The Index Approach in Early-Stage Venture Capital: Reconsidered

The venture capital (VC) landscape is marked by its dynamism and complexity, especially in early-stage investing. The traditional approach in VC, characterised by a selective and intensive vetting process, often contrasts with the concept of ‘index investing.’ This article revisits the indexing approach in early-stage VC, incorporating insights from recent studies and data, including a critical analysis from Whoisnnamdi.com, to evaluate its viability and strategic value.

The concept of index investing in early-stage VC is rooted in the power law distribution theory. This theory posits that in venture capital, a small number of investments yield disproportionately high returns, analogous to the outliers in a power law distribution, such as the Googles or Amazons of the world. Theoretically, spreading investments across a broad spectrum of early-stage ventures could increase the probability of capturing these outliers, thus potentially maximising returns.

AngelList provides empirical support for this theory. Their data analysis reveals that portfolios with a larger number of investments tend to outperform those with fewer, concentrated bets. This finding suggests that a broad, index-like investment approach at the seed stage could yield higher returns than a selective strategy.

Despite the theoretical and empirical support for index investing in early-stage ventures, most, if not all, VCs adopt a highly selective approach. This selectivity is not driven by the abundance of options but rather by the scarcity of investable opportunities that meet their rigorous criteria. As a result, VCs often exercise extreme caution in their investment choices, wary of the high failure rates among startups.

Creating an index for early-stage investments involves several practical challenges:

The 1/N heuristic suggests investing an equal amount in a broad set of assets, without overemphasising the fundamentals of each. In VC, this could translate to investing equal amounts across a diverse set of early-stage companies. This approach simplifies investment decisions and could potentially counter the overfitting and overintellectualisation that sometimes plague venture capital investment strategies. Notably, this method has been supported by Nobel Laureate Harry Markowitz, who favoured a simpler investment approach over more complex models.

In light of the data and theory, it’s time to reevaluate the potential of index investing in early-stage venture capital. While the traditional selective approach has its merits, especially in late-stage investing where the opportunity cost of missing a winning investment is more bounded, early-stage investing might benefit from a more diversified approach.

The decision to adopt an index investing strategy in early-stage VC should not be taken lightly. The approach has theoretical and empirical support, particularly in aligning with the power law distribution of venture returns and offering a diversified investment portfolio. However, practical challenges and the nature of early-stage investing, which often requires a hands-on, deeply involved approach, pose significant hurdles.

In conclusion, while indexing could complement traditional VC strategies, especially in diversifying risks and potentially capturing high-performing startups, it is not a one-size-fits-all solution. The approach should be tailored to the specific context of the fund, its access to deals, and its capacity to manage a broad portfolio. In the dynamic landscape of venture capital, a hybrid approach that combines the best of both traditional and index investing might offer a more balanced and effective strategy for navigating the high-risk, high-reward world of early-stage investments.