Untangling Luck from Skill - by Rick Zullo and Sophia Dodd

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Original article and tweet thread

Key Takeaway

For entrepreneurs: The current seed stage market is less attractive than it has been in the past decade, with lower valuation premiums and increased dilution from larger funding rounds, making it crucial for startups to demonstrate exceptional growth potential to stand out.
For investors: Past performance in early-stage investing, particularly from vintages like 2014, may not be indicative of future success due to changing market conditions and the need to distinguish between luck and skill in investment strategies.

Summary

The article "Untangling Luck from Skill" by Rick Zullo and Sophia Dodd from Equal Ventures discusses the challenges in the venture capital industry, particularly in early-stage investing. It highlights how the seed stage market has become less attractive, with valuation premiums dropping to historic lows and increased dilution from larger funding rounds. The article warns against relying on past performance, especially from successful vintages like 2014, and emphasizes the need for investors and limited partners (LPs) to evaluate current market conditions and distinguish between luck and skill in investment strategies.

Insights

Historical Context: The 2014 vintage for early-stage investors was exceptionally successful, with an average valuation premium of over 68x for companies that raised a growth round in 2021.
Current Market: The seed stage market is currently less attractive, with a valuation premium below 10x, the lowest on record, and increased dilution from larger funding rounds.
Recency Bias: LPs and GPs are pursuing more exposure to what has worked in the past, which could prove dangerous due to changing market conditions.
Future Projections: To achieve similar returns as the 2014 vintage, the average valuation of growth stage companies in 2031 would need to be a staggering $11.54 billion, which is unlikely.
Need for Discipline: Early-stage investors need to figure out their “right to win” and practice discipline to ensure they are breaking away from the crowd and delivering returns that resemble those of successful past vintages.

Implications

For VCs: The overall basket of early-stage investing is less attractive than it was in 2014, and average managers are likely to produce less exciting returns. VCs need to develop strategies that address the current market conditions.
For LPs: LPs need to evaluate past performance of managers and determine whether it was driven by skill or luck. They should consider new managers capable of addressing the needs of today’s market rather than assuming prior returns will persist.
Market Dynamics: The venture capital industry needs to adapt to changing market conditions and develop new best practices rather than relying on past successes.