Not the best time to invest in cryptocurrency as a venture capitalist (VC). As projects they were actively promoting, like Terra, failed spectacularly and negatively impacted the entire cryptocurrency industry, many of them have seen the value of their investments and reputation plummet.
In the months and years prior, the mere fact that one or more VC funds had backed a project was typically sufficient to send any associated token surging. Contrary to those heady times, there are now significant doubts surrounding the wisdom and cunning of venture capital funds, which retail investors frequently used as models for their own investment choices (judging by rallies after funding rounds).
However, experts in the crypto sector assert that following the current crisis, VC funds will place a greater emphasis on conducting in-depth research and exercising due diligence when making decisions. Although the cryptocurrency market is expected to remain erratic and volatile for the foreseeable future, VCs should gradually start to take less risk in the long run.
The reputation of VC funds with a focus on cryptocurrencies has suffered recently, according to commentators.
“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,” according to Anthony Georgiades, a co-founder of the blockchain Pastel Network, which focuses on NFTs, and a general partner at VC firm Innovating Capital.
In addition to the obvious fact that the value of their investments has fallen precipitously, VCs have recently lost favor for a variety of other factors. The founder and chief scientist of the DFINITY Foundation, Dominic Williams, believes that part of this has to do with how VCs have shifted away from a more traditional model in which they backed only one startup or project in any given area, which frequently 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 said.
Indeed, a few too many funds began investing too widely, including in rival projects, and without actually supporting the platforms they were investing in, according to Williams. There is a case to be made that some VCs rushed to invest in several projects without doing their due diligence, which may have spread their resources too thinly.
Additionally, some cryptocurrency venture capital funds have been behaving less like venture capitalists and more like speculative investment companies.
Commentators claim that some investors made the decision to go even more "long" the market in an effort to get their finances back in the black rather than manage their risk and change their strategy during the downturn.
The fact that venture capital funding is significantly higher than it was a year ago, despite prices broadly declining since November, serves as a hint in this regard.
Mahesh Vellanki, a Managing Partner at crypto-focused venture studio SuperLayer, stated that "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."
Additionally, according to Reuters this week, who cited data from market data provider PitchBook, venture capitalists invested USD 17.5 billion in blockchain and cryptocurrency companies in the first half of 2022. As a result, investment is on track to surpass the record USD 26.9 billion raised in 2017.
However, Vellanki interprets these comparatively high numbers as evidence of shrewd investors "buying the dip" and acquiring shares in projects at a discount rather than as proof of extravagant spending.
Regardless of how the current data should be interpreted, the majority of commentators concur that in the wake of recent failures, VCs need to refocus their efforts and strategies.
"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.
Anthony Georgiades contends that going forward, more investigation and general diligence are required to identify the projects that are actually viable and essential for the ecosystem's survival.
"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 said.
Even though this change has forced at least one venture capital fund to fail, it will ultimately be advantageous for the industry as a whole. Georgiades also expects businesses to start investing in fewer projects, giving recipient teams more time to conduct thorough research, choose wise investments, and actually support client portfolios.
Other commentators agree that VC funds should pay more attention to the teams behind startups and projects because excellent and highly qualified staff can mean the difference between an interesting idea failing and succeeding.
"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," according to Mahesh Vellanki, who also cautions VCs against over-capitalizing projects and fostering unhealthy growth.
As was already mentioned, news of VC investments frequently moves the cryptocurrency market, and it is likely that retail investors do the same. However, many observers believe that this is a risky tactic and that it may continue to be risky even if most crypto VCs tighten their practices 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," according to Dominic Williams.
Simply put, small-scale investors should be aware that many funds employ a strategy whereby the majority of the projects they invest in end up losing money. As a result, copying a VC fund's picks at random is typically a losing strategy for retail investors.
"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," according to Vellanki.
Finally, even in the future when they have greatly improved their investment models and strategies, VC funds are still likely to experience risk. This is merely due to the fact that none of them possess a crystal ball, despite how much time they may spend reading prospectuses, whitepapers, and pitches.
"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," says Georgiades.
By fLEXI tEAM