Problems of Crypto Venture Capital
“We are backed by the best VCs in the space.” If you had ever looked at some protocol’s landing page, you have probably read this line. If you’re curious enough, you would probably ask a couple questions:
- Who are the best investors? Why are they the best?
- How to rank investors? What separates the best ones and worst ones?
Actually, those questions are really harder to answer than you think, because the whole VC thing is built not only on financial metrics, but people and people’s opinions.
Different funds have different theses, different strategies of investing, different visions of exiting, different ways of supporting the projects, etc.
The same style of doing business can produce different results: you can either succeed or fail. However, the question of what success really is, still remains the question without an answer.
Having worked commercially more than 2 years in blockchain space and VC in particular, I have noticed main problems of crypto asset managers which provide capital to early stage startups, I will cover the topics like:
- Suffering of new Crypto Funds
- Definition of a “good” and a “bad” VC
- Problems of famous VCs with large capital
- Problems of investment stages
How Crypto Funds work
To kick it off, let’s quickly and simply explain how Venture Capital Fund works. Because most of the people don’t even know that Crypto Funds also do fundraising from other Funds (which are called Funds of Funds, but that’s another story). Basically you have to know the following roles:
- Limited Partners a.k.a. Investors or LPs (not liquidity providers, it’s not DeFi)
- General Partners a.k.a. Managers or GPs
- Portfolio Partners a.k.a. Companies or Startups
- Limited Partners are rich guys, who want to multiply their investments, but they don’t have enough knowledge and/or time, but they have a lot of money.
- General Partners are smart guys, who have a lot of knowledge and free time to manage the money, but they don’t the initial capital (or the inital capital is not big enough to hedge the risks).
- Portfolio Partners are also smart guys, who try to build the innovative single product or service and bring it to the market. These guys are usually experienced, and they know (not always) what is the current problem in the market, how painful it is and how to fix it. However, they need the money to kick it off and capture the market, otherwise the proces could take centuries.
Basically, the whole VC structure is a chain of giving and returning:
LPs give money to the GPs → GPs give money to the startups → startups return money to the GPs → GPs return money to the LPs. Ok, so where does the yield come from? Regular users.
It’s also important to understand the main tasks of all categories of partners:
- LPs have to choose the right people to manage their money and take returns
- GPs have to choose the right people to provide the LPs’ money
- Startups have to do everything possible (and impossible) to earn the money for themselves and the investors
However, there are some big problems which happen in crypto VC industry, that are uncovered and ignored. I didn’t explain everything about VC structure, operations, money management, etc. I will cover it through the explanation of the problems that Crypto VC industry is currently facing.
Problems of Venture Capital
However, it would have been strange not to address the topic of problems in Venture Capital, and specifically in Crypto Venture Capital, which often renders venture capital toxic and detrimental to the entire industry.
Funds Copy Each Other
If you weren’t involved in the Venture Capital before, I’ll tell you that one of the main questions investors are interested in is who are going to be their co-investors. Why is that a problem?
- General Partners, by definition, are managers of capital. Ideally, they should make their own decisions, conduct their own due diligence, form their own thoughts, opinions, etc.
- For example, if you are a new fund that decides to replicate a16z deals, it is essential to recognize the crucial role of risk management, which is often not fully understood by General Partners (GPs). Big tier-1 funds have significantly more capital and greater capital efficiency, providing them access to deals that may not be accessible to smaller funds.
- Choosing to replicate a16z deals with relatively low valuations for your fund introduces a different Risk/Reward Ratio. Large funds are sometimes comfortable with the prospect of losing some capital, as seen in cases like a debank degen playing with shitcoins on Solana.
- As a GP, you cannot simply mimic the approach and then claim, “Well, a16z invested, so we decided to enter the deal too because they’re the best in their field.” Your rationale for the investment should be independently proven; otherwise, you contribute nothing new to the industry and merely return investors’ money, allowing them to choose a hedge fund instead.
But that also happens with tier1-tier2 funds. The best example of that is Standard Crypto, who almost always co-invests with Paradigm and a16z.
Here’s some of the investments of Standard Crypto:
As you can see, most of them are co-investments with Paradigm and a16z. That’s definitely not too bad, as the primary purpose of capital is to generate more capital. However, essentially, there are guilds of huge funds that often attract many users despite having a raw product (hello, Blast L2).
Playing Against Community
That was mentioned by Nick Tomaino from 1confirmation fund that the tokenomics of projects have changed, but did they change in a good way? I’m referring to the allocations of tokens for the team and investors.
- Bitcoin — 0% allocated for the team and investors because there were no investors (huge shoutout to Canto).
- Ethereum — almost 10% allocated for the team and investors.
- Solana — 62% allocated for the team and investors.
Nowadays, it’s considered normal for a team to have 15–20% of the supply, and investors to have 15–20% of the supply. Could you imagine the big players controlling almost half of the supply and calling their protocol decentralized? Really?
Furthermore, there are many cases where the team and investors have the same vesting schedule, which is the biggest red flag, in my opinion. Imagine a guild having 40% of the supply with the same cliff and the same vesting; that’s literally called “an opportunity to dump on regular users.”
Possibly the most famous case is, of course, a16z having control over a Uniswap DAO.
How can you call Uniswap a DAO when 4% of all UNI supply is controlled by a16z? It is literally a necessary amount to pass any proposal. So, the blockchain world, which is defined to be “decentralized,” is now being centralized by big funds.
Most users don’t understand that VCs work collaboratively with protocols, and some of them absolutely don’t care about your bags. You definitely need to be smarter.
Fear of Missing Out Created by Big Names
This is literally addressed to the community; it’s not a VC problem but a derivative of the VC problem.
We all know Paradigm as possibly the best fund in crypto, staying apart from everyone. The impact they have is difficult to overrate; the amount of work they do in open source is insane, and the protocols they back are well-known.
However, there’s a significant issue, a deadly combination of words like Paradigm + Airdrop. I want to highlight the latest investment in Blast L2 Protocol and what is wrong here. First of all, let’s see what we know:
- Optimistic Rollup, Native Yield (promised)
- No documentation, no mainnet, no testnet
- Inviting friends to get rewards (ponzi)
- The only thing the protocol does is deposit assets from ETH to stETH (Lido) or send to MakerDAO, in the case of stablecoins.
- Locked for 3 months, bye ETHs
- Backed by Paradigm
If Blast didn’t have the last bullet point, what would be the percentage of people willing to delegate their assets? You know the answer.
We essentially face the same situation with friend.tech. How many people would use OnlyFans on the blockchain with a (3,3) mechanism if it weren’t backed by Paradigm and didn’t have the airdrop? You know the answer.
The community started acting crazy to farm points and speculate on the market. However, how does it make the industry better? Will friend.tech be remembered?
We could observe the shift towards the concept of “protocol of the founder with a little support from the investors” to “protocol of the investors with a little support from the founder.”
Never ending funding
Back in October 2023, multiple protocols shut down, including Utopia, Yield Protocol, SuperDAO, and Fuji Finance. The reason is simple — they did not achieve Product Market Fit.
The current state of startups resembles rat races, involving new investment rounds until finding product-market fit. Possibly, the most important metric here is burn-rate, a.k.a. how much money the team spends each month. The goal is simple — become profitable, however, there can always be some problems.
Protocols go through pre-seed, seed, private, strategic, series A rounds. Running for funding currently is so common that it became a standard, but it shouldn’t be like that.
There are basically two reasons why a protocol asks for capital:
- Capture the current market
- Not profitable → running out of funds → need new money
Let’s deeply explain the first reason. Asking for money with a working model is made to expand. If you want to expand quickly and focus on the current markets — you want to have more money than the revenue you get. For example:
- I want to expand and gain more users using the protocol, and I’m currently generating $100k a month.
- With $100k a month, I’ll need to spend 12 months to get to the point where I want to be.
- Risks: the market can change really quickly, so I want to reach the point in 3 months to catch the opportunity.
- I sell my share to Private Investors to get that money to expand + adding the revenue.
- Now I can focus on expanding, farming more revenue, getting new features, R&D, etc.
Most of the protocols aren’t profitable, and money is easily wasted. The point of Venture Investing is to support founders; however, not many of them have an understanding of achieving the right product-market fit.
A good example here is Uniswap, which generates cash exclusively for its liquidity providers. The protocol itself does not include a Fee Switch for various reasons, so UNI holders are not currently earning. This is why projects like UniswapX and other iterations, such as Uniswap v4, emerge — an attempt to create a protocol that not only benefits the ecosystem but also adds a little extra to their own pockets.
Bull market investments don’t define great protocols or great investors; everything is built in a bear market. Bull market valuations are not reasonable; every great company is defined during a crisis, and the strongest survive and continue fighting.
Conclusion
I have addressed the main problems of crypto venture capital. Of course, there are also positive aspects. I’m not here to blame venture capital, as I am actively involved in it myself. However, it’s important for people not to romanticize these matters and to understand that there can be drawbacks as well.
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