Liquid Venture Capital
Disclaimer: This is not financial advice. Anything stated in this article is for informational purposes only, and should not be relied upon as a basis for investment decisions. Chris Keshian may maintain positions in any of the assets or projects discussed on this website.
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This is a seven-part series on FJ Labs’ investment process for liquid crypto:
The emerging cryptocurrency asset class necessitates a nuanced investment approach. Cryptoassets are effectively early-stage investments in internet-native companies, in which the value is held in a liquid asset as opposed to illiquid equity. This nascent asset class therefore exhibits characteristics of both traditional venture capital and public equities. As such, these assets offer a unique investment profile that combines venture-style returns with lower risk and a shorter commitment.
Situated at the intersection of conventional venture capital practices and public equity investing, Liquid Venture Capital (LVC) stands out as a novel paradigm shift that is more appropriately positioned to navigate the dynamic cryptocurrency markets. LVC is primed to redefine investment methods, addressing many limitations of the traditional VC model and providing outsized returns with the benefit of liquidity and active portfolio management.
Token Models Necessitate a Nuanced Approach
Before discussing the merits of liquid venture capital, it is important to understand the token-based economies that have played a crucial role in the shift towards this emerging investment approach.
In Q1 2021 alone, venture capital funds funneled an impressive $2.3 billion into token investments. These tokens perform various functions – they act as a medium of exchange, represent a store of value, accrue value from the cash flows of a business, and grant governance rights.
As shown below, in order for investors to maintain comprehensive exposure to crypto, some portion of their total investment should be allocated to liquid crypto, as it comprises the lionshare (mega-cap and small-cap crypto) of the total investable landscape in this emerging asset class.
Source: CoinMarketCap, CBInsights, S&P, Sparkline. Q4 2022.
By inextricably linking the value of a token to the success of the project that launches it, companies are able to offer tokens that represent real value and are often the only means of getting exposure to their success. Moreover, token holders align incentives amongst users, investors, and speculators, and foster a unique sense of community and shared purpose. This cultivates a more participatory form of investing, effectively transforming investors from passive spectators to active contributors.
Crypto tokens are more lucrative than equities, given the size of the TAM and the network dynamics at play in internet economies. By way of example, in July 2019, venture funds invested $20 million into Solana Labs and received SOL tokens rather than Solana Labs equity. Over the next year, the SOL token surged over +20,000% to a peak market cap of $78 billion.
In order to understand why venture capitalists opted for SOL tokens instead of Solana Labs equity, we need to understand the economics of tokens. Kai Wu, Sparkline Capital, provides an excellent summary of the merits of a token investment through an analogy to traditional equities, reproduced below:
Dividends - Companies reward shareholders with dividends (paid in either cash or stock). Similarly, crypto projects may reward tokenholders with additional crypto. Such yields can be generated from a variety of underlying sources, such as exchange trading fees or staking rewards.
Buybacks - Companies also reward shareholders with buybacks. By reducing share supply, buybacks increase the value of remaining shares. Crypto token burns remove coins from circulation to the same effect. In August 2021, Ethereum started burning a portion of tokens sent as transaction fees, deflating supply.
Issuance - Companies issue shares to raise capital and incentivize employees. There is no cap on equity issuance or total supply. In contrast, token issuance and supply are often capped. Bitcoin caps total supply at 21 million, while Ethereum caps annual issuance but not total supply.
Vesting - Startup equity granted to venture capitalists and key employees often has a vesting period before it can be sold. Tokens have similar provisions. This is especially important as token liquidity generally occurs sooner.
Governance - Common shares carry voting rights on key matters of corporate policy, such as board composition and M&A. Governance tokens grant similar voting rights, such as over the use of the DAO treasury, token economics, and key technical proposals.
These characteristics have given rise to a novel, more flexible, internet-native asset class, and has resulted in a veritable Cambrian explosion in crypto assets and token models. The most important attribute of these assets is that they are fully liquid, meaning that investors do not have to wait for a fundraising round or for a company to go public in order to realize a return on their investment. I will delve deeper into the benefits to this liquidity advantage later in this essay.
A final point to note regarding token investing is that, while significant value is generated by investing early through SAFT (simple agreement for future tokens) contracts and private VC deals, much of the value appreciation for these assets occurs after the token is publicly traded. As elucidated by Arthur Cheong, Defiance Capital, “crypto networks exhibit power law and market leaders can continue to lead and dominate, as demonstrated by the dominance of big tech firms as a percentage of US stock market capitalization”. As shown below, the majority of price appreciation occurs for many assets post-token generation event (TGE), i.e. after a token is publicly traded.
LVC Token Investing is a Blue Ocean
Despite the above advantages to liquid token investing, there are far fewer structural buyers in liquid crypto markets. Instead, the majority of long-term institutional capital has gone into venture investing. VCs have invested close to $70B in crypto startups in 2021 and 2022, significantly more than all previous years combined.
Source: The Block Research
Although certain venture capitalists have some leeway to directly invest in liquid cryptocurrencies, their primary focus revolves around primary market venture deals. This inclination stems from their specialized expertise and the structural considerations inherent in venture funds. Even in instances where VCs do venture into the realm of liquid crypto investments, they generally do so on deal by deal basis, with limited ability to actively manage positions according to the latest fundamentals.
The Limitations of Traditional Venture Capital
Traditional VC operates on the principle of illiquidity. Investors pledge their capital to startups for prolonged periods, frequently years, before a liquidity event, such as an IPO or an acquisition, offers a return. The VC model, while valuable in its capacity to foster innovation, is fraught with illiquidity constraints for both fund managers and investors.
GPs
The traditional VC model exhibits a "power law" nature, wherein a small percentage of investments yield the majority of returns. Out of every ten investments, only a few will succeed, while others may fail or achieve moderate success. As described by Tushar Jain and Kyle Samani (Multicoin Capital) “a venture fund might make 20 investments. 15 of them will probably return nothing. 3 or 4 may return 5-10x. And 1 or 2 may return 20-30x. This hypothetical fund will return 2-4x despite the fact that 75% of investments returned 0x.” This power law dynamic is visualized in the image below. This demands diversification to spread the risk and necessitates a sizable fund to absorb potential losses. If fund managers were able to divest in companies before their investment went to zero, and reallocate that capital to other opportunities, the return profile would look radically different.
Source: Sparkline Capital
LPs
Most VC funds have a 10-year time horizon. The long-term illiquid nature of VC investments poses significant challenges, as it restricts the agility of investors, locking up their capital and limiting their ability to react to real-time market developments.
LVC Offers a Compelling Alternative Approach
At the core of LVC is a unique philosophy, combining traditional VC's long-term view with the flexibility essential in the crypto markets. This strategic blend allows for a dynamic investment approach that can react to market fluctuations.
GPs
At the heart of this revolution are tokens, which can be traded on various exchanges. The availability of these tokens offers investors immediate liquidity, a stark contrast to the 'lock-in' periods associated with traditional VC investments. This permits investors to adapt to market changes, taking advantage of investment opportunities as they emerge. As such, LVC fund managers do not have to ride their losing investments to zero, but instead can cut these positions if their initial investment thesis fails to materialize. By re-hypothecating this capital, LVC funds can stay exposed to the best investment opportunities, and navigate the evolving investment landscape with real-time information.
LPs
This liquidity advantage carries through to LPs, who can withdraw capital from these vehicles anytime. LVC fund managers could offer quarterly or even monthly liquidity to investors, allowing these allocators more optionality.
The Liquidity Premium
The option value of liquidity can be represented by a function of the anticipated volatility in the future opportunity set. If no intriguing opportunities are expected to emerge, the cost of forgoing liquidity is minimal. Conversely, if the future is promising, and the opportunity set is large, illiquidity carries a substantial cost.
Investments in early-stage innovation exhibit remarkably high implied volatilities. The potential outcomes for startups vary significantly due to the power law. As such, VC and LVC investors - who’s mandate is to invest in innovation - should assign a high premium to liquidity. Technological trends can swiftly change, and the best startups of today may not retain that status tomorrow. This is overwhelmingly evident in the crypto space, where novel blockchain applications and products arise and fail in a cyclical progression as the asset class matures. Liquidity in these markets empowers investors to navigate the rapidly evolving landscape.
Conclusion
Despite the inherent volatility of the crypto market, skilled management and investment strategies can yield impressive returns, with the average VC fund's net IRR outperforming Bitcoin by nearly 50% when calculated from each fund's final close date. Moreover, while LVC does present an intriguing risk profile - while its 1-year downside deviation being higher than that of Bitcoin, its 3-year downside deviation is notably lower. This indicates that over a longer time period, the associated risk with the asset has decreased. In other words, while the investment may have higher short-term volatility as compared to Bitcoin, over a longer-term horizon its risk profile is lower and returns are relatively more stable.
Crypto investing has always been a fascinating landscape, full of potential yet marred by reflexive price cycles and extreme volatility. Venture capital (VC) firms traditionally invest in startups, patiently waiting for a liquidity event to reap returns. However, the advent of cryptocurrencies and token-based ecosystems opens the door for a new dimension to this investing paradigm: liquid venture capital. We believe this paradigm shift and novel approach is the best way for investors to gain exposure to the emerging cryptoasset class.
