What’s Behind the Multi-Billion Dollar Venture Capital Interest in Crypto?

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The mercurial rise in popularity for the ICO fund-raising model has led many industry observers and evangelists to conclude that the days of venture capital are long gone.

Indeed, the market for ICOs has exploded in the past year and a half. During the first quarter of 2018, ICO funding easily outstripped the full year sum for 2017. The ability for retail investors to contribute to projects they believe in, and the freedom it grants companies themselves, made ICOs appear as the only solution going forward.

Even so, the VC world has not stayed on the sidelines as many participants would be led to believe. The sector’s search for new profitable ideas and opportunities meant that eventually, the draw of cryptocurrencies and blockchain would be too strong to pass up. Many VC firms have also had time to establish themselves in the ecosystem, with crypto-centric funds starting to appear as early as 2013.

The reasons for this interest in a seemingly competing funding model is simple. For VCs, crypto and blockchain offer a market of untapped profit potential that provides significant liquidity and financial flexibility. Moreover, the increasing likelihood that blockchain is here to stay, and its embrace by the mainstream means that a VC company that doesn’t at least have a plan in place to adapt could be left in the dust.

A More Efficient Investment Model

One of the problems VC firms have when it comes to a poor-performing investment is their inability to withdraw easily. With traditional funding, once a check is signed and deposited, it is difficult to recoup those funds outside of an acquisition or IPO, potentially notching a sizable loss in VC portfolios. Instead, blockchain gives VCs a significantly more flexible investment vehicle.

For one, VCs have more investment models to choose from when buying into new projects. They can choose a standard equity deal similar to ones they sign with traditional startups. VCs can also choose a SAFT (Simple Agreement for Future Tokens) model, which offers several benefits. SAFT allows companies to fund projects in pre-ICO stages and cash out with a fixed number of tokens once the product is launched. These tokens do not represent equity in a company and thus provide greater freedom to companies themselves as well. This lets VCs invest more directly in an underlying technology as it has a greater incentive for it to succeed.

Additionally, the liquidity offered by the crypto market means profits can be realized much faster with a blockchain-based company. Moreover, receiving tokens instead of shares means VCs have an asset they can easily unload should their investment under-perform. This easy mechanism also means that VCs have some level of protection against sharp drops in cryptocurrency valuations and volatility. Equity rarely sees the massive shifts in price tokens and cryptocurrencies presently exhibit, something VCs are loath to absorb into their funds. Having a mechanism that allows them to cash out before a downturn makes a more appealing investment opportunity.

Even so, volatility adds an element of opportunity for many VCs. In 2017, the average return for hedge funds was 8.7%; a sample of crypto-based funds, on the other hand, experienced returns of nearly 3,000%. In fact, the VC world has been dabbling in cryptocurrencies for the past 5 years to cash in on the enormous returns. Since 2012, VCs have contributed over $2.5 billion in investments—representing more than 1,000 deals—with $1 billion of that sum arriving in 2017 alone.

Another major hurdle that is currently being cleared for VCs to really penetrate the crypto sphere is regulatory. Despite the growing popularity of cryptocurrencies, the industry remains largely unregulated, creating potential problems for firms that have strict compliance requirements and stakeholders who are more risk-averse. Even so, improving regulatory frameworks and increased clarity should help improve it.

Though regulators continue to put downward pressure on prices, it is clear to institutional investors that having a clear framework in which to operate will be a major sign to enter the market. Indeed, new laws aimed at increasing security, protection, and reducing fraud, could have a substantial impact. Decisions like the SEC’s recent announcement to classify bitcoin and Ether as commodities, and not securities, also means that VCs can enter the market with less fear of legal repercussions. Moreover, the global nature of blockchain and its regulatory framework makes it easier to navigate the ecosystem to find favorable conditions.

“The SEC and other regulators are going to regulate as they deem appropriate, and have been actively trying to engage the crypto community in recent months to get more input. I think as more established funds and companies—like Science, A16z, and others—move into the space, it helps to add a layer of perceived legitimacy, which may encourage regulators to act more quickly…I think the current uncertainty creates the risk of the united stated becoming a jurisdiction of second choice relative to other countries with defined, friendly policies. I think the SEC and other regulators are aware of this as well, and are trying to balance their missions of encouraging innovation and protecting consumers, and am confident that we’ll see meaningful, well thought out, and industry-friendly guidelines before too long,” said Greg Gilman, CEO of Science Blockchain

Finally, it is difficult to understate the competitive nature of the VC ecosystem, and how it plays a part in the rapidly growing blockchain sector. For many companies, even those wary of a possible bubble, the opportunity costs of ignoring cryptocurrencies and blockchain are too high. Instead, most VC firms are looking for ways to at least dip their feet. Whether this is more limited in scope—investing in other funds with crypto portfolios—or a full-fledged plan such as launching a crypto-specific fund, the results bear it out. While 2017 ended with only 58 crypto-centric funds listed, the first half of 2018 has already seen more than 225 new funds open.

Interest Is only Growing

This surge in crypto funds is unlikely to be an anomaly as blockchain ingrains itself as a disruptive technology. With the crypto sector laying the foundations for broader adoption, VCs will have greater incentives to explore the sector, creating a hybrid funding model for many blockchain startups that holds greater value than a simple ICO. Already, several large players in VC—including giants like Alphabet and Sequoia Capital—have funneled millions into major projects, and more are lining up. However, the change will not be easy, or painless, as it requires VCs to seriously reconsider their business model. Per Tom Graham, co-founder of TLDR Capital,

“ICOs are a major threat to the business model of venture capital and have dramatically reduced the cost of innovation financing for protocol and utility token projects. ICO investors have little bargaining power and do not demand preference shares or special treatment. Capital is no longer a bargaining chip for VCs to extract large equity stakes and control of budding innovation projects. Today, new crypto investment firms need to provide services that are valuable to crypto projects and the communities they create – where money is easy, value-add is king. In the past, venture capitalists offered value in the form of money and advice, but few bothered to develop services and products that really helped projects succeed.”

Big names like Lightspeed, which also funded Snapchat, and Venrock—the Rockefeller estate’s VC arm—have announced their intentions to start backing new projects with investments planned for across the sector. Others have been quieter, but nonetheless active. By March 2018, more than $400 million had already been pledged from VC funds to blockchain firms operating a variety of industries. While ICOs will continue to dominate headlines with their immense valuations and goals, VC will provide the foundation many of these projects need to actually succeed.

Featured image from Shutterstock.

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