A bear market could signal change in the way institutional investors view crypto investments, and that’s not necessarily a bad thing for an asset class sometimes mistaken for consisting solely of volatile currencies.
“A misconception about the crypto space is that there is a single thing – cryptocurrency – to allocate to, but that couldn’t be farther from the truth,” says Scott Army, Managing Director, CIO at Galaxy Vision Hill. “There’s massive segmentation and specialization. Often, the early days of a multi-decade technology map well to venture allocations, and that’s the easiest way for institutions to enter the space.”
In other words, the real potential in crypto is on a longer time horizon than many investors might realize based on the history of the asset class. In 2018, the ICO [initial coin offering] bubble burst because investors fundamentally lost confidence in crypto. That is not the case today, and institutional investors eyeing the space with headline-generated trepidation might reconsider what could be rare opportunities.
“The longer the time horizon, the easier it is to focus on building great technology and useful products,” says Ben Forman, Founder and Managing Partner, ParaFi Capital, a firm focused on investing across the crypto ecosystem. “We’re long term focused, and investors are taking a multi-decade view around crypto. However, in the near term crypto has developed into a volatile, macro-driven asset class.”
Changes for the better in early-stage investments
The crypto ecosystem has developed by leaps and bounds in a relatively short time, attracting massive amounts of venture capital and private equity. In its brief history, the space has demonstrated a knack for innovation – particularly during challenging times, which highlight projects that have longevity and the ability to grow.
“During moments like this, there are select opportunities to make investments into great companies with time sensitive financing needs,” Forman says. “It’s natural in times of fear to freeze until you know markets will go up again, but if you look back at the last cycle, the 2018/2019 vintage turned out to be the best.”
As Army noted, being an early mover in crypto-related technology that evolves over many years is a natural fit for institutional investors. But early-stage venture investing has evolved from the “early days” deals (think five years ago) that were structured as simple agreements for future tokens (SAFTs). The owner of a SAFT is not an equity owner, which leaves them vulnerable and without the protection typically afforded equity owners.
Much more prevalent today are structures that comprise a SAFE – simple agreement for future equity – with a token warrant attached.
When tokens are expected to comprise most of the value in an equity investment, a pre-existing equation in the SAFE determines how many tokens are issued pro rata to the equity owners. This creates protection for investors (notably supported by significant existing case law).
Identifying quality
The use of tokens is one area that can contribute to separating quality investments from less desirable opportunities. It’s not uncommon for token vesting schedules to allow a founder to de-risk their entire token stake within 18 months. That can get messy quick for a decentralized autonomous organization (DAO), becoming a major hurdle to those communities reaching their full potential. Some argue such actions are detrimental to the creation of quality companies and products.
“Token vesting schedules are too short and not aligned to the long term,” says Forman. “That is one trigger of market selloffs. Capital formation is the foundation of capitalism. If you’re a founder and building a company, you don’t have the option to de-risk – you must build until an eventual exit. That long-term incentive alignment with investors and builders is extremely important. Neither party can really sell. Instead, you must create value.”
Another consideration in the search for quality investments is anonymous founders or team members, especially in decentralized financing. That’s at odds with investors’ need to be comfortable with the management team. Investors should insist everyone on the management team make themselves known for vetting purposes. Of course, claims regarding the efficacy of technological innovations must be accurate, too.
For smart investors who understand how to approach the nuances of the space, however, there is an abundance of opportunity in crypto and the asset class has a consistently improving track record.
“Top crypto assets and crypto companies are real products that actually work,” says Haseeb Qureshi, Managing Partner, Dragonfly Capital, a global crypto asset management firm with venture and hedge fund strategies. “Enormous numbers of people have interacted with them and understand what crypto is and why it’s going to be useful,” he says. “DeFi [decentralized finance] is real. NFTs [non-fungible tokens] are real. Investors continue to interact with them despite the downturn. Most of the shocks that have affected crypto prices have been exogenous.”
Focusing on early-stage strength
While it’s easy to get hung up on red flags while performing due diligence on early-stage investments, Qureshi suggests flipping the lens and peering from the opposite viewpoint.
“In early stages, we tend to invest more for strength than for lack of weakness,” Qureshi says. “It’s easier to plug a hole than to build a world-class strength where none currently exists. We’re more inclined to invest in something amazing with a glaring flaw than something that has no flaws but doesn’t get us excited.”
Could early-stage opportunities evolving today eventually be viewed as a legendary vintage? It’s impossible to say for certain, but Army has done benchmarking on vintages that provides something akin to a rearview mirror of the future. The work wasn’t limited to crypto, either.
“The best vintage returns have come through investing during previous bear markets,” he says. “Many of the public assets that become household names are earliest stage venture investments when things seem dark. The 2021, early 2022, and maybe even 2023 vintage could end up being classic for having invested in venture crypto.”
With the amount of technological buildout happening in the space, vast stores of capital capable of being directed toward it, and the growing realization that blockchain-related products are more than viable, the space seems poised to produce highly sought vintages for many years to come.