I think most people allocating to crypto VCs don’t really know how to evaluate them.
TradFi people don’t know how to spot a good crypto VC investor. Crypto natives have no idea what it takes to run a fund. Even institutional allocator consultants like Albourne are still figuring it out in crypto. And average retail participants know almost nothing about funds in general.
The materials you receive from a fund are not going to include all the information you want — or need — to know. You get a deck, you get a one pager, maybe there is some longer form writing about the thesis. That’s about it.
But you also get calls with the team, you can email them questions, and you can ask them to fill out a DDQ. It’s on you to ask good questions — which is why it’s important to have a framework.
Here’s what I’d think about when evaluating a crypto VC.
-operational due diligence
1. Investment Thesis
A fund’s investment thesis articulates the perceived opportunity and the plan to take advantage of it. In VC especially, this usually involves some insight into the future — we believe x is going to happen, and so we’re looking to invest in y.
Early crypto VCs were generalist funds that raised money on a simple thesis: it’s early. We believe blockchain will see explosive growth and transform industries, and we’re looking to invest in it.
Years later, we understand that while blockchain might be transformative, it’s going to take a lot longer than we’d like. At the same time, the crypto ecosystem has grown vast and complex enough that “generalist” often signals inconsistent or low-nuance knowledge across a lot of space.
Now that “blockchain is about to explode” doesn’t work and saying you’re a generalist that invests across infra, defi, payments, NFTs, and gaming raises more questions than it answers, I expect a fund thesis to be a little more focused and substantive.
A good investment thesis should feel insightful. Be careful about over relying on track record given how much the dynamics for crypto VCs are changing.
There’s a balance with an early-stage fund. Too specific or granular a thesis may mean that the opportunity set is small and the return profile is skewed to an extreme. Too broad a thesis and you’re forced to trust the team not to chase whatever the flavor of the month is.
A very high-level example of a non-generalist thesis that’s popular now: the crypto infrastructure required for mass, mainstream use doesn’t exist yet, but it will — so we’re looking to invest in the [insert various infra subsectors] solutions that can scale crypto to [some number of] users. To be clear, you’d need to put a lot of meat on that skeleton for it to become an insightful, substantive thesis — or really a thesis at all. Good infra deals are now among the most coveted and competitive, and infra funds are becoming more popular.
Access refers to the ability to get into competitive deals — with sizable allocations. If the fund has poor access and is relying on low and mid-tier deal flow, it may not matter how good the thesis is. They’ll end up making too many investments and/or sizing up in some very mid stuff (both bad for returns).
Most of what’s being built in crypto is either garbage, too early, or a knock off with a twist nobody cares about. Riskless regulatory arbitrage — i.e., buy anything in a private round and dump it on retail at a multiple, almost guaranteed — no longer exists. Great opportunities are very limited. There are very few signals among a lot of noise, and VCs need to be able to not only find them but get access to them as well.
Access is based on the fund’s name/reputation, the team and their network, their value add (if any), their likability, their presence at conferences and events, etc. Find out how they source their deal flow and what it’s like. Ask for their pipeline.
If it’s not the manager’s first fund, you can look at previous investments and that should give you a decent sense, but if it’s a new manager you’ve got little to go on — and this is very important. Having your own network and presence in the industry, including at conferences and events, is probably the best way to understand who they are and where they stand among founders and other VCs. Ask around about them.
3. Fund Construction
Knowing the thesis and having a sense of their deal flow, you can consider the size and target number of investments in context.
If a fund is targeting a $30m raise and plans to make ~40 investments, the average check size needs to be ~$750k. If that fund has a 4-year investment period, it needs to average 10 investments per year.
How much opportunity do you think there is within their thesis? Have they shown they can get $500k-$1m+ allocations in those deals? Can they lead a round? Can they average nearly an investment a month?
You should also know the stage and valuation range they are looking to invest in. That’s a given, but that info is particularly relevant here.
This is an important part of the evaluation. It’s not an exact science, but you should try to gauge whether their fund size is out of balance with their access to good deals that are within their criteria. If so, they’ll end up needing to fund garbage, write 100 checks, or drift on strategy to fully deploy.
You should be able to see at this point why smaller funds with good access are the sweet spot for LPs — and why Paradigm raising $2.5B was such a questionable move.
4. Portfolio Management
For the sake of clarity, let’s split this into two sections. The first is about managing and supporting active investments; the second, liquidity — or exiting those investments.
Contrary to popular belief, there is a lot that a VC can do in the time between when the investment is made and when it is sold.
First and foremost, a VC can participate in governance or stake tokens to secure the network, depending on the investment. Find out how active and sophisticated they are on these fronts. But this is pretty low stakes.
There are a variety of ways that a VC can help its portfolio companies in a more meaningful way, whether it’s with the idea itself, or finding talent, or making important industry connections. Good VCs will recognize constructive ways for their portfolio companies to work together to achieve their goals and facilitate those collaborations.
This part is tough if you’re talking about a new manager, but if there are previous funds, look at the portfolio and see if you have a way to talk to any of the founders. If you can talk to someone at an investment they marked to zero, that may be especially enlightening.
Ask about exiting positions, because it’s a fantastic way to gauge how experienced and sophisticated the team is and how carefully they’ve thought through the lifecycle of the fund.
In traditional VC, a fund typically gets an exit opportunity, or “liquidity”, on a small percentage of its investments. Crypto (token) VC is unique because all or almost all the investments are going to become liquid, or at least to some degree.
Take the hypothetical $30m, 40 investment fund mentioned earlier. If their investments perform well, they could end up with a $100m+ portfolio of 30–40 liquid assets. That’s a little simplistic, but the point is that managing that part of the fund’s life is very different, and it’s not something trad VCs have to be so good at.
What are their frameworks for deciding when to sell? What strategies will they employ? What’s their execution like on open market stuff? What OTC desk relationships do they have? Have they used forward contracts? Are they going to make in-kind distributions of tokens? Do they have any broad portfolio hedging strategies? Does that include using derivatives?
I think you can usually put a crypto VC on his or her back foot if you’re sophisticated enough to really press on the thinking about both timing and execution of exits.
At this point, you’ve got a good sense of what the fund is trying to do and how they plan to do it. You’ve assessed the team indirectly by evaluating their thesis, their access, the size and number of investments they’ve chosen for their fund, and how they think about exiting.
Now you have to decide whether this group of people can execute the plan they’ve laid out.
I learned how to think about fund management from working at good tradfi funds. There is a lot of wisdom and institutional knowledge to be leveraged from that world. In my opinion, there is no replacement for that experience.
However, as I’ve said elsewhere, crypto fund managers tend to either be crypto natives who have no experience in fund management or tradfi fund people who aren’t crypto native.
I think being crypto native is probably more important for crypto VC investing. Ultimately, access and deep understanding of the ecosystems and the technology are how you find winners early. You could be really buttoned up tradfi people doing everything right, but if you aren’t part of the community your deal flow is probably worse, and your pedigree won’t necessarily matter.
But if the VC is founded by crypto natives, I’d like to see them bring on someone senior who has institutional tradfi fund experience on the operations side — most likely a CFO, COO or a GC/CCO. There is more that happens behind the scenes than you probably realize, especially as the business gets larger. These people keep the train on the tracks and know how to operate and scale an investment management business better than crypto natives do.
Operational due diligence (ODD) is not only necessary, but valuable — and yet it is apparently barely a thing in crypto. It should be clear by now that this is an industry-wide issue.
ODD helps you understand whether the fund has appropriate resources (internal and external), processes and controls to execute on its strategy while avoiding a variety of risks to itself and its investors. This is part of “ok, they have a good plan, but can they actually do it?”
ODD could be a thread of its own. When you deal with the most buttoned-up, institutionalized allocators in the world investing at scale — pension funds, endowments, sovereign wealth funds, and their consultants — ODD is a full cavity search. Trading, Ops, Finance, Legal, Compliance, Risk Management, Technology, Information Security. Everything.
Point being, ODD can be wide ranging:
Provide formation certificates and governing documents for all entities in the structure. Provide an employee list. What is your process for approving an investment, is there an investment committee? If so, who is on it and how does voting work? Where does the fund custody its assets? What are the security procedures around your wallets? Around the exchanges you use (and please list the exchanges)? What are the procedures for transacting on-chain? Who is authorized to execute transactions? What are the cash controls? At what banks do you maintain accounts? Who is outside counsel (onshore and offshore)? Auditor? Compliance consultant? If you have previous funds, show us their performance. Show us recent investor letters. Show us sample investment memos. Who owns the management company? Please provide structure charts. Also provide KYC documentation for anyone who owns >25%. Have you had any inquiries from or correspondence with regulators? How are expenses allocated between the fund and the management company? Who bears the fund’s organizational expenses? What has the expense ratio been like in your other funds? How much money have the GPs committed?
This could go on nearly forever. I think a lot of what’s above should be asked most of the time in crypto.
At this point, you like everything you’ve seen, and you want to invest. Now it’s time to review the documents and terms more closely. This typically includes a Private Placement Memorandum (PPM), a Limited Partnership Agreement (LPA) and a Subscription Document. You’ve likely had access to the docs and known the general terms of the fund from very early on in your process. But there is nuance here, and you want to know more than just “2 and 20”.
Management fee. Typically, 2%. I’ve seen 2.5% for a small crypto fund. A reasonable thing to look into is whether the fund will continue taking full management fees after the investment period is over. There’s a decent argument for the fee to be reduced at that point if the manager is large enough.
Performance fee. Typically, 20% of profits. Also known as “carried interest”. In some cases, performance fee is higher above a certain hurdle. For example, a fund might take 20% up to 5x net and 30% on any returns above that. Performance fee is usually straightforward in crypto VC, but can get complicated in different contexts — waterfalls, preferred returns, hurdles, etc. Important to understand how it works, because it affects the return profile.
Reinvestment: Can they reinvest proceeds from other investments if still within the investment period?
LPAC: Is there a Limited Partner Advisory Committee? Who is on it and how frequently will it meet? What kind of issues would the LPAC be approached about?
Fund Life. How long is the total life of the fund? How long is the investment period? Do the docs provide for any extensions, and if so, is any LP or LPAC consent required? You want to understand what happens if the fund reaches the end of its expected life and is still holding illiquid investments.
Permissible investments. Is it a pure token fund? Will they make equity-only investments as well? Can they invest in other funds? Can the fund use derivatives for hedging purposes? Some of this should have factored in earlier in the process.
Side Letters. Ask if there are any. The fund’s general partner can make side letter agreements with certain investors to give them more favorable terms. Find out if there are any strategic LPs or if anyone has better terms than you in general.
You can keep going down the line, but the point here is, the last thing is to make sure you completely understand the fees, the timing, and the fund’s investing constraints. They should make sense in context.
If you can make it through this framework with a crypto VC, get straight answers, and end up feeling that they sounded thoughtful, knowledgeable and prepared across the board — you’re probably talking to one of the better funds in the space.
If you’re an investor or fund manager and want to discuss any of the substance here in more detail, feel free to reach out on Twitter!