- Many crypto VCs have found themselves losing traditional operational discipline.
- Funds started investing quite broadly, and without providing any real support to the platforms they invested in.
- VCs need to refocus their energies and strategies in the aftermath of recent collapses.
- Indiscriminately copying the picks of a VC fund is generally a losing strategy for the retail investor.
It’s not the greatest time to be a venture capitalist (VC) in crypto. Many of them have seen both the value of their investments and reputation plummet, as projects they were actively promoting, such as Terra, failed spectacularly, hitting the whole crypto industry.
In previous months and years, the fact that one or more VC funds had invested in a project was usually enough to send any corresponding token surging. In contrast to these heady days, there are now serious question marks hanging over the wisdom and shrewdness of VC funds, which retail investors have often used as models for their own investment decisions (judging by rallies after funding rounds).
However, figures working within the crypto industry claim that, in the aftermath of the current crisis, VC funds will increasingly focus on conducting rigorous research and due diligence in making their decisions. And while the crypto market is likely to remain volatile and unpredictable for the foreseeable future, there should be a gradual decline in risk-taking behavior from VCs over time.
Crypto VC funds take a reputational hit
Commentators are in agreement that the reputation of crypto-focused VC funds has taken a beating in recent weeks.
“Over the last cycle, having a top-tier VC on the cap table became a stamp of approval and self-fulfilling prophecy of sorts. Unfortunately, during an era of tremendous risk-on activity and low-monetary policy, many of these VCs have found themselves losing traditional operational discipline such as risk management or portfolio construction practices,” said Anthony Georgiades, a co-founder of NFT-focused blockchain Pastel Network and General Partner at VC firm Innovating Capital.
Aside from the obvious fact that their investments have sharply dropped in value, VCs have fallen out of favor for other reasons over the past few months. For Dominic Williams, the founder and chief scientist at the DFINITY Foundation, part of this is to do with how VCs have moved away from a more traditional model in which they backed only one startup or project in any one given area, something which often encouraged funds to concentrate more support on their chosen investees.
“When they started investing in crypto, initially they used the same approach, and their involvement fairly transferred status to the projects they invested in. But as the crypto bull market began to ‘float all boats’, and product/market fit became less important than hype, all that changed,” he told Cryptonews.com.
Indeed, for Williams, a few too many funds started investing quite broadly, including in competing projects, and without providing any real support to the platforms they invested in. This arguably spread their resources too thinly, while there’s also an argument to be made that at least some VCs rushed too hastily to invest in multiple projects, without conducting due diligence.
On top of this, some crypto VC funds have been acting less like venture capitalists, and more like speculative investment firms.
A recalibration of focus
According to commentators, some investors chose not to manage their risk and pivot their strategy during the downturn but instead attempted to go even more ‘long’ the market in a bid to push their finances back into the black.
Some indication for this is provided by the fact that, even with prices falling across the board more or less since November, venture capital funding is significantly higher than it was a year ago.
“According to Dove Metrics data, the amount of capital invested in the space in May 2022 increased 89% from USD 2.233bn in May 2021,” said Mahesh Vellanki, a Managing Partner at crypto-focused venture studio SuperLayer.
Also, in the first half of 2022, venture capitalists invested USD 17.5bn in crypto and blockchain firms, Reuters reported this week, citing data from market data provider PitchBook. That puts investment on course to top the record USD 26.9bn raised last year.
That said, Vellanki interprets these relatively high figures, not as evidence of profligacy, but as evidence of savvy investors ‘buying the dip’ and acquiring stakes in projects at a discount.
Regardless of how the current figures can be read, most commentators agree that VCs need to refocus their energies and strategies in the aftermath of recent collapses.
“VCs and hedge funds need to step back from the crypto hype machine, including announcements of fake partnerships, noise created by marauding armies of shills and trolls on social media, and glowing coverage in pay-to-play industry reports and media, and so on, and focus on substance. Successful technology investors from the past have focused heavily on the technical understanding of the entrepreneur and the technical and product teams they have built, yet, today, most investors in crypto don’t even look at the team,” said Dominic Williams.
Likewise, Anthony Georgiades argues that, from now on, more research and overall diligence need to be conducted to determine which projects are truly viable and necessary for the longevity of the ecosystem.
“As funds begin to blow up and find themselves underwater, I believe we will see a return to patient capital and increased diligence approaches. Terms will be more investor friendly, forcing founders to display more operational discipline,” he told Cryptonews.com.
Ultimately, this shift will be a positive for the industry as a whole, even if it has required at least one VC fund to go belly up. Georgiades also predicts that firms will begin to invest in fewer projects, thereby giving recipient teams more time to research properly, make smart investment decisions, and actually provide tangible portfolio support.
Other commentators affirm that VC funds should also increase the attention they pay to the teams of startups and projects, since high-quality and highly experienced/skilled personnel can be the difference between an interesting idea that fails and one that succeeds.
“Early stage VCs should focus on backing strong, high integrity teams going after market opportunities that feel sustainable with sound economics. Later stage VCs should definitely be conducting responsible due diligence and focusing on identifying key risk levers and whether the business or token economics make sense,” said Mahesh Vellanki, who also advises VCs against over-capitalizing projects and creating unhealthy growth.
Retail investors and future risk
As mentioned above, news of VC investments has often moved the crypto market, with retail investors presumably following the lead of funds. Yet, for many observers, this is a dangerous strategy and may remain dangerous even if most crypto VCs tighten their games in the coming months.
“The danger of investing in a project that has raised significant funds from VCs and hedge funds, is that they will have bought at a major discount, and as soon as their vesting expires, they will seek to secure profits by dumping a large portion of their holdings on the markets. This is exacerbated if many of their investments did not work out, because the pressure to sell tokens to obtain a return of their [liquidity providers] is increased,” said Dominic Williams.
More simply, retail investors need to remember that many funds use a strategy whereby their profits come from only a few of the projects they invest in, with the rest essentially losing money. As such, indiscriminately copying the picks of a VC fund is generally a losing strategy for the retail investor.
“Venture funds have large portfolios in hopes that just a few companies generate all of their returns while the rest generate minimal or zero returns. Additionally, venture funds don’t always generate great returns, and returns may be unclear for years,” said Mahesh Vellanki.
Lastly, VC funds are always likely to encounter risk, even in a future where they’ve considerably improved their investment models and strategies. This is simply because, no matter how much time they spend looking at prospectuses, whitepapers, and pitches, none of them have a crystal ball.
As Anthony Georgiades concludes, “Of course, as with all investments, there is risk involved, and unforeseen circumstances can cause some projects to tank when they otherwise wouldn’t have. It’s not a perfect science, but the return of core investment pillars like diligence, patience, portfolio construction, and risk management will be a net positive for the future of the industry.”
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