Sam Huleatt“Executives and investors commonly rely on their own experience and information in making forecasts (the “inside view”) and don’t place sufficient weight on the rates of past occurrences (the “outside view”).”
-Base Rates by Michael Mauboussin (PDF)
Michael Mauboussin and Annie Duke, two of the best minds on the science of decision making, frequently talk about the importance of “base rates”. Think of base rates as unbiased probabilities, or sources of truth: they are the probabilities that have historically proven to hold true.
Examples:
- 10% of people are left handed
- 50% of marriages end in divorce
As humans we are terrible at forecasting the future. We tend to be overconfident and overly optimistic with our predictions. Take the statistic that 50% of marriages will end in divorce: nobody enters a marriage thinking this static applies to them. If we acted rationally and created a strategy adhering to base rates, most people would start marriages with a prenup — but they don’t.
This same overconfidence and bias frequently plays out in venture and alternative investing:
“My friend was an early investor in Figma. I’m just as smart and connected as she is, therefore, I should also should start angel investing so I don’t miss out on the next unicorn”
“Everyone is making money trading NFTs. But unlike most of these *idiots* I actually know something about finance and art so I’m likely to crush it”
“Wow, Sequoia is investing in this deal on AngelList! Since they are a top 1% VC fund, this deal will likely be a winner, I’ll co-invest as well”
Sally previously invested in Plaid and now she’s suggesting I co-invest in a new fintech deal. She obviously knows how to pick ‘em so I’m investing double my typical check size!
We often ignore even well known probabilities and instead forecast with overly optimistic internal narratives, what behavioral economists refer to as the the “inside view”.
The best way to combat the trap of narrative bias is to hold yourself intellectually honest using base rates (a.k.a., the outside view). When I coach new angels, an exercise I take them through is starting from the assumption that the base rate applies to them (a.k.a., the assertion that most people are MUCH better off investing in stocks). I then put the onus on the individual to convince themselves they can outperform the base rate.
The technique of first looking at base rates (and then building a case for investment from there) applies to many areas of investing and strategy decisions.
Without a consideration of base rates, most investors are also prone to base rate fallacies.
As an example: the media loves to focus on stories of young technology founders. You’ve probably heard: “being a startup founder is a young man’s game”. This created a false narrative - or base rate fallacy - that the majority of successful tech founders are young. We might assume a base rate like 75% of first time VC-backed founders are under 25. In fact, the median age of a first time VC-backed startup founder is 31+ and the average tech founder is 40!
To my knowledge, no good collection of venture base rates published, until now.
Drumroll…*
General
- Investing on AngelList, a venture backed, seed-stage startups has a 2.5% chance of becoming a unicorn [link]
- Note timing matters: from 2018-2021 this probability increased 2x
- A “good” pre-seed startup should have a history of 5-7% month over month growth, with 10%+ being exceptional [link]
- On an annualized basis, the most exceptional SaaS companies revenue will “triple, triple, double, double, double” [link]
Angel Investing
(Note: historical data sets for angels are small and sparse)
- The larger the portfolio, the more likely you are to make money
- 50 company angel portfolio had a median IRR of about 10%
- Even with 50 companies, 11% of investors lost money
- Note: Angels can crush it. Investors in Uber turned $5,000 into nearly $25M. [link]
- Large returns (over 4x) generally take 10 years before liquidity [link]
- Most operator-angels expect an IRR of 30%+
- Most will achieve IRRs of more like 20% according to data
- Top quartile angels could hit 45%+
- More due diligence leads to better outcomes [Link]
VC Funds
(Note: more historical data is available for venture funds than angels)
- In venture capital (and angel investing) the strength of your network/access matters most:
- Kauffman Research has shown a GP with a top 1% network will have an average realized multiple of 10.86x.
- If network quality drops to top 10%, a GP’s expected multiple drops to ~6x
- Only 25% of funds will generate an annualized return greater than 25% [link]
- Only 1 - 4% of all venture investments return 10x+
- The average venture fund will perform worse than the stock market (with no liquidity optionality)
- Note: when evaluating new managers as an LP you must feel the GP’s edge can lead to outperforming 50% of existing funds – otherwise it’s not worth the trade-off.
- A professional investor (emerging manager) should expect the following follow-on or graduation rates:
Seed —> >35% should graduate to Series A
Series A —> >50% should graduate to Series B
Series B —> >50% should graduate to Series C
Series C —> >60% should graduate to Series D+
*Note: I will continue to update as I find new base rates