Most VCs missed exposure to crypto assets. How can VCs adapt to crypto?

9 min readMar 13, 2018

This post reflects my personal views on the current crypto market.

Since spring ‘17, I have been writing about the crypto ecosystem and trying to share some thoughts around investing in this new asset class as an institutional investor. If you are an investor or just keen to discuss crypto you can email me at ebrunet40@gmail.com or use https://earn.com/etiennebrunet/ if you want a quicker response.

Short summary for people with little time and who do not want to check my cool graphics:

2017 was a pivotal year for crypto assets, the crypto market is too now big to be ignored by investors
VCs need to adapt their investment mandate in order not to miss (again) return through protocol investments. As return from equity investment will most likely be always lesser than successful token investment. Network > Company
VCs need to adapt and change their investment process for crypto assets
Generalist VCs need to adjust their investment strategy and structure
Today, investors have five investment strategies to crypto: ignore, invest in Equity, invest in crypto fund, setup in-house team and change investment mandate or setup a separate crypto fund

2017 was a pivotal year for crypto assets, the crypto market is now too big to be ignored by investors

First let’s look at some (BIG) numbers:

Total network: The total network capitalisation of crypto assets started in 2017 at $17bn and ended at $565bn, or equivalent to a 33.2x increase in 12 months. (Source: Coinmarketcap)
Total Bitcoin daily volume transacted: $83m was transacted on January 1st ’17 vs $13bn on December 31st ’17. Now you get why all the exchanges have built just a massive war chest. Note this does not account for OTC transactions. This is only for Bitcoin also.
Tokens: There are now 1,500+ number of tokens compared to 624 tokens at the beginning of 2017
% Bitcoin share: Bitcoin on the first of January 2017 represented 88% of Total Market Capitalization. Interestingly, the total market share of Bitcoin reached 36% at the end of 2017 an is now around 42%
$1bn+ ICO: About 24 crypto assets have a market cap of $1bn+ (based on total number of units of the asset that have been created on the asset’s blockchain since the first block) and 32 if you account for total numbers of units a la OnChainFX
ICO: About $3.8bn was raised through ICO in 2017
ICO returns: ICOs delivered at least 3.5x more capital to blockchain startups than VC since 2017
VC Funding & M&A: Coinbase raised at $100m at a valuation of $1.6bn, Ledger raised $75m and Circle acquired Poloniex for about $400m. These are not ICO deals but proper “company” transactions
Pre-sale: Since the beginning of 2018, Telegram raised $850m in pre-sale from Tier I investors as a pre-product, pre-launch, pre-revenue, pre-token company. The company may look to raise further funding through another pre-sale round and expect to raise $2bn in total funding

Great. Now you get it. Enough money has been raised and transacted that VCs should care about this asset class.

Note: All the network market cap are based on total number of units of the asset that have been created on the asset’s blockchain since the first block. This is the most common way to compute market cap at the moment. As my point was to highlight growth rather than building an index, allocated % in a portfolio I think this method is fair.

Most VCs missed exposure to crypto assets.

Early crypto retail investors have made a fortune. Early crypto hedge funds have generated substantial amounts such as Pantera Capital which delivered a 24,004% return between its launch in ‘13 and December ‘17. Most of the quant funds and family offices have been able to capture some of the crypto asset returns as they have a more open investment mandate and experience in investing in liquid and alternative assets.

Some astute investors such as Founders Fund took the bet to invest directly in Bitcoin and others like Ribbit Capital (Nikolay Kostov), Benchmark and Union Square Ventures were early investors in crypto funds, respectively Pantera Capital and Polychain — making them happy LPs.

However, most generalist VCs have missed exposure to crypto assets. Post the 2013 boom, some VCs made few investments in Bitcoin application companies. Even though some segments such as Exchanges (Coinbase, Bitstamp), Payment (Abra, BitPay) and Custody (Ledger) have seen up-round, a simple buy & hold strategy in Bitcoin and Ethereum would have generated higher return.

At the same time, most of the investment in private blockchains seem too early to be assessed due to the long sales cycle, except for Ripple which is doing well thanks to its token.

The lack of M&A in Bitcoin and Blockchain companies have been major challenges for VCs. Though, some M&As have recently started to kick-off such as BitGo/Kingdom Trust, ShapeShift.io/Keep Key and Circle/Poloniex. With large war chest, it seems very likely that Tier I exchanges will enter an M&A phase to consolidate their market share and expand to new market (e.g. custody). A recent sign of this trend is the appointment of Emilie Choi as new head of corporate development at Coinbase. Having said that, the potential return linked to an equity investment in a company is likely to be lesser than a successful investment in a network.

VCs need to adapt and change their investment process for crypto assets

With 1,500+ token based companies, it is very difficult to select which ones have a real business model and could be a good investment target. Token based companies are different than classic early stage technology investments. See below the major differences:

Sourcing: Projects are often very early stages and entrepreneurs are not only based in major cities but around the world
Evaluating: Investors need to adapt their due diligence with more attention to team, community, technology (code review) and token mechanism / token economy
Investing: VCs need to pay attention before ICO to % of token issued, discount, lock-up etc.. When the token is launched, the network valuation can be very volatile
Valuation: We are at the very start of understanding how to value crypto assets. Early projects use quantity theory of money “MV = PT” very different from cash flow projection and still very early days to have a proper framework
Governance: VCs do not have board seat and the usual governance rights through token investment. Hence, there needs to be a strong and lasting relationship between investors and entrepreneurs
Supporting companies: Protocol based companies have a massive importance the first years of inception and need support and not just “few good intros”
Exit strategy: VCs are not used to exit public position, hence publicly traded tokens are challenging for VCs. How much to sell? When to sell? What are the execution risks associated?

Generalist VCs need to adjust their investment strategy and structure

In addition to their evaluation process, Generalist VCs need to adapt their mandate and investment structure in order to be able to invest in both Equity and Tokens.

Thanks to ERC20 Token, FOMO and low interest rates, it seems that it has never been easier for crypto entrepreneurs to raise funding, money has really become a commodity. Having said that, recent SEC subpoenas and challenges around KYC/AML process push crypto investors to adopt a staging investment process instead to simply do a public ICO.

“$180 million worth of capital was raised by projects that had initially planned a public sale, but eventually cancelled it and raised privately.” January 2018 TokenData

As soon as a team and vision is formed, crypto entrepreneurs look to raise a seed round ($2–5m) from specialised crypto funds (a la Polychain, Metastable, BlueYard Capital) and may include a generalist seed/Series A investor. The investment is generally made through equity (Great no headache around token custody) with a clause allowing investors to get an allocation in a future ICO. These investors will help the founders to refine their token economy, support hiring talents and other cool stuffs.

Once the whitepaper is written, the code partially written (kudos if they share it at this stage on GitHub) and a legal structure is in place, some companies may want to raise a larger pre-sale. In this round, crypto funds, family offices and generalists VCs will often invest and may get a discount. Finally, the token company may want to do a final public sale or just simply an airdrop to its users.

How can VCs adapt to investing in crypto?

Today, investors have five investment strategies to adapt to crypto:

Ignore: Most investors don’t understand crypto nor blockchain. They feel little urge to take a risk in a new area when they have nailed down how to invest in marketplace and SaaS companies. On top of potentially missing return, they face the risk not to take the opportunity to learn about a new sector that could disrupt their current portfolio companies.
Equity Investment: Few VCs made early bets back after the first major public crypto boom back in late 2013 with equity deals such as Blockchain.info, KnCMiner and Circle. However, due to a lack of M&A and low activity in 2014 to 2016, most them decided to ignore blockchain and bitcoin. Now, these VCs are back into the game but face a major challenge: they are only a handful of good companies raising through equity. Alternatively, some interesting assets are seen too expensive such as some exchanges. Investors are moving into cash pre-sale like Telegram offering the opportunity to invest in cash rather than tokens.
Invest in crypto fund: This is very new but some VCs have become fund of fund. For example, out of nowhere Andreessen Horowitz has become one of the top crypto fund of fund with investments in Polychain, Metastable, Blocktower and more recently Multicoin Capital. They are hedging themselves, building a strong community in the early days of a new sector and learning from the best teams. Very smart. Although, they have to bear the management and success fee...
Set up a specific team and get approval from LPs to do both equity and token deals: Most top US funds have now a “crypto guy/girl” such as Alexander Pack at Bain Capital Ventures, Matt Huang at Sequoia capital or Jesse Walden at Andreessen Horowitz. These funds have understood that they need to allocate more time to crypto and that the Fintech guy/girl checking Coindesk once per week and who goes to cool events cannot really do that much. The top challenges for VCs are to find such talents and to have the support from all partners as there is always on partner less enthusiast about crypto, “Yes Blockchain. No Bitcoin. Why Token?”.
Setup a separate crypto fund: Though there are 220+ reported crypto funds, if you really look at the list there are only 15–20 real institutional graded funds such as Polychain, Nick Tomaino and Digital Currency Group. Most of the others are disguised family offices setup by crypto millionaires. Setting up a crypto fund has fantastic upside opportunities but only few have a real long term competitive advantage and lesser will be able to create a platform. Moreover, at the moment most of them are just a “one man/woman show” rather than a proper investment team with support and resources.

Thank you for reading my post.

Don’t forget to share with friends and your bitcoin early adopters colleagues!

Best,
Etienne

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