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As the broader market went risk-off roughly one year ago, venture capital funds began to pull back from funding crypto ventures.
Quick Venture Capital Primer
The business side of VC is a bit opaque at times so we’ll explain it briefly here.
You probably already know that venture capital is a type of investment strategy that involves investing in the equity of newer, unproven companies. VCs buy small stakes in businesses and provide capital and varying degrees of support for founders.
VC funds invest in different stages of a startup’s life cycle. These include:
Pre-seed: Startup is just about to get off the ground. You ask your buddies from college, your rich uncle, and mom / dad for some funds. You might be able to pull off getting some angel investors and smaller VCs in at this stage. The total raise is typically less than $1 million.
Seed: You have a pathway to revenue and a product to launch. More VCs will be interested at this stage, especially if you can show some traction with prospective customers. In crypto, a lot of VCs and angels focus their investing in this stage. Check sizes are usually $1 - $5 million (generally on the lower end).
Series A: Making it past the seed stage means a startup has gained some measurable traction in the form of users, revenue, etc. At this stage the startup raises capital to invest it in growth and really establish product market fit.
Series B: The company has real traction and needs to grow quickly. Series B funding is for startups that have already achieved product market fit.
Series C onward: Fast growing companies that have success in their market already and are on the path to an IPO (or potentially a sale). Companies may raise additional rounds beyond the Series C if they need to before an IPO.
Generally speaking, larger funds invest in later stage companies. These funds have too much capital to invest and small investments do not move the needle. Investments also have an overhead cost as each portfolio company will have an investment team responsible for its performance. An alternate approach for larger funds is to take up most/all of earlier stage rounds instead of sharing the cap table with a group of VCs.
As you can imagine, most companies don’t make it. The exact numbers are debatable. The most popular number is that 90% of businesses fail, whereas some say “only” 70% of VC funded businesses fail. Either way the hit rate is quite low.
The funnel below from CB Insights provides some clarity on what portion of companies go on to late stage funding. Note that some companies decide to forgo raising additional capital because they no longer need it and not because their business failed.
Important: don’t take these numbers as gospel - the data is a few years old and these numbers are for “traditional” tech companies. The funnel for crypto startups is likely to have materially different numbers. The point is that a small portion of companies make it to late stage rounds.
1% of companies achieving unicorn status feels highly overstated but we’ll run with it. We can all agree that the number of unicorns is extremely small. With such few companies making it on to become home runs, getting good quality deal flow is paramount. Winning funds build reputations that improve their deal flow, thereby improving their returns. This allows them to raise larger funds and grow their operation which lets them look at more deals and win more. As with most things, bet on winners to keep winning.
VCs invest in the time of a company’s life cycle that is considered most risky. You won’t see private equity funds in these deals until very late in the game, if at all.
The core premise of the VC model (and what it is famously known for) is the idea that if you invest in enough moonshots with potential, some of them generate outsized returns to the point of making up for all the losers and then some. But you are going in with the idea that most investments will be failures.
If you want to dive deeper on the history and the business of venture capital, check out The Power Law by Sebastian Mallaby.
VC Fund Structure Basics
We won’t go too in depth here but you should understand how VC funds are structured so you better understand the business model.
Remember - a venture capital fund is just a pool of capital used to make investments in line with their strategy and generate a return on investment. The concepts below are on the legal structuring side of things, but the core business model is 1) raise a fund 2) invest the fund 3) harvest the investments 4) earn management fees and performance fees 5) raise more funds.
The people who supply the capital are Limited Partners (LPs) in the fund, whereas the people who manage the capital (the people who work at the fund) are General Partners (GPs).
GPs earn carried interest (typically 20% of fund returns) and management fees (typically 2% of assets per year).
The most important part to know is that venture capital funds have a finite life. While a fund’s life might be 7 - 10 years, funds are typically done investing by year 3 or 4. After this initial investment period they may only focus on harvesting and supporting existing portfolio companies.
VC funds that are freshly raised will invest more aggressively because they need to put their money to work.
Crypto vs. Traditional VCs
Crypto VCs and traditional VCs have some differences. The most notable difference is token exits. Instead of waiting 5-10 years for an IPO or an M&A exit, crypto VCs can exit in as little as 12 months after a startup issues a token and the tokens vest. Liquidity is the primary difference between crypto and traditional VCs.
This created a very profitable dynamic for VCs. Even terrible investments that should’ve gone to zero were able to find some liquidity. VCs could exit their tokens either directly after they vest or indirectly by selling unvested tokens at a discount.
What Are Crypto VCs Investing in Now?
Now that you have a foundational understanding of the VC business model, let’s take a look at what startups are receiving investments in this crypto bear market.
Birds Eye View
Galaxy Research has put together an excellent report on the high level crypto VC funding data for 2022 here. Here are our key takeaways from their data:
Crypto and blockchain startups received $30 billion in investments in 2022 (primarily in the frothier, first half of the year)
% of deals at the pre-seed stage has declined for the last 6 years
As the market turned sour in 2022, VCs went risk-off and focused their investing in later stage deals
Unsurprisingly, deal size and valuations came down massively from Q4 2021 to Q4 2022
Largest sector by deal count was “Web3” which Galaxy defines as NFTs, DAOs, metaverse, gaming, and other web3 platforms (we assume this means web apps with some crypto component)
The largest check sizes were for crypto trading startups
DeFi funding was in the mid to high single digits as a percentage of total investments
Notably, more than 40% of all deals involved startups with a US HQ. This is a staggeringly high number. US regulations will have a material affect on the crypto landscape as a whole
Crypto VCs received $33 billion in allocations in 2022 (primarily in first half), up 70% from 2021
What does all this tell us? It’s generally in line with what we would expect. Despite the fact that VCs are supposed to be swinging at risky ventures, they are not immune to fear, uncertainty, and doubt in the market. As market conditions worsened, they had to shift their focus to supporting existing portfolio companies and invest more in later stage deals that are less risky.
Users and revenue may not have mattered in 2021, but they do matter now.
Current Landscape
Using data from DeFi Llama we can look at what kinds of projects are being funded today. Note that the dataset may not be exhaustive.
The largest raise of 2023 so far was a $65 million Series B for Taurus. The round was led by Credit Suisse and just closed today. Taurus provides “digital assets infrastructure” for European institutions. Deutsche Bank is also among the investors in the round along with Switzerland’s Pictet Group. Taurus is building a platform for regulated institutions covering custody, tokenization and trading.
The largest seed round of 2023 to date was a $45 million round from a group of 9 banks (BBVA, BNP Paribas, CIBC, and more). This capital was for Carbonplace, a blockchain enabled network for carbon credit transactions. Based on the information we have it appears Carbonplace will be its own private blockchain. Given the investor base, we are assuming there will not be any token.
The key takeaway here is that regulated institutions are still interested in crypto and willing to invest large sums of money to access the market in a regulatory friendly manner. This has pros and cons. In one sense, it validates the digital assets thesis. Slow moving, archaic institutions are betting on the sector. However, they probably aren’t going to come buy our tokens in the near future.
Year to date 2023 data shows 42 seed rounds completed with an average size of $7.9 million. As of the same date in 2022, there were only 15 seed rounds with an average size of $7.6 million. We may be seeing early signs of a resurgence in early stage investing in crypto after a muted Q4 2022. Some rebound is to be expected as valuations have come down significantly and VCs are able to find more deals. VCs may also be investing more aggressively out of the gate this year if they stayed on the sidelines for the last 6+ months (remember, VC funds have a limited life!).
Infrastructure, gaming, NFTs and DeFi are leading the charge in investments, although the largest raises are for startups serving regulated financial institutions.
A new “Ethereum Killer” is entering the fray. Monad closed a $19 million seed round led by Dragonfly Capital and includes well-known crypto angels such as Naval and Cobie.
Influencer Gary Vaynerchuk invested in Webacy, a service to improve self-custody security. We haven’t used it so we can’t attest to its efficacy, but it’s certainly a needed service in the space (particularly for a lot of NFT investors).
VitaDAO raised a $4.1 million seed round from investors including Pfizer’s venture arm and Balaji. The DAO is focused on R&D in the longevity space and the extension of human life. You can check out some of the projects they fund here.
Overall, there are some pretty interesting projects being funded and the environment seems to be improving compared to Q4 2022. In-line with our views shared with paid subscribers in November, the worst is likely behind.
You can check out other recent raises here. Let us know if there are any that catch your eye in the comments!
Until next time, anon…
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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Thank you. Great insights, as always!
From a retail perspective: Is there a way to construct an investment edge from VC data like this?