The long-awaited re-correction of private tech startup valuations and fundraising expectations has a web3-sized asterisk next to it.
While many funds are returning to more conservative check-writing, with a focus on profitability and business fundamentals, crypto remains a sector in the spotlight that attracts dedicated billion-dollar funds and investment terms that remind us more of 2021 than 2022.
So, is it hype, the promise of innovation in crypto, or a little bit of both? Venture capitalists and founders across all fundraising stages spoke to current investment strategies when it comes to investing in this cohort of startups. The contrasting strategies come down to technical differences in cap tables, the culture of communities that many companies in this space are built upon, and, of course, the non-crypto world’s fear of missing out.
Tokens and the future of future equity
Web3 cap tables typically range across four different categories, Chris Matta, president of 3iQ Digital Assets, explained to TechCrunch. The first is the traditional cap table, which is similar to traditional technology companies and follows a classic business model that’s more “accessible and understandable by investors,” but would not include a token model.
The second is a hybrid cap table that has a core list of traditional equity holders along with some investors who are in a token conversion agreement that will grant them token allotments once the token tied to the company is launched. “These business models focus on the token but use the equity as a transition structure,” Matta said.
Third is a token-first structure, which has a “lean cap table” consisting of the startup founders that’s a pure placeholder on the road to a fully tokenized structure, i.e., the primary capital-raising vehicle, Matta said. “These structures were popular in the 2017-2018 [Initial Coin Offering] days and have become less prevalent today.”
Lastly, decentralized autonomous organizations (DAOs) that have popped up in the past 12 months generally have no centralized entity but have typical rights and governance structures that a traditional non-web3 company would have.
There’s also a simple agreement for future tokens (SAFT), where investors don’t own equity in the company, but see value in its token and will eventually get the company’s native coin, Yida Gao, general partner at Shima Capital, said. Alternatively, there are simple agreements for future equity (SAFE), in which a company provides an investor rights to future equity without specifying the price per share during the initial investment.
Influx of cash-rich attention
“The days are long but the years are short in crypto,” Stan Miroshnik, partner and co-founder of 10T Holdings, said to TechCrunch. “When we started the fund (over three years ago), the premise was really there was no one tooled up to write a $50 million check into the blockchain space at all.”
In the past 12 months, there’s been a combination of traditional growth investors and crypto-focused investors tapping deeper into the space. Then there are strong existing venture asset managers with more dedicated crypto strategies like Andreessen Horowitz (a16z), Lightspeed Venture Partners, Bain Capital and Sequoia Capital, to name a few.
Yet, things are accelerating across the board in crypto. Last year, about $32 billion of capital pooled into the crypto world, and this year, $11.35 billion has been invested to date, according to data compiled by PitchBook.
There’s a clear difference between traditional equity investing and putting capital to work in web3 and crypto companies in terms of ownership, Gao told TechCrunch. “In traditional equity investing you want to have a Series A or seed stage investor have 20 to 30% ownership of the company,” he said. “But having 20 to 30% ownership of a token or of a network is very bad and frowned upon by the community. And web3 is all about the community.”
One way that web3 and traditional venture investments differ is how equity stakes are purchased. “Tokenized equity” is a common term across the digital asset industry and involves issuing a digital token, or cryptocurrency, that can signify equity in an organization. The token then serves as equity for investors, but can also be bought by retail investors through a centralized crypto exchange like Coinbase or a decentralized crypto exchange like Uniswap.
Tokenized equity is different from traditional equity because ownership rights differ; board seats are not handed out to tokenized equity holders, and in a DAO, where tokens equal voting power, venture investors may not be able to arrogate more votes per share, as is standard in some startup deals.
If there’s a token holder that has 20% ownership of a network, it’s too centralized for web3’s mission of decentralization, Gao noted. “There will be fear from the community that the individual or entity can dump on the retail investors or community or they’ll have too much voting power relative to the rest of the community, so investors are open to taking lower ownership of a token.”
Owning traditional equity in web3 is similar to owning equity in Web 2.0 companies, Gao said. But the nuance is that owning 10% equity of a web3 protocol doesn’t necessarily equate to owning 10% of the organization’s tokens, Gao said. Therefore, an investor would most likely get fewer tokens, perhaps as high as 5%, even if they have more equity. This can be used for a number of things, like governing power to vote on issues within the organization, but without giving them a majority stake.
Aligning tokens with purpose
If a founder is confident in what they’re doing, they should try to make sure they align themselves with the ecosystem that they’re building their company in, Do Kwon, the founder of Terraform Labs, which created the crypto tokens LUNA and stablecoin TerraUSD (UST), told TechCrunch.
“I think if you’re a hedge fund, you should definitely consider investing in liquid tokens because they’re a lot easier to trade,” Kwon said. “The expectation should be that you are going to trade in and out. But, I think if you’re a venture capitalist, you should have a preference for longer-term positions. So it could be in the form of equity but also in the form of tokens that are locked up for a reasonable amount of time.”
Last year, the five-year-old crypto lending platform Celsius raised $750 million, marking one of the largest crypto funding rounds for 2021. Celsius gave investors in its Series B solely equity, no tokens, Alex Mashinsky, CEO of the company, told TechCrunch.
The main difference between web3 cap tables and traditional startup cap tables is the structure of a company, because the way a C-corp would provide investors with equity would differ from the way a decentralized organization or DAO would, he said. Today, Celsius owns half of its CEL tokens and only sold investors tokens in its initial coin offering (ICO) in 2017 when the company first launched, Mashinsky said.
“We don’t need to give tokens anymore,” he said. “If you can raise money through equity, you want them as equity investors because they’ll stick with the company for a long time. Sometimes when you give tokens they sell them quickly because it’s like easy money, it’s not like equity.”
The subtleties of web3 cap tables create specific challenges for investors seeking venture capital-esque returns from early investments.
Culture of community
Lydia Hylton, partner at Bain Capital Crypto, said that in Web 2.0, ownership is between investors, the founders and the team. In web3, ideally, the company is majority-owned by the community, which makes it difficult to get the ownership targets that VCs want.
“The model of a single investor having a 20% stake is almost unheard of,” Hylton, who previously worked at Redpoint Ventures, said.
To be able to invest more broadly in crypto companies, she thinks VC funds will have to get comfortable with betting on liquid tokens. In February, Sequoia Capital announced a new $500 million-plus fund focused primarily on liquid tokens and digital assets. “Our goal with this fund is to participate more actively in protocols, better support token-only projects, and learn by doing ourselves,” the venture capital firm wrote in a blog post announcing the fund.
“There is a more collaborative feel when you invest in web3 projects,” Gao said. In general, there are more investors on the cap table in web3, compared to traditional companies where there’s a lead investor who takes majority ownership, he said.
“I’m seeing more party rounds than not because crypto founders believe there’s a lot of capital out there, and as investors, you need to have other value-adds other than just capital,” Gao said.
It’s not just ownership that crypto companies have a different perspective on — it’s advice. Crypto companies have needs quite different from traditional funds. While a Web 2.0 company may need help going public, hiring executives, or structuring an organization, web3 companies may need guidance designing tokens or with cryptocurrency taxes.
established roles are changing in crypto / web3:
Software eng > Software editors
Community mgr > Value Manager
Game design > Economy design— Mercedes Bent (@mercebent) January 20, 2022
Reading between the lines, the difference in what founders may determine to be a “value add” means that generalist firms have to use different techniques than crypto funds to win deals.
Freestyle VC, which just closed a $130 million sixth fund, only leads about 10 seed-stage rounds per year, a “high-conviction, low-volume” route that partner Jenny Lefcourt has no plans on changing. However, she recently started cutting smaller checks into web3 companies because “you can’t stand by the sidelines and read to learn — you have to get in the middle.”
“The majority of [Freestyle’s web3 deals], we can’t get ownership because that’s either not the model or we haven’t earned the right to be a leader,” she said. “We’re not Paradigm, or pick your favorite [venture firm].” Web3 companies that get Freestyle money thus won’t get the same hand-holding as a core portfolio company, but they will get a more generalist adviser to help translate the still-confusing language of the future.
“What’s interesting is that you can get a lot of crypto money into a crypto deal, but crypto is technology, and if it is a consumer experience, you need people who really understand go-to-market, positioning, consumer marketing,” Lefcourt said. “All the old rules apply.”
Still, she admits that hype plays a solid role in the overall worth of crypto companies at this moment in time.
“Web2 got the memo about valuations coming down, and web3 has not,” Lefcourt added.
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