👶 Young
remarkably consistent but it does not lose money in the 🐜 Small 🐘 Large
major tech selloffs. On the other hand, style factors not only 🚀 Fast-growing 🚀 Fast-growing
detract from the overall return, but explain the large relative 🧬 Innovative 🧬 Innovative
losses of the strategy in the 2000 and 2021 tech busts. Source: Sparkline.

Venture capital returns are indeed all about innovation. In The next table compares the characteristics of large-cap and
fact, venture capital actually has adverse style exposures early-stage innovative stocks to those of the S&P 500. It
(i.e., unprofitable and expensive). Fortunately, the driving shows both the headline portfolio characteristics from
force of innovation has more than offset the headwinds from Exhibit 18 and Fama-French factor exposures from Exhibit 22
these unfavorable factor tilts. (the latter are in yellow).

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Exhibit 25 Large and small innovation stocks both beat the market.
Strategy Characteristics While early-stage innovators have higher returns, they also
have higher risk (e.g., volatility and drawdown). Innovation
at smaller firms is more “boom or bust.” Unlike larger firms,
they cannot diversify their R&D across many projects.

Importantly, the returns of large and small innovators ebb

and flow in tandem. The two strategiesʼ monthly returns are
93% correlated. Even the correlation of their returns relative
to the market is a robust 85%.

We next show the returns of “pure innovation” for both large

and small innovators. As a reminder, pure innovation strips
out the impact of the market and Fama-French style factors.
The returns look very similar and have a 63% correlation.

Exhibit 27
Source: S&P, Ken French, Sparkline. Calculations are weighted averages Pure Innovation
with weights equal to position size. Metrics in red utilize analyst estimates.
EPS is earnings per share and R&D is research and development. *PhDs
scaled by billions (e.g., # PhD employees per $1 billion market cap). Final six
metrics estimated by regressions on Fama-French factors. As of 8/31/2022
(except Fama-French factors are as of 7/31/2022).

Our large-cap innovators are much larger and older than our
early-stage innovators. While they are a bit slower-growing
and less intangible-intensive, they still enjoy a lead over the
market. On the other hand, they are less expensive and
significantly more profitable than their smaller brethren.

The next chart compares the performance of our large-cap

and early-stage innovators to that of the S&P 500.

Exhibit 26 Source: S&P, Ken French, Sparkline. Pure innovation is the residual return
Innovation Everywhere! a er removing Fama-French factors. See important backtest disclosure. As
of 7/31/2022.

Small innovation and large innovation are not two separate

factors. Instead, there is a single universal innovation factor
driving the returns of venture capital, early-stage innovation
stocks, and large-cap innovation stocks. Innovation matters
for all companies – private and public, small and large.

In summary, we were able to faithfully replicate the returns

of the venture capital index using liquid public stocks. Next,
we isolated the pure innovation factor driving the strategyʼs
returns. Finally, we found that this innovation premium
exists not only in small but also large stocks.

Source: S&P, Sparkline. Innovation strategies assume 0.5% bps of annual

expenses. See important backtest disclosure. As of 8/31/2022.

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Crypto Tokens Equities are not the only way venture funds get exposure to
early-stage crypto projects. Venture firms can also invest in
crypto tokens issued by these organizations. They may
Crypto Venture Capital
negotiate discounted allocations from protocol treasuries or
As we saw, crypto is the hottest theme in venture capital. simply buy on the open market. In other cases, they receive
Many venture investors view blockchains as a platform as token distributions due to their equity stakes.
transformative as the internet in the 1990s. In 2021, venture
firms invested $33 billion in crypto companies, representing Crypto tokens can be even more lucrative than equities. For
around 10% of total venture funding. example, in July 2019, venture funds invested $20 million
into Solana Labs but received SOL tokens rather than Solana
Exhibit 28 Labs equity. Investors reaped an epic windfall when the SOL
Blockchain Venture Capital token subsequently surged over +20,000% to a peak market
cap of $78 billion (although it has since fallen a lot).

Tokenomics 101 🍎
In order to understand why venture capitalists opted for SOL
tokens instead of Solana Labs equity, we need to understand
the economics of tokens. Perhaps the most intuitive way to
explain “tokenomics” is by analogy to equities.

💰 Dividends
Companies reward shareholders with dividends (paid in
either cash or stock). Similarly, crypto projects may
reward tokenholders with additional crypto. Such yields
Source: Galaxy Digital Research, Pitchbook, Sparkline. As of 12/31/2021. can be generated from a variety of underlying sources,
such as exchange trading fees or staking rewards.
Venture capitalists have reaped extraordinary returns from
their equity investments in crypto startups. Below is a list of 🔥 Buybacks
top crypto unicorns. The valuations may be a bit generous Companies also reward shareholders with buybacks. By
inasmuch as they may not yet reflect write-downs from the reducing share supply, buybacks increase the value of
recent crypto rout (i.e., only Coinbase is publicly traded). remaining shares. Crypto token burns remove coins
from circulation to the same effect. In August 2021,
Exhibit 29 Ethereum started burning a portion of tokens sent as
Top Crypto Unicorns 🦄 transaction fees, deflating supply.

🖨 Issuance
Companies issue shares to raise capital and incentivize
employees. There is no cap on equity issuance or total
supply. In contrast, token issuance and supply are o en
capped. Bitcoin caps total supply at 21 million, while
Ethereum caps annual issuance but not total supply.

🦺 Vesting
Startup equity granted to venture capitalists and key
employees o en has a vesting period before it can be
sold. Tokens have similar provisions. This is especially
Source: CB Insights, Sparkline. As of 8/31/2022. important as token liquidity generally occurs sooner.

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🗳 Governance value, its two constituents offer very limited breadth. The
Common shares carry voting rights on key matters of other half is split evenly between small-cap crypto and
corporate policy, such as board composition and M&A. venture equity. These groups offer a much broader and
Governance tokens grant similar voting rights, such as more diverse opportunity set with thousands of assets.
over the use of the DAO treasury, tokenomics, and key Finally, public stocks are basically a rounding error.
technical proposals.
Exhibit 30
Of course, there are many ways that crypto and equities Crypto Opportunity Set
differ. Token rights are enforced by so ware code, whereas
equity rights are enforced by the legal system. There are also
regulatory differences (but we are not lawyers and donʼt give
legal advice). Most interestingly, smart contacts open up an
exciting range of unique token features (e.g., airdrops, NFTs).

Crypto Opportunity Set 🌎

As mentioned in Value Investorʼs Guide to Web3 (Jan 2022),
there are four ways to get exposure to the crypto industry:
🐘 Mega-cap Crypto (BTC, ETH)
🪙 Small-cap Crypto
🏛 Venture Equity Source: CoinMarketCap, CBInsights, S&P, Sparkline. We exclude stablecoins.

🏭 Public Equity As of 8/31/2022.

Crypto and equities provide access to distinct opportunity Most institutional investors have used venture capital as
sets. For example, OpenSea, an NFT marketplace, is a private their entry point into crypto. However, venture equities only
firm with no token. In contrast, its competitor LooksRare cover around 25% of the opportunity set by market value
distributes 100% of its profits to its tokenholders. Investors and 50% by names. Investors seeking full coverage should
can only own OpenSea via equity and LooksRare via token. also consider allocating to tokens.

Cryptocurrencies are a large asset class. In total, crypto has Crypto Winter ☃
roughly $1 trillion in market cap spread across 9,000+ assets.
In Value Investorʼs Guide to Web3 (Jan 2022), we introduced
However, most of this value is in mega-cap crypto. Excluding
a framework for assessing the fundamental value of digital
Bitcoin ($380B), Ethereum ($190B), and stablecoins ($150B)
assets. Using data from GitHub, blockchains, and social
leaves $270 billion in market value for small-cap crypto.
media, we build metrics for crypto projectsʼ human capital,
brand equity, intellectual property, and network effects.
While private markets are opaque, we estimate another $270
billion in value is spread across several thousand private
Since 2014, the total fundamental value of the crypto asset
crypto startups. As mentioned, these most recent valuations
class grew at a remarkable 50% compound annual rate. Our
may not reflect impending markdowns, so perhaps it would
paper included a chart comparing total crypto market cap to
be fairer to haircut this estimate by 25 to 75%.
fundamentals. The next exhibit updates this chart.

Finally, we counted only a couple dozen “pure play” crypto

stocks. The total market cap of these stocks is a mere $30
billion, of which Coinbase alone is half (i.e., $15 billion). At
least for now, the overwhelming majority of crypto firms are
not listed on stock exchanges.

The next exhibit maps the full crypto opportunity set. While
mega-cap crypto comprises half of the industry by market

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 Liquid Venture Capital | Sep 2022

Exhibit 31
Crypto Price and Fundamentals (Updated) Innovation Investing
Venture Alpha
“Emphasizing inefficiently priced asset classes with
interesting active management opportunities increases
the odds of investment success. Intelligent acceptance of
illiquidity and a value orientation constitute a sensible,
conservative approach to portfolio management.”

🎓 David Swensen, former Yale Chief Investment Officer

David Swensenʼs genius was realizing decades ago that the
nascent venture industry was rife with inefficiencies. His
pitch for venture was less about the beta of the asset class
Source: CoinMarketCap, CoinGecko, Messari, Santiment, CryptoCompare, than his belief that skilled managers could find alpha.
Sparkline. The green line shows updated data since the original chart ended
on 1/31/2022. As of 8/31/2022. Swensenʼs argument is reflected in the now conventional
wisdom that venture index returns are driven by top funds.
We originally showed this chart as of 1/31/2022 (blue line). Harris et al (2020) found that venture capital funds outside
We argued that despite strong fundamental growth, prices of the top quartile either barely outperformed or greatly
had overshot to the upside. Several months later, with prices underperformed the stock market. Fortunately, the top
down 67% from their peak, the market now appears more in quartile did so well that they more than made up for the
line with fundamentals (green line). other 75%, leading to a respectable average return.

Interestingly, total fundamental value has remained steady Exhibit 32

this year. While network activity has markedly slowed, this Venture Fund Persistence
decline has been offset by stickiness in developer and social
engagement. Despite the large outflow of speculators, the
builders have mostly stayed. For what itʼs worth, we saw this
pattern in previous crypto winters as well.

As discussed, venture equities have yet to suffer many down

rounds. The venture capital index is down only 3.98%. While
the embattled BlockFi was forced to take a 90% hit, most
crypto firms raised immense warchests in the boom and are
unlikely to be in need of cash for a while.

In contrast, crypto tokens are liquid, and price discovery has

not been kind. Most small-cap tokens are trading 60 to 90%
below last yearʼs highs. All else equal, we believe this
presents a more interesting opportunity for value-oriented
investors building long-term allocations to Web3. Source: Harris et al (2020), Sparkline.

Importantly, the researchers also found that venture fund

returns have been highly persistent. Managers with top
quartile funds are significantly more likely to have future
funds in the top quartile. This persistence is likely due to the
ability of top-tier venture firms to attract deal flow. As an

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 Liquid Venture Capital | Sep 2022

allocator, if you are lucky enough to be in a top manager, Investments in early-stage innovation have very high implied
sticking with them is generally a good idea. volatilities. The range of startup outcomes is extremely wide
due to the power law. Crypto tokens allow us to directly
The problem is that most of the best venture managers are observe this volatility, which o en runs at 100% annualized.
at capacity and closed to new investors. And, as we just saw,
the bottom 75% of funds are less than inspiring. Moreover, Therefore, investors in innovation should place an especially
the authors found that the mean, dispersion and persistence high premium on liquidity. Technological trends can shi
of venture manager returns have all weakened since 2000. abruptly, and the best startups today may not be the best
tomorrow. Liquidity allows investors to course correct in the
This is the logical result of the institutionalization of private face of a rapidly evolving landscape.
markets. Swensen was early in identifying the inefficiencies.
However, venture capital has matured into a $2 trillion
industry. This influx of capital has likely eroded much of the
Lifecycle of Innovation 👶👦👨👴
advantage Yale enjoyed as an early mover in the late 1980s. “We think the VC model is outdated. It creates an odd
dynamic between us and founders, where on the eve of
an IPO they're asking if we're going to have to get off
Option Value of Liquidity
their boards and quickly distribute the stock. Why
One big unlock for Swensen was his belief that Yale could should that be the default, particularly when so much
withstand a considerable allocation to illiquid assets. Yaleʼs value creation happens later?”
multi-decade investment horizon and wealthy alumni donor
base made it particularly well suited to commit heavily to
🌲 Roelof Botha, Sequoia Capital
illiquid funds with decade-long lockups.
Sequoia Capital, arguably the most well-respected venture
capital firm, recently restructured around an evergreen fund
One common justification for allocating to illiquid assets is
and registered as an SEC advisor. This allows them to hold
the so-called “illiquidity risk premium.” This is the excess
onto the public shares of their winners long a er the IPO. As
return investors should expect (in theory) to earn for bearing
of Oct 2021, Sequoia already held $45 billion in the public
illiquidity. Yale was early to embrace private equities when
shares of firms such as Unity and DoorDash.
the illiquidity risk premium was very large. However, a lot of
capital has flooded the private markets since then.
Sequoiaʼs argument that most value creation happens a er
the IPO is patently true. Sequoia uses Square as an example.
Some believe that the pendulum has swung too far. AQR has
They helped Square build to a successful $2.9 billion IPO but
argued that allocators now view illiquidity as a “feature not a
missed out on most of the post-IPO gains on its way to a
bug.” As we saw, venture returns are highly smoothed. AQR
$117 billion valuation. This has been the case for most iconic
posits that investors may even be willing to accept a lower
companies. As the next exhibit shows, 99.966% of Amazonʼs
return for the ability to bury mark-to-market volatility. AQRʼs
value came a er its 1997 IPO.
Cliff Asness has cleverly called this “volatility laundering.”
Exhibit 33
Investors should remember why liquidity is valuable in the Post-IPO Compounding
first place. Liquidity is effectively an “option” that grants
investors the ability to change their mind or respond to new
investment opportunities. Conversely, investors who lock
themselves into the current opportunity set forgo the ability
to take advantage of future opportunities.

We can model the option value of liquidity as a function of

the implied volatility of the future opportunity set. If we
donʼt expect any interesting opportunities to crop up, there
is little cost to forgoing liquidity. Conversely, if we expect the Source: Sparkline. Does not take into account dividends. As of 8/31/2022.
future to be very exciting, illiquidity has a high cost.

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 Liquid Venture Capital | Sep 2022

Investors should consider following Sequoiaʼs lead. The full We have published several papers on “intangible value.” This
lifecycle of innovation extends far beyond the IPO. Investing idea extends traditional book value to encompass intangible
in innovation means owning more than just private startups. assets, such as innovation, brand equity, human capital and
Innovation is not only the driver of venture capital returns network effects. We believe this framework enables us to
but has also delivered excess returns in small-cap stocks, apply value principles to new frontiers.
large-cap stocks, and crypto tokens.
If youʼre interested in learning more, we would recommend
Exhibit 34 the following papers:
How to Invest in Innovation
🏛 Intangible Value: Stocks
🪙 Value Investorʼs Guide to Web3: Crypto tokens
🧬 Investing in Innovation: Innovation stocks

Conclusion
Venture capital has been the killer app for elite institutional
investors. However, as capital has flooded the asset class,
investors are looking for other ways to harness its returns
without the illiquidity and adverse selection.
Source: Sparkline.

The true source of venture returns is innovation, which also

Innovation investors should consider a portfolio of all four occurs at public companies, both large and small. We
pieces, balanced to obtain the desired blend of size, liquidity believe that investors should extend their “innovation
and sector exposure. Very large allocators could consider allocation” from venture capital into public equities. This
cap-weighting for capacity reasons. Meanwhile, those with should help investors capture the full innovation lifecycle
alpha views could allocate more to certain categories (e.g., while enjoying greater liquidity.
crypto tokens, an inefficient “frontier market”).
In addition, while many investors have used venture capital
Value Investing as their beachhead into crypto, liquid tokens offer at least as
“All markets have boom and bust cycles, and I think the interesting an opportunity set. In line with Swensenʼs
venture capital market has even more exaggerated original thesis, we believe that tokens provide exposure to
boom and bust cycles.” blockchain innovation in an inefficient frontier asset class.

🗽 Fred Wilson, Union Square Ventures

In his quote from earlier, Swensen argued that investors
should employ a value orientation. We believe this is
especially true in the innovation sector. In Investing in
Innovation (Apr 2022), we showed that technological
revolutions are especially prone to hype and speculative
bubbles (e.g., canal mania, railroad mania).

Our mission is to bring the time-tested principles of value

investing into new frontiers. While we are excited to apply
innovation investing into liquid venture capital and crypto
tokens, we believe investors must first arm themselves with
the tools of value.

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 Liquid Venture Capital | Sep 2022

Backtest Disclosure
The performance shown reflects the simulated model performance
an investor may have obtained had it invested in the manner
shown but does not represent performance that any investor
Kai Wu actually attained. This performance is not representative of any
Founder & CIO, Sparkline Capital LP actual investment strategy or product and is provided solely for
informational purposes.

Kai Wu is the founder and Chief Investment Officer of Hypothetical performance has many significant limitations and
Sparkline Capital, an investment management firm applying may not reflect the impact of material economic and market
state-of-the-art machine learning and computing to uncover factors if funds were actually managed in the manner shown.
alpha in large, unstructured data sets. Actual performance may differ substantially from simulated model
performance. Simulated performance may be prepared with the
Prior to Sparkline, Kai co-founded and co-managed benefit of hindsight and changes in methodology may have a
Kaleidoscope Capital, a quantitative hedge fund in Boston. material impact on the simulated returns presented.
With one other partner, he grew Kaleidoscope to $350
million in assets from institutional investors. Kai jointly The simulated model performance is adjusted to reflect the
managed all aspects of the company, including technology, reinvestment of dividends and other income. Simulations that
include estimated transaction costs assume the payment of the
investments, operations, trading, investor relations, and
historical bid-ask spread and $0.01 in commissions. Simulated fees,
recruiting.
expenses, and transaction costs do not represent actual costs paid.

Previously, Kai worked at GMO, where he was a member of

Index returns are shown for informational purposes only and/or as
Jeremy Granthamʼs $40 billion asset allocation team. He
a basis of comparison. Indexes are unmanaged and do not reflect
also worked closely with the firm's equity and macro management or trading fees. One cannot invest directly in an
investment teams in Boston, San Francisco, London, and index. The S&P 500 is a popular gauge of large-cap U.S. equities
Sydney. that includes 500 leading companies. The Russell 1000 Index
consists of the approximately top 1000 U.S. stocks by market cap.
Kai graduated from Harvard College Magna Cum Laude and The Russell 1000 Value (Growth) Index includes those Russell 1000
Phi Beta Kappa. companies with lower (higher) price-to-book ratios and expected
and historical growth rates.

No representation or warranty is made as to the reasonableness of

Disclaimer the methodology used or that all methodologies used in achieving
This paper is solely for informational purposes and is not an offer the returns have been stated or fully considered. There can be no
or solicitation for the purchase or sale of any security, nor is it to be assurance that such hypothetical performance is achievable in the
construed as legal or tax advice. References to securities and future. Past performance is no guarantee of future results.
strategies are for illustrative purposes only and do not constitute
buy or sell recommendations. The information in this report should
not be used as the basis for any investment decisions.

We make no representation or warranty as to the accuracy or

completeness of the information contained in this report, including
third-party data sources. This paper may contain forward-looking
statements or projections based on our current beliefs and
information believed to be reasonable at the time. However, such
statements necessarily involve risk and uncertainty and should not
be used as the basis for investment decisions. The views expressed
are as of the publication date and subject to change at any time.

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