Crypto is by no means shy of scepticism. If the bitcoin ‘silk road’ saga was not bad enough, the 2016/17 ICO-fuelled hype cycle further tainted the industry, tapping into negative behaviours typically unseen in common markets.
Crypto has therefore become, in some regard, a dirty word — leading to the vast majority of the global population dismissing the legitimacy of the industry and the new asset class entirely, without any real investigation.
For those that have spent some time to research and investigate, but remain sceptical, typically fall into one of the following buckets:
- Consider all cryptocurrencies as fiat currency or Bitcoin competitors (Warren Buffett and, to some extent, Antony “Pomp” Pompliano) — Sceptics in this camp mistakenly consider all cryptocurrencies to solely be competitors of fiat currencies or bitcoin (proposing to be a new form of money/store-of-value).
- “Blockchain, not crypto” (Jamie Dimon)— Sceptics dismiss crypto as an investable asset class and believe that the value is in the underlying technology — the blockchain — which, they mistakenly believe, works perfectly well in a distributed, non-decentralised, fashion.
- ROI is too low; the mortality rate is high, and future liquidity events are unforeseeable — Discounting a few exchanges and wallets, there has not been a major VC success story that has captured the imagination of investors.
- No evidence of product-market fit — Since crypto remains in the ‘infrastructure phase’, these sceptics consider the market too early for entry. They mistakenly believe that capital deployment post-infrastructure phase may make the most sense. The reason is that they believe the value will mostly accrue towards the application layer of the new tech stack, like how it did for the Internet.
An investment thesis is defined as a reasoned argument for a particular investment strategy, backed up by research and analysis. Building a successful thesis begins with:
(1) establishing a framework for rigorous analysis at the Micro-level; and
(2) aligning that view with the Macro environment.
Since crypto is like no other market I’ve seen before, investors are having trouble crafting a thesis that aligns with their understanding of what makes a good or bad investment decision. To expand:
Before making an investment decision, it is essential to understand what is happening at a micro-level, so that investors can make a sound judgement on the project’s probability of success. Typical VC-style analysis involves evaluating the team, the technology, the profit-model, barriers to entry, and so on.
While much of the framework is similar when applied to crypto-networks, in many ways it is not — since crypto-networks are not the same as companies. The basis of assessing good project qualities and identifying key market risks pose fundamental differences making the traditional qualitative evaluation framework obsolete.
The macro-thesis is interchangeable with an investors market strategy. Investors, as well as their prospective portfolio companies, need to understand what they are looking for clearly.
To arrive at this point, I’ve broken down the formation of the macro-investment thesis into three steps, each of which presents their own unique set of challenges when applied to the crypto space.
(1) End State
The first step in crafting a macro-thesis demands investors to see the ‘grand vision’ crypto proposes, so that any investment decision they make in the near-term will be — in their eyes — future proof, by aligning with their long-term outlook.
The key challenge here for traditional tech VCs is in overcoming the enormous educational barriers to truly understand the new software and economic primitives crypto unlocks and the problems (with the legacy system) it seeks to solve. Once that feat is overcome, the next step requires a degree of imaginative thinking to envision how socioeconomic systems will exist as decentralised ecosystems.
Fortunately, there seems to be a consensus within the crypto VC community with regards to the ‘end state’, gravitating towards three macro narratives: open finance (DeFi), decentralised Internet (web 3.0), and non-sovereign money.
(2) Reverse engineer — Envisioning the tech stack
Investors must hypothesise how the new paradigm crypto proposes will be architected and what such technology stacks could potentially look like, evolving from their centralised predecessor establishments. Understanding of the limitations of the technology as it stands today combined with an ‘end-state’ hypothesis, investors can begin to ‘reverse engineer’ the technology stack they are envisioning layer-by-layer. This allows them to hypothesise where they see value accruing in the long-term and where it will not.
We are yet to reach a general consensus among the developers and investor communities regarding stacks. Diverging opinions among specialists further exacerbate educational complexity.
(3) Market research — Where we are today
The final phase of macro-thesis formation is understanding what is possible today and what isn’t. Aside from being aware of the landscape and competition forming, investors must be acutely aware of macro-level factors that could drastically impact the investment thesis in its current form. This can be broken down to:
i.) Global regulatory environment — unforeseen events that may impact attacked jurisdictions; and
ii.) Technological innovation — as we are at the cusp of innovation, existing limitations could potentially be overcome by new technologies, rendering certain components of the ‘envisioned’ tech stack obsolete.
The major challenge here is the commitment necessary to stay in tune. VCs must have their finger on the pulse to revaluate their investment thesis and adapt swiftly and accordingly.
Starting a new crypto-focused investment division demands more than just an investment thesis. In particular, investors must also think about the right structure and subsequent implications on tax, reporting, regulations, and fundraising.
When it comes to forming a fund, traditional venture capital structures may not suffice. Conventional venture structures prevent VCs from disclosing information to regulators and minimises administrative costs, assuming that they limit their fundraising to High Net Worth Individuals and Institutions. However, this limits VCs to investing a subordinately small % of the fund in non-qualifying investments, which would include crypto-assets (much less than what is potentially desired).
Besides, as crypto-assets are native to protocols that provide some form of utility, they’re existence from the onset is critical for certain projects. Once the protocol is live, this means that the native crypto-assets will become tradeable in the secondary markets. Considering that the protocol is normally very early stage in its lifecycle, the price of the crypto-asset can experience extreme volatility as other investors are continuously having to re-evaluate the probability of the project’s success.
As a result, there is much confusion around whether hedge fund structures or venture fund structures are the better choices for making active crypto-asset management allocations.
Due diligence is an investigation or audit of a potential investment to confirm all facts, that includes the review of financials, valuation and legal records.
Crypto is a new asset class, whereby (depending on the crypto sub-asset classes) value flows in different ways when compared to traditional securities.
Over the last few years, crypto-native investors in ICOs emphasised qualitative considerations in their investment decision-making, paying little to no attention to quantitative analysis. White papers, for the most part, contain poor disclosures in relation to the assumptions used to price the tokens issued, often resulting in questionable valuations.
When investing in early-stage businesses, traditional tech VCs typically pay much attention to valuation through a thorough analysis of financial data and assumptions — using traditional valuation techniques and principles. Therefore, the key challenge for tech VCs new to crypto is in understanding the mechanics of crypto-economic systems and taking upon themselves to apply the right fundamental and relative valuation techniques and principles to make investment decisions with conviction.
To further exacerbate complexity, a healthy degree of differences in opinions still remains within the crypto finance community when it comes to the application of valuation techniques to crypto-assets. However, significant progress is being made.
Cryptocurrency and blockchain businesses do not create new problems investors cannot tackle from a legal standpoint. Instead, it introduces a variety of complexities VC investors traditionally do not have to deal with, resulting in a greater commitment of time and resources. These comprise of, but are not limited to:
(1) Complex corporate structures — crypto-networks and their operating businesses involve multiple entities, domiciled in crypto-friendly countries. These are typically unfamiliar jurisdictions to investors.
(2) Token classification — Investors must ensure that the crypto-assets issued or held on the target company’s balance sheet strictly comply and align with the regulatory framework in the residing jurisdiction.
(3) Intellectual property — Investors must ensure that intellectual property created is held in the appropriate corporate entity for compliance purposes and without negatively impacting the valuation of the target company.
(4) KYC/AML — Investors want to be sure that crypto-issuing entities employ the best security practices as well as measures, specifically Know Your Customer (KYC), Anti-Money Laundering (AML), and Combating the Financing of Terrorism (CFT).
Traditionally, VC investors offer support to their portfolio companies post-investment. Equipped with their unique framework for success (usually acquired through years of pattern recognition or their own entrepreneurial / start-up experience), they typically offer their knowledge to founders or share resources that can help their portfolio of companies to grow.
As discussed in this article, crypto brings forth new problems that traditional tech VCs haven’t come across before. The challenge for investors here is to learn and understand how best a VC can add value to founding teams and early-stage crypto-networks, expanding beyond the capabilities of their existing platform.