What are the differences between traditional VC and Crypto VC?

Written by: @cjin, Tonic Fund Co-Founder

Introduction

Last year (2021/8), due to a friend's suggestion in a Facebook post—if fundraising for a Crypto project, the most important thing is: "Don't look for non-professional Crypto investors anymore." I quickly wrote a post comparing the differences between traditional VCs and Crypto VCs.

As Q1 of 2022 is about to end, I want to organize my thoughts again from the perspective of VCs, looking at the drastic changes in the startup investment ecosystem brought about by Crypto.

Is there really a big difference between Web2 and the Crypto/Web3 era?

Early Venture Capital in the Web2 Era

Looking back to the rise of Web2 in the 2010s, the cost of developing software startups decreased, and initial funding needs were minimal. The most significant change in the venture capital industry at that time was the emergence of many angel investors, early-stage funds, accelerators, and funds specifically investing in Social apps, Mobile apps, and even funds investing in Google Glass apps, etc.

Many "traditional venture capital or investment departments" also began to invite young people to look at early-stage startup cases or to engage with startups through investments in early-stage funds.

Originally, investors in various fields had different specialties, just like some excel in semiconductors, some in software, and some in biotech. As for whether they are "professional crypto investors," aside from their understanding of the industry, we can start with equity vs token investments:

Can Traditional Venture Capital Funds Buy Tokens?

Traditional venture capital invests in companies by purchasing equity (shares) issued by the company, while "Crypto" projects naturally issue tokens.

Each venture capital fund, when established, will sign an LPA (Limited Partnership Agreement) with its investors, which may not necessarily allow for the flexibility to buy tokens. For example, venture capital funds established in the United States generally have only 20% of their allocation available to invest in this high-risk asset class, and fund managers need to reach a consensus with their LPs on whether they are willing to bear high risks, especially since many LPs are more traditional large companies and funds.

Token vs Equity Public Offering Speed

Venture capital funds originally had opportunities to liquidate their shares only during i) IPOs, ii) mergers and acquisitions, iii) liquidations, or iv) secondary market transactions. Now, many situations involve Crypto projects completing a funding round with investors, or even listing on exchanges without raising funds from VCs, without the previous experiences of equity-based fundraising through Series ABCDE… or the Pre-IPO concept.

Given this speed, if a venture capital fund does not invest in the first round, will it have to buy on the open market like retail investors later?

Recently, VCs looking to invest in teams that have already issued tokens negotiate a market price discount with the project, but VCs must persuade the founders and the community or foundation to explain—"What can this VC help with?" This forces VCs to act early to secure deals.

A derived story:

Take Sushiswap as an example. Their fundraising plan last year seemed to end without success. The community (token holders aka retail investors) had many questions for the VCs they wanted to invest in—"What can you VCs do besides providing money? (If Sushi wants to raise funds, we retail investors can do that too)."

The "Sushi community" even voted to rate the VCs they wanted to invest in, and well-known traditional VCs like True Ventures and Lightspeed were surprisingly ranked at the bottom by the community. It's a parallel world…

Token vs Equity Liquidity

How do Crypto VCs decide whether to hold or trade already circulating tokens, which differs from the long-term holding mentality of traditional VC funds focused on equity investments?

If the tokens of the projects you invested in are listed on exchanges, retail investors can buy and sell them, but you may not have unlocked your tokens yet. Even when the lock-up period ends and linear unlocking begins, many people will check if your wallet is "hodling" this token, especially when the market is booming and prices surge.

Would you consider using another wallet to short in the futures market to make the fund profit (or hedge against losses), or would the fund's LPs hope you quickly realize profits? Does this fund have the flexibility to do so? This is something traditional VCs may not have considered yet.

Are you?

The market changes are not only happening in the Crypto circle; traditional startups are also moving towards earlier-stage companies.

Previously, startups would go public after progressing from Seed to ABCDE rounds. In recent years, Europe and the U.S. have opened up more lenient Equity Crowdfunding, and the SPAC trend that was popular in the U.S. two years ago (which has cooled down in 2022) has also allowed companies to raise funds from retail investors earlier.

Combining the above points 2) and 3), it has also led to the current competition in the Crypto circle for the earliest investment opportunities.

Exclusivity in the Crypto Circle

In recent years, the Crypto circle has seen many innovative business models and new fundraising methods for token listings, with some Crypto projects resembling social experiments. However, like in any industry, there will be some bad actors. Many people entering the Crypto circle, even innovative developers, are often viewed by the media or those who dislike new technologies as part of a black market or scams.

This has led believers in Crypto to say "few understand" and "WAGMI," reflecting an attitude of knowing that Crypto is the future, and those who understand it do, while debating with skeptical investors is exhausting, NGMI.

When hearing the weary comments from current Web2 entrepreneurs or investors dismissing various new practices in Web3, or referencing laws established before World War I, the younger generation of Web3 entrepreneurs naturally adopts a defensive mindset, wanting to connect with entrepreneurs and investors who are already on the same track.

What Can VCs Help With?

Take the example of a Paradigm researcher saving Sushiswap with $350 million in 2021/8.

Paradigm is a highly sought-after Crypto fund by many crypto teams. One of Paradigm's founders is Fred Ehrsam (co-founder of Coinbase) and the other is Matt Huang (former Sequoia Partner).

Paradigm has many talented researchers, one of whom, @samczsun, saved Sushiswap from a vulnerability, preventing $350 million from being attacked.

This sounds like a superhero story. Interestingly, Paradigm is an investor in Uniswap and even helped design V3, but when they discovered that Sushi, a competitor and homage to Uni, was in crisis (even Sushi itself was unaware), they proactively stepped in to help.

Later, in 2021/11, samczsun saved a dYdX smart contract from being hacked:

Back to Paradigm, but does every VC have such strong technical capabilities to help teams? Teams can issue tokens and raise funds themselves, so what can VCs really help with?

How Do Traditional VCs vs Crypto VCs Evaluate Investment Cases?

i) Seller's Market: Fundraising Before Development and Customer Acquisition

As mentioned earlier, early-stage venture investment has been thriving for over a decade, and many people evaluating Web2 software startups have extensive experience, looking at various indicators from market, team, product, traction, to product data to assess whether the team has found PMF (Product-Market Fit).

However, evaluating Crypto projects presents some inherent difficulties:

Web2 VCs love to ask teams about: Active Users, Retention, CAC, LTV, etc., but many Web3 companies' products are still undeveloped, with no users and no retention.

Web2 channels spend money on Google/Facebook ads, making CAC calculation straightforward. However, most Crypto projects cannot buy ads through Google/Facebook.

Remember a popular article from the Web2 era—"Growth Hack is the new VP Marketing"?

The current situation for Crypto projects is: Tokenomics is the new VP of Growth (this is not a famous saying, just my observation).

Crypto VCs focus not only on the business itself but also need to understand how Tokenomics is designed to enable project growth.

ii) Can You Invest in Anonymous, Community-Operated Teams, or Non-Corporate DAOs, Remote Teams?

Privacy, decentralization, and direct trust in Smart Contracts are inherent traits of blockchain projects; at least Bitcoin is an example of anonymity.

If a team is willing to face investors and the community with their real identity, it can certainly enhance their social proof.

Before the pandemic, many VCs only invested in teams from certain regions (for example, only investing in Silicon Valley companies). VCs that previously invested in international teams would usually travel abroad for due diligence.

During this wave of Web3's rise, everyone has been operating in remote models across time zones during the pandemic, and many Crypto projects have yet to meet their members in person.

Crypto-native VCs and their LPs are accustomed to this ecosystem, and we can even see the emergence of anonymous venture partners (like Starry Night Capital's GP @vvd) or funds claiming to be anon-friendly, such as dao5, or traditional large VCs like Bessemer establishing BessemerDAO.

iii) Fund Utilization

Outstanding Crypto projects target global markets, and in this industry, everyone is competing globally for Crypto customers and talent. In the past, Silicon Valley investors complained that their investments were used to pay for San Francisco's rent and salaries, and traditional VCs now need to understand that even a team in Asia is competing with Silicon Valley for talent and users, and the salaries paid will also be considerable.

These Crypto-native entrepreneurial ecosystems present significant challenges for traditional VCs in their evaluations.

Investment Competitors

In the past, early-stage VCs would avoid investing in competing portfolio companies to support their teams and avoid conflicts of interest. If they invested in competitors in the same field, they would have to publicly explain it.

For example, why did a16z founding partner Marc Andreessen personally answer on Quora about investing in both PicPlz and Instagram, which are both social photo apps?

Crypto funds with traditional VC backgrounds still avoid investing in competing teams. However, emerging Crypto VCs, many of whom come from hedge funds and trading backgrounds, may not realize the drawbacks of investing in competing teams, as their operations are more short-term.

Community Participation, Meme

The Crypto "community" primarily gathers on several Web2 services: Discord, Telegram, Twitter, or Signal. Traditional VCs previously built customer communities targeting entrepreneurs and did not need to engage with retail investors in the public market. However, in the Crypto era, anyone can participate in investing in early teams and compete for community voice as Degen, especially since the Crypto community is filled with various memes, abbreviations, and humorous images.

Traditional VCs, burdened by past norms of communication, are not well-received in the Crypto circle. However, to enter the Crypto space, VCs must target a customer base that includes not only entrepreneurs but also "peers" in the investment community, which now overlaps increasingly with "community/investors/users." This group of "community/investors/users" may have a louder voice influencing project direction (which is not necessarily a good thing).

How should traditional VCs respond? The best way I can think of is that traditional VCs might have to spin off a Crypto Fund themselves, at least spin off a Twitter account with an "intern" tone.

1/ Sequoia started using some crypto terms on Twitter to hint at entering Crypto.

2/ Crypto Fund - Zeeprime humorously describes itself as being in the "meh" group in community ratings of VCs, often being listed as "and others" after well-known VCs in fundraising press releases.

3/ CMS Holdings has a main account and a CMS intern account, which helps share key notes and tweets that resonate with the community.

Traditional VCs Participating in Crypto

Now, Crypto projects need to lay out various resources while fundraising: experienced Crypto entrepreneurs, those with Tokenomics design experience, connections with different chains, exchanges, and protocols, influential KOLs with community voice, and traders who can activate the market…

These aspects are currently challenging for traditional VCs to participate in, so we will gradually see various traditional VCs needing to establish their own Crypto Funds.

When Sequoia established its Crypto Fund, they stated that it was their first time creating a fund for a single industry. The fund primarily aims to operate with liquid tokens, including investments, staking, providing liquidity, and participating in governance.

The new fund DAO5, led by former Pantera GP, aims to closely align the interests of VCs and entrepreneurs: allowing the founders being invested in to also receive tokens and participate in DAO decisions.

The changes in the Crypto circle are rapid, and many new practices have emerged since last year's post. This is a summary of my observations during this time.