Crypto Venture Capital: Hic Sunt Leones
Venture capital (VC) is always at the forefront of progress. It is the SWAT of the investment business and the riskiest funding soldiers of fortune. And fortune is only one piece of the success formula that VCs continue to upgrade constantly. This almost-closed club knows the price of failure and victory. Its battle-hardened members seem to have the keenest sense of smell for ROI — VCs have entered the crypto world with confidence.
General VC Landscape
Let’s take a look at the motherland of crypto newcomers: the traditional VC landscape. Is everything okay there, or are any factors causing VC funds switch from classical model and investment sectors in favor of the crypto abyss?
This is all about money: 41.1% growth with a little shift in the early stages is evidence of strong supply in terms of financial resources. What about projects?
Here, it’s almost the same YoY growth — 40.1%. But the feature that stands out in VC’s 2018 year is a nine- or ten-figure venture-funding rounds. This was a rare event in 2017. That is the past, and here is the present:
Please take a look from another period angle:
It is great to find crypto teams among the supergiant league: Robinhood, the zero-commission stock trading and cryptocurrency app headquartered in Menlo Park, is #6 in terms of top VC funding rounds in 2018. The crew raised $363 million in their Series D round in March 2018 (with Digital Sky Technologies as the lead investor).
We can state that we are seeing strong financial-resource flow growth, which proof is the number of successful rounds VCs completed to fund their activity during 2018. For example, the summer of 2018 was hot for three market leaders, which collected $4 billion in total:
- Lightspeed Venture Partners (LVP), an early-stage investment firm with an 18-year-old team, got $1.975 billion, and crypto was in the headlines because of of LVP’s focus. It should be mentioned that $175 million got LVP’s APAC branch, based in India. It was founded in 2004, and has had only two rounds as of yet — in 2015 ($135 million) and July 2018 ($175 million.) We will come back to international activity (and resource allocation) as a must-have-part of a successful VC fund strategy — the trend in 2018.
- Index Ventures, with a 22-year-old team, closed 2 funds for $1.65 billion in total: $1 billion for growth rounds, and $650 million for early-stage investment.
- Scale Venture Partners, an 18-year-old company, raised $400 million. This former branch of Bank of America’s venture capital arm pushed its AUM to the level of $1.8 billion.
There is an age factor in the teams’ descriptions from the three examples above. And each of them represents a golden era at the beginning of the current century. But take a look at the changes within the industry based upon the age factor:
It would be fair to state that we are seeing a certain rejuvenation in the industry. Of course, this is partially caused by its internal nature: funds are born, reborn, and closed by its parental creator. But we will need to pay attention to the crypto factor, too, as soon as the VC funding boom is powered by growing demand from crypto projects, also. VSs’ funding supply response was $4 billion in 2018–4x comparing to 2017. And that brings challenges and changes into the VC ecosystem, as we will see below.
VC has no lack in terms of resources. They even get it from investment objects, as in the Ripple case: it invested $25 million (in XRP) into Blockchain Capital, one of its own investors.
Super-giant funding rounds are called to meet growing supply part to allocate funds limited partners have as a widely available. Availability is a critical factor to focus on — this plays an active role to reshape VC, not only as a check producer, but e.g. competence and international network owner (we will come back to this soon). Crypto is hunting for a value-added offer, which is a more of a limited one rather than the money itself!
Let’s take a look at the VC industry sector, which has adopted crypto as the core of its investment activity.
VC’s Crypto Alley
The first nine months of 2018 brought us $12.3 billion (according to Fabric VC) in total ICO volume. Excluding Telegram ($1.7 billion) and EOS ($4 billion) heavyweights we got $6.6 billion.
$4 billion represents total VC funding (according to a new Diar report) into the crypto ecosystem in 2018, which is 60% of “net” ICO turnover. So don’t believe anyone who says there is no big money inside the crypto industry — there is enough, and more.
2016 — $667 million; 2017 — $1 billion (x1.5); 2018 (Q1-Q3) — $3.9 billion (x3.9). It is more than evident that VC had sufficient motivation to switch resources into crypto projects. The top VC funding rounds in the crypto industry are listed below:
Please note that the largest deals in 2018 raised more than $1.3 billion, with most of these deals representing traditional equity investments. The only exception was DFINITY, which had a native utility token. Equity investment is a part of VC’s old-school attitude, but it is evolving. Moreover, there is a totally new formation of investors who are able to understand crypto — the formation of brave enough to place a risky stake and put all of their resource eggs into one crypto basket.
The Digital Currency Group (DCG) is the best example of the one and a definite market leader. It is a VC firm with a single focus on the crypto industry:
- 157 investments, which is more than twice the amount of its two nearest competitors (Pantera Capital — 76, Blockchain Capital — 75)
- 105 portfolio companies
- 20 exits, which is a fantastic indicator for a classic VC, taking into consideration that DCG is a three-year-old company.
This team represents a totally new attitude in venture capital, taking into account the specifics of the crypto industry. It plays on both the equity and token side, which includes currencies. According to Founder and DCG CEO Barry Silbert, the company has 50% in Bitcoin, 25% in Ethereum Classic, 15% in Zcash, 5% in Decentraland, and 5% in ZenCash (as of July 2018).
There is strong evidence of turning VC in the direction of the crypto alley. Crypto projects are welcoming new resources and successfully whetting VCs’ appetites:
This kind of VC’s positive response is a good sign: VC has interest, and is feeling the competition of its counterparts. Thus it is ready to raise its stakes within a brand-new crypto game. But it is not enough to utilize the potential of both sides (crypto project and investor). There is a number of challenges to face and changes to implement from both sides in order to get the maximum result out of win-win cooperation between the crypto world and the VC industry.
Crypto VC Upgrades
Crypto companies represent brand-new technology, and they are developing a market that did not exist several years ago. It’s all about shifting the market paradigm from competition to cooperation. Crypto is a new class of assets to deal with. Its characteristics are different from the current assets VC has in use, while VC has a stable model and a fixed set of tools with which to operate. Tools, internal structure, funding structure, network capacity etc. — all must be upgraded in accordance with the new reality.
Multi-Layer Approach
VC often uses a multi-layer approach to propose different products and reach different target audiences (and share risk or generate better performance). This refers to VC in general, and crypto VC in particular.
Crypto VC
Take, for example, DCG’s subsidiary, Grayscale Investments LLC, which was established in 2013. According to the Q3 2018 report, the company has raised more than $330 million in the current year.
“Grayscale Investments, LLC (“Grayscale”) is the sponsor of Bitcoin Investment Trust, Bitcoin Cash Investment Trust, Ethereum Investment Trust, Ethereum Classic Investment Trust, Litecoin Investment Trust, XRP Investment Trust, Zcash Investment Trust and Zen Investment Trust, and the manager of Grayscale Digital Large Cap Fund LLC. The trusts and the fund (collectively, the “Vehicles”) are private investment vehicles, are NOT registered with the Securities and Exchange Commission (“SEC”) or any other regulatory agency in any jurisdiction, and are NOT subject to the same regulatory requirements as SEC-registered exchange traded funds or mutual funds…”
DCG’s goal was to propose trade in the digital currency asset class for institutional investors. It has reached its target. The Grayscale example shows how crypto can be traded via trusts. These trusts are funded by institutional investors: 59% of investments flowed into the firm from that group throughout 2018, while 73% of monetary inflows in Q3 came into the firm’s Bitcoin Investment Trust.
Thus, there are three layers within DCG, and each proposes its own unique product:
- DCG itself,
- trusts for trading cryptocurrencies via single-asset investment products; and
- the Digital Large Cap Fund. This is a pocket fund — the AUM is $12.2 million — that enables investors to enter a ready-to-use diversified mix of digital assets through a traditional investment vehicle (without the challenges of buying, storing, and keeping digital assets).
This was the creativity crypto-focused VCs brought into the industry. Now let’s take a look at classic VC behavior in the context of flirting with crypto.
Classic VC
Funding leaders do their best to be in the right place at the right time. These firms must do their best, however, to maintain their performance and keep their brands free of the bad luck crypto still has in those circles (and among the firms’ LPs).
Classic VCs are more than ready to proceed with the crypto experiment, but they are choosing appropriate structuring, which lets them separate previous accomplishments from new beginnings. There are three options for accomplishing this:
- Spin out — this one takes the longest. It has no well-known example on the market, but it is still an option (as well as staying away from crypto in general).
- Carve out a pool of resources within a preexisting fund. The next step proposes two options:
- manage the pool independently
- invest it into another fund
3. Launch a new fund.
Lightspeed Venture Partners (LVP), the firm behind Snap unicorn, is a good example of looming changes on the market. There are internal deliberations regarding how to set up the company in order to go into crypto. It is not an exception but seems to be the rule that nearly every top-tier investment team is struggling to structure itself to develop its crypto wing.
LVP is going to follow the “carve-out” path. This attitude is not a new one for VCs: it is well used, as in the Kleiner Perkins Caufield & Byers case, when the iFund was set up to invest in Apple-related projects, or when Accel set up Big Data Funds to invest in aligned startups.
“Carving out” is the most probable outcome for the Lightspeed crypto initiative, which will be based on its newly-raised fund. It will reserve some of the cash exclusively for crypto deals rather than creating an entirely separate fund. The situation, however, has been fluid. LVP’s first move in the crypto field has been rather successful in terms of the investment object — Basis. This could whet the appetite and bring a new crypto project to the VC market.
This could happen due to an effort led by LVP’s partner, Aaron Batalion, who is going to drastically scale up the firm’s activity within the crypto space. The company is ready to support and back its employee with the launch of a new fund to be spent solely on crypto investments. It is important to notice that Batalion is going to launch a crypto project of his own, which won’t carry the LVP brand — it is about dissociation (for a probation period, until crypto goes mainstream.)
It should be mentioned that partners’ stepping down activity is a good-enough attitude to disguise new beginnings of VC firm. For example, Dr. Beth Seidenberg left Kleiner Perkins Caufield & Byers to start her own firm with a focus on biotech and health investments. The result was $320 million in funding for Westlake Village BioPartners to incubate and invest in early-stage life-sciences companies. Whether or not a move like this represents a real switch in one’s career or functions simply to cover the company’s tracks in the direction of new experiments remains to be seen.
Andreessen Horowitz (a16z), one of the leading VC firms worldwide, closed a dedicated crypto fund from a subset of its limited partners, who provided the firm with $300 million in June 2018. This fund is not solely focused on crypto, but it is powered by two key professionals whose track record indicates Andreessen’s ambitions within a brand-new industry mostly.
Katie Haun is leading the fund, with general partner and well-known crypto enthusiast Chris Dixon. Haun is an ex-federal prosecutor with the U.S. Department of Justice (DOJ), where she spent 10 years and focused on fraud, cybercrime, and corporate compliance (working alongside the SEC, FBI, and Treasury.) She was also the DOJ’s first-ever coordinator for digital assets, and led investigations into the Mt. Gox hack. Katie was part of the task force that investigated (and ultimately took down) the online drug marketplace Silk Road. She’s a director on the board of Coinbase, which was backed early on by a16z, and is where Haun got to know Dixon (who is also on the board). Assignments speak more than press releases, don’t they?
We should understand that VC is working with a conservative public. Thus, launching specially-themed funds is a way to attract a certain type of limited partners, who are ready to dive into high risks and huge potential gains. Moreover, the majority of funds operates under the venture capital exemption to Dodd-Frank, which means they are limited to 20% of its holdings at a cost in “non-qualifying” investments, which includes crypto tokens. This is not an issue in a specialized crypto fund.
Competence Outsourcing
A bad experience (in crypto in particular) for a classic VC means damage to its reputation, first of all. On the other hand, nobody wants to miss the opportunity — fear of missing out (FOMO). There is a compromise solution: invest in third-party funds.
This trend can provide a huge boost to crypto-focused VCs. Competence is extremely valuable, and the crypto industry is a very young one to provide investment companies with sufficient and top-quality human resources. Thus, crypto-focused funds can take advantage of a situational opportunity to raise money from investment colleagues. This is all about advantages — as soon as LPs are more time- and cost-consuming as a result of lower capital concentration.
“We see a lot of upside to keeping it under the same roof,” says Albert Wenger, Managing Partner at Union Square Ventures (USV). The team is taking a long-term bet on crypto, but it will not break out a separate fund to do so. The company has its own investments in crypto (Coinbase, CryptoKitties), but it goes to an outsourcing model for the most part, and develops a pool of investments into a number of funds.
Multicoin is the sixth crypto fund the firm has invested in over the last two years. It joins the list of other crypto focused funds in which USV has invested previously: Blocktower Capital, Polychain Capital, Metastable Capital, Autonomous Partners fund, and Placeholder. This type of strategy and funds’ portfolio provides USV with diversification of risk and much broader penetration into the crypto industry rather than taking crypto steps on its own. VC also benefits from a shared flow of information with its partners.
Union Square Ventures is not new to this type of approach. Polychain Capital was backed by USV and Andreessen Horowitz in 2016. This was the first round after angel funding, and it had $10 million in total. In 2018, Polychain Capital attained the status of the first $1-billion crypto fund. That is the dynamics and success VC is looking for.
Cooperation
As well as businesses can find its solutions for climbing into the crypto sky due to blockchain consortiums VC funds can also go into different types of cooperation.
Strategic Partnership
Sweet couple of Union Square Ventures and Andreessen Horowitz has participated together in 11 deals since 2013. The latest joint investments from both companies are OpenBazaar and CryptoKitties.
The most prominent deal of these market leaders was Filecoin, a project born from the acceleration provided by a $120,000 check. The campaign is outstanding because of two key points:
- Volume: $252 million was collected via ICO ($200 million in the first half an hour) and the presale stage ($52 million); it was the biggest ICO funding for that period of time.
- Structuring: it was the first regulated (strictly U.S.-focused) ICO that allowed the participation of accredited investors.
To comply with SEC and FCA security regulations, the team used a private offering exemption available under Section 4(a)(2) of the Securities Act and Articles 48–50A of the Financial Services and Markets Act 2000 (Financial Promotion) Order of 2005. By restricting the offering to accredited or high-net-worth investors, the issue was not subject to registration or review requirements.
Protocol Labs (which stands behind Filecoin) initiated the offering to potential investors via a Simple Agreement for Future Tokens (SAFT) and an accompanying offering memorandum. The SAFT investment model means accredited investors acquire the right to purchase future tokens once the project is fully developed and launched. That was just a brilliant precedent for the whole market!
Regulated status brings challenges to the project in terms of potential investor audience. Despite the decentralization behind Filecoin, it did not go to the crowd. That put the project on thin ice: the first regulated ICO campaign with no crowd behind it, and no gray/black-market crypto investors. And the latter had been dominant for a long period (until that moment). But there was a strong component of VC cooperation, however, which played a critical role in terms of both regulatory compliance and promotion:
- Regulatory Compliance: Classic VC is not new on the market, and thus has tremendous experience in structuring deals. Classic VC has good contact with state bodies, including the SEC. Union Square Ventures and Andreessen Horowitz visited the U.S. Securities and Exchange Commission for a private meeting to discuss the exemption of blockchain-based tokens from the agency’s oversight in April 2018, a few months before the Filecoin ICO (while it was in the preparation stages). This was no coincidence, to be sure. So who is pushing crypto forward?
- Promotion: To push the main sale for accredited investors, there should be strong opinion base and funding background. Andreessen Horowitz and Union Square Ventures was a great initial base to join for a number of investment industry heavyweights like the Digital Currency Group, Sequoia Capital, Winklevoss Capital, and dozens of others resource owners.
It should be noted that following market leaders and their deals is a ready-to-use strategy for the individual investor, too. The presence of top-layer investment players is a quality mark which is the result of the deep and long analysis companies complete before entering into a project.
Competence-Based Joint Ventures
The Basis project (stablecoin) is a good example to demonstrate the advantages of the competence-based joint ventures VCs use to get the best results.
$133 million in funding (April 2018) was the premier in terms of investment in tokens for several teams: Lightspeed Venture Partners and Bain Capital Ventures, the venture division of Bain Capital (and the Digital Currency Group investor), which recently raised its biggest amount at $1 billion.
Bain Capital Ventures led Basis’s round to provide financial resources with a number of heavyweights like the Digital Currency Group, Andreessen Horowitz, MetaStable Capital, 1confirmation, Pantera Capital, and PolyChain Capital.
A number of USV’s portfolio companies have held or are holding ICOs, including the social-media platforms YouNow and Kik. Furthermore — and perhaps as a hedge — both Andreessen and USV have invested in cryptocurrency hedge funds as equity investors (Polychain Capital) and deployed capital as limited partners (MetaStable), giving them broader exposure to token markets.
Google Venture was among the investors in Basis, too, but again, it was less about money resource but its best competence to share with the project — technical one. Alphabet’s venture team built the bridge between the $133 billion project and its best developers.
Valor Capital participated in Basis funding. It positions itself as “…the pioneer cross-border venture fund bridging the U.S. and Brazilian technology markets.” The key role of this participant is to open a huge Latin America market for Basis as a product.
International Cooperation
The VC world knows it for sure that adoption of a product or service means business development and therefore returns. Crypto funds share in this understanding. Valor Capital’s participation is evidence of the presence in the project of a component to boost Basis in a certain market. But there are going to be international cooperation-focused teams in which the international component is the core, but not a component.
A trade war is taking place between two leading economies: the U.S. and China, two leading countries representing West and East. So it is more than a pleasure to find Dragonfly Capital Partners, which is building a bridge across the West-East abyss.
Dragonfly Capital Partners is a newborn $100 million fund with a focus on crypto investments. It announced its launch in October 2018. Dragonfly’s mission is to “bridge the gap between East and West in the crypto economy.”
There are two key leaders in the founding team: managing partners Bo Feng and Alexander Pack. Focus your attention on the fact that Pack is not a newcomer to crypto. Alexander previously managed crypto and fund investments for Bain Capital Ventures, and was a general partner investor in Polychain Capital. No assumptions, but this group of VCs seems to have established a solid basis to gain significantly on U.S.-Asia cooperation in the context of crypto.
And the group is a solid too where the Western team includes: Salil Deshpande (Pack’s Bain Capital Ventures old boss, Forbes Midas List member), Andreessen Horowitz (co-founder Marc Andreessen), Chris Dixon (Andreessen’s crypto fund co-leader), Cyan Banister (Founders Fund), and Olaf Carlson-Wee (Polychain). The Asian team includes the founders of Baidu, Meituan-Danping, Meitu, and China Renaissance Bank, Midas List VCs Neil Shen (Sequoia China) and Bob Xiaoping Xu (Zhenfund). Strategic investors like OKEx and Bitmain have also joined.
Since early 2017, there has been a new trend in the U.S. in which a number of Asian funds have become actively involved in early-stage crypto investing. According to a Wall Street Journal analysis, Asian investors directed 40% of a record $154 billion in global venture financing, while their American counterparts contributed 44%. U.S.-based deals by venture capital and tech investment firms made up of $67 billion in venture financing, while $61 billion was led by Asian investors.
It only took ten years to boost Asia’s share from less than 5% to the current level. Thus Dragonfly can be seen as an experiment to take control over the shift from one side and dive oppositely into the Asian market with all of its tremendous potentials.
In any case, it is an extremely useful initiative in terms of two leading global economies that are critically influencing the rest of the world in the area of crypto adoption. It is not only about funding a portfolio of more than 20 companies that are ready to onboard investments already (like Spacemesh, Basis, and Oasis Labs), but setting the global trend that crypto VC will follow in the near future.
Conclusion
The classic VC and crypto VC markets are both showing good dynamics in terms of growth. It’s great to see not tiny tries but strategic moves from market leaders. They are ready to meet new challenges and act accordingly. There is a rare example when top-tier classic VC did not provide its position regarding crypto investment, in word or action.
Thus, it would be fair to state that clarity is now a characteristic of crypto perspectives to turn into regular investment tool.
Crypto-specialized funds are gaining momentum. If one has highly-qualified expertise within crypto and (preferably but not must have) a proven track record it attracts the necessary financial resources to manage.
The truth is, there is no lack of resources on the market — there is a lack of competence and professionals, passionate leaders who are able to feel the market’s heartbeat, to contribute market growth and development.
It is pure luck to find examples like Union Square Ventures. This is not only because of its crypto activity in general: projects in the blockchain/crypto sector make up about 15% of its active portfolio, and closer to 25% of its recent investments. This is because of its promotion of the concept of the evolving role of the investor. It was brought by Multicoin fund, which was backed by USV this year.
It is great to find Andreessen Horowitz and USV cooperation case, when these two did their best to push ICO forward in the regulated area. Yes, it was about money, too, but VCs took lobby function and fulfilled it quite well — we have had numbers of regulated ICO campaigns after the first (Filecoin), based on state-business cooperation. That is about evolving role and lobbying 2.0, isn’t it?
Evolving role means turning the investor into a universal team player rather than the “bank” of the project. It is important to understand the essence of the new coming era of decentralization. Adoption is an important part of any project’s development, but DLT-based and community-driven solutions keep adoption as their god. Only these types of solutions have a long-term perspective to survive and become dominant soon.
That is why we get a separate class of VC companies, like SVK Crypto. It was co-founded by BlockOne, publisher of the EOSIO blockchain protocol. EOS is an active investor by itself, but also launches additional channels to boost its ecosystem and develop its community and network. This is due to the fact that SVK Crypto invests in projects that are building on the EOSIO blockchain platform.
It is important to emphasize that crypto VC is not primarily funding-side, but a competence keeper and value-added services provider with guidance, community, and support (business, technical, organizational). VC turns into a platform solution.
No more coach seats — crypto VC is a fielder now.
Crypto funds provide the connection between the capital and projects. The capital comes mostly from current VC market players and crypto-industry participants. A well-established, competence-backed crypto VC fund has no need to promote itself among “retail” clients (LPs) — their capital comes from a 20% portion of classic VCs. LP is ready to pay extra to cover its risks and compensate for a lack of crypto competence. The latter includes both technical understanding and investment activity within the industry.
In terms of investment activity, it is hard for LP to catch market leaders among specialized crypto VCs. There is a lack of statistics and time-tested funds’ performance. Moreover, there is a global downward trend, and most crypto funds are down at least 50% since the start of the year. LP is more short-term-based decision-maker in terms of crypto.
Classic VC (the supplier of crypto VC) plays long and has an appropriate vision as well as an understanding of the current market conditions and perspectives.
Moreover, classic VC understands crypto assets’ “magic” features. Previously illiquid type of assets — technology projects with long investment cycles — turns into a liquid one. The liquidity of the crypto market has been growing and therefore cutting locked-up-capital risks. Do you remember the Digital Currency Group, with its 20 exits for three years?
That is the possibility VC will never miss: act like VC, get public liquidity.
The assumption is that classic VCs will be very active as soon as domination in this direction can be lost quickly — very, very quickly. First, LP will soon get missing parts, and refuse to pay the middleman’s fee. Second, there is the trend of investment activity stirring up from direct crypto-market participants like Binance, EOS, Bitmain, etc. This is probably the reason we are seeing lots of cooperation on the VC market in different forms, and line-ups including great U.S.-Asia joint ventures.
No matter what the reason, cooperation is a good trend, anyway — it pushes crypto adoption among VCs forward.
The VC industry is ready to change. How deep the changes will go remains an open question. For example, VCs often keep reserve funds to participate in funding events of a project not to dilute its project’s share. These funds can be redirected to resources like computing power, the money itself, and real estate to push the project further toward wider and faster adoption. Is VC ready to change its structuring — time will tell. How deep the changes can be — VCs will show.
Crypto is a recognized investment tool. We should all give many thanks to VCs for its persistence. VC has been turning the crypto abyss into a valley for years. Due to this persistence also we are on the verge of the next big thing within the crypto world in the context of institutional money flow. Fasten your seatbelts!
Thank you, VC! Faithfully yours, Crypto.
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