6 Questions to ask a Crypto Fund — Before You Take their Money
How to Properly Diligence Investors
Taking money from outside investors is one of the largest decisions founders make. Unlike a bad hire or failed marketing campaign, you can't change your mind months or years later — you're stuck with what you got. In a rush to find funding, founders often fail to actually diligence their investors.
As bad actors flood the crypto space, it’s more important than ever to diligence potential investors. A fund’s structure directly impacts its incentives, behavior, and solvency and so founders should research investors as much as possible before taking their money. Beyond asking for references, the following questions are important to ask crypto funds.
1. How is your fund structured?
Why you should care: it directly impacts a fund’s investment strategy and behavior
Most crypto funds are either structured as hedge funds or venture capital funds.
Venture Capital Funds (eg USV, Placeholder Capital)
VC funds are investment vehicles that deploy capital into early-stage companies. VC funds tend to be illiquid vehicles with 10 year locks ups (meaning that limited partners cannot withdraw their funds during that period). They generally invest in illiquid assets like equity or SAFT’s.
For further reading on VC fund structure, I’d suggest this post from Leo Polovets of Susa Ventures.
The good: VC funds give investors a long time horizon and so remove early liquidity pressure
The bad: Likely less experience trading liquid assets like tokens, more structural constraints on funds (so potentially cannot do things like stake tokens)
Hedge Funds (eg BlockTower, Multicoin)
Hedge funds aim to maximize investor returns while minimizing risk and generally have a large leeway in investing strategy (eg can take both long and short positions). In crypto, they generally invest in liquid assets like tokens.
The good: Experience trading liquid assets like tokens, more likely to be able to actively participate in networks (eg staking)
The bad: Generally shorter investment horizon than VC funds, can face liquidity pressure if LPs withdraw funds
2. What is your fund’s lockup period for LPs?
Why you should care: liquidity constraints can force a fund to sell their investments, which can flood the market with your token and drive down price
Most VC funds have 10 year lock-up periods for their limited partners (LPs) meaning that those LPs cannot withdraw funds for that period of time. Hedge funds generally have much shorter lock-up periods (often 12 months) and so LPs can withdraw their funds quarterly or annually after that. If you are raising equity (or via an illiquid instrument like a SAFT), you should understand how funds will handle the investment in the event that they face significant LP withdrawals.
3. Will you actively participate in our network?
Why you should care: investors participating in a network can help bootstrap network effects
I buy into the view that going forward founders will prefer investors that actively participate in their networks (eg by staking, running nodes, participating in governance, etc). Early investors staking or mining tokens helps incentivize early users of a network and bootstraps network effects, especially in early days when it may not yet be profitable to do so.¹
Some of the most forward-looking funds in the space have already started doing this:
- Multicoin Capital with MakerDAO and Livepeer
- Fabric Ventures with Ocean Protocol
- Notation with Livepeer
You should understand how a fund has engaged with the networks of portfolio companies and what their plans are going forward.
4. How do you view competitive investments?
Why you should care: it impacts whether a fund will back your competitors
VC funds generally don’t invest in competitors to portfolio companies. There are good reasons for this — they generally have non-public information about portfolio companies that would be useful to competitors and they’re often fairly involved in things like hiring or customer introductions that can be zero-sum across competitors.
This is not nearly as widely accepted in crypto, partially because a lot of the software is open source (Ari Paul has a relevant tweet-storm on this). If a fund promises significant value beyond their capital with things like introductions or recruiting, you should make sure you understand how they view competitive investments. My personal view is that the more involved a fund promises to be, the less likely you want them to be investing in competitors (partially because it means they’re more likely to have non-public information).
5. Who are your LPs?
Why you should care: it impacts whether their fund is around in five years
If one of your investors is not able to (or chooses not to) raise a subsequent fund, it will make your life more difficult — it means that that investor cannot continue supporting you (financially or otherwise). If you go out for a subsequent fundraise, most prospective investors will look to existing investors for signal because they have the most context on your company — if your current investors are no longer actively investing (and so cannot participate in a subsequent fundraise), that will have negative signaling and making raising future rounds more difficult.
Funds that have more institutional LP’s are almost definitely more likely to be able to raise a subsequent fund. For example, Paradigm recently raised $400M from institutional LPs like the Yale Endowment. It is highly likely that when Paradigm goes out to raise its next fund in 2–4 years, the Yale Endowment will still be solvent and investing in the asset class. On the other hand, newer fund managers that raised money from their ETH-rich friends are probably less likely to be able to raise subsequent funds. Many funds will be hesitant to reveal their LPs because of NDA’s — understanding what types of LPs they have (eg HNWI’s, VC funds, endowments, friends & family) is still valuable information.
6. What non-financial goals do you have?
Why you should care: it determines what strings are attached to their capital
Many funds in crypto are part of a larger entity that makes investments for financial reasons (to generate returns) and strategic ones (to incentivize developers to build on their protocol).
Exchange Funds
Many exchanges, including Coinbase and Binance, have set up venture funds in the past year. I haven’t heard first-hand of any onerous terms being applied by these funds but founders should understand if these investments obligate them to list on a given exchange first.
Ecosystem Funds
As layer-one blockchains have raised huge war chests, many have decided to allocate some of their capital to ‘ecosystem funds’ like EOS’s $1B fund and Consensys’s $50M venture arm. These funds all have non-financial agendas. For example, EOS’s fund explicitly states that it’s “focused on the growth of the EOS ecosystem.” If you’re evaluating an ecosystem fund, make sure you understand exactly what terms come with an investment.
If you have questions on running diligence on potential investors or think I missed anything here, don’t hesitate to reach out via Telegram.
Some disclosures: This isn’t legal advice — hire your own lawyers to review contracts, especially when taking money. I’m indirectly invested in some of the funds mentioned via a fund of funds. Some of the funds mentioned here are investors in CoinList, where I’m employed. These are my personal views and not those of CoinList.
¹ Kyle Samani has done a great job articulating this thesis here
Thanks to Samit Kalra and Michael Gasiorek for helpful edits.
