The State of Crypto Venture Investing: Insights from Acquired Podcast Hosts

In a recent episode of the Validated podcast, host Austin Federa sat down with Ben Gilbert and David Rosenthal, the hosts of the popular Acquired podcast, to discuss the current state of crypto venture investing. As seasoned investors and tech industry analysts, Ben and David provide valuable insights into the challenges and opportunities in the Web3 space, as well as the broader venture capital landscape.

The Evolution of Crypto Investing

Ben and David's journey into the crypto space began at different times and through different avenues. Ben's exposure started during his college years from 2008 to 2012 when he witnessed classmates mining Bitcoin and losing money in the Mt. Gox collapse. David, on the other hand, was introduced to crypto through Fred Wilson's AVC blog and Union Square Ventures' early investments in the space.

The hosts highlight that there were distinct waves of venture interest in crypto. The earliest adopters, like Fred Wilson, saw potential in Bitcoin and blockchain technology before most. Then came a wave around 2014-2015 when the popular mantra among VCs was "I don't believe in Bitcoin, but I believe in the blockchain." This period saw investments in companies like Ripple.

The Paradigm Shift in Venture Capital

A significant turning point in crypto venture investing occurred around 2019. Ben and David discuss how this wasn't necessarily due to a technological change, but rather a paradigm shift in how VCs perceived the space. As Ben explains:

"I think a lot of people who went from investing in crypto for speculation could cross the chasm to, 'Oh, I see, I can invest in these because they're going to make actual web apps in a decentralized manner that have different utility.'"

This shift coincided with a period when VCs were seeking the next big computing paradigm after mobile. The promise of blockchain and decentralized applications provided a compelling narrative for investment.

The Current State of Web3 Venture Investing

The conversation then turns to the current state of Web3 venture investing, which has seen a significant drawdown along with the broader venture capital market. David emphasizes that while Web3 may have been hit particularly hard, the entire venture capital industry is experiencing a slowdown:

"The reality is all of venture has gotten whacked. Like the difference between, you know, how much Web3 within, you know, venture at large has gotten whacked versus how much, you know, venture as a whole, like, David, I totally disagree. It's not like way."

Ben adds context to this by comparing pre-seed valuations of crypto companies during the peak of the market to current valuations:

"Pre-seed rounds now are something like of regular non-crypto companies are something like 6 million pre. And in the craziness, you got up to a world where like companies were coming out of YC and doing like 18 million pre, and effective. I would say companies at 40 pre, 50 pre. But crypto companies, I was seeing at 50 or 100 and like the hottest ones were at like 150 pre-product, you know."

The Macro Environment and Its Impact

The hosts attribute much of the current slowdown in venture investing to changes in the macro environment, particularly rising interest rates. Ben points out that with guaranteed returns of 5% on low-risk investments like CDs, there's less incentive for investors to chase high-risk opportunities:

"When you have interest rates that go up, there are a lot of very low risk investment opportunities that have great returns. Like yesterday, I went and bought a 12 month CD for a guaranteed 5%."

This shift has led to a redistribution of capital along the risk curve, with fewer investors willing to take on the high risks associated with crypto and Web3 investments.

The Numerator and Denominator Effects

An important concept discussed in the episode is the numerator and denominator effects, which help explain the current hesitancy in venture capital deployment. David explains:

"LPs means limited partners. These are the folks who invest in venture funds, mostly institutions, university endowments, pension funds. Increasingly sovereign wealth funds, yep."

The numerator effect refers to the reduced value of liquid assets in LP portfolios due to market downturns, while the denominator effect describes how this reduction increases the proportion of illiquid assets (like venture investments) in the overall portfolio.

Ben elaborates:

"And then suddenly that now the denominator effect kicks in where your 15% exposure to alternative assets or high risk assets jumps to 30% of your whole portfolio. And suddenly every single owner of capital or every single steward of capital, these LPs are hitting the panic button going, 'Oh my God, oh my God, oh my God, we are way overexposed on the highest risk stuff.'"

This dynamic has led to a situation where LPs are reluctant to make new commitments, and VCs are hesitant to call capital for new investments.

The Principal-Agent Problem in Venture Investing

The discussion touches on the principal-agent problem in venture capital, where the incentives of general partners (GPs) may not always align perfectly with those of their limited partners (LPs). Ben explains:

"The owners of the capital, the principles of capital, don't care about your next fund. Like the dollar in my fund one has no feelings about a dollar in my fund two. But the GP totally wants there to be a fund two."

This misalignment can lead to different behaviors depending on market conditions. In boom times, GPs might be incentivized to deploy capital quickly to raise the next fund. In challenging times, like the current market, GPs might be more hesitant to deploy capital to avoid putting pressure on their LPs.

The Function of Venture Capital

Despite the average venture return over a 10-year period being close to zero or slightly negative, venture capital continues to play a crucial role in the startup ecosystem. Ben and David explain that the function of venture capital is to capture outsized returns when investments are successful:

"When you get it right, you get it really right. That is the function. There's a couple of statistical interesting things about venture that make it different than other asset classes. One is you absolutely do not want to index venture."

They highlight that unlike other asset classes, venture capital exhibits a persistence of returns, meaning that top-performing firms tend to continue performing well in subsequent funds. This dynamic creates intense competition among LPs to invest in top-tier venture firms.

The Technical Nature of Crypto Investing

The conversation turns to the highly technical nature of crypto investing compared to traditional venture capital. Austin notes that some of the best-performing crypto funds, like Dragonfly Capital and Paradigm, have engineers as general partners who can deeply analyze the technical aspects of projects.

David suggests that this technical focus might be a function of the current stage of the crypto industry:

"I think it may be the stage that crypto has been at. One of the things about this industry is you never know how things evolve and making predictions is a surefire way to look silly. But I would guess I think it's more likely than not that Web3 crypto investing will evolve to look more like the business model first model that you're describing."

He draws a parallel to the early days of SaaS investing, where a deep technical understanding was necessary before the business models became more standardized and widely understood.

The Revenue Model Challenge in Web3

One of the persistent critiques of Web3 projects is the lack of clear revenue models. Austin points out that even successful platforms like Ethereum have struggled to generate significant protocol revenue. Ben suggests that this uncertainty around business models is a key factor in the current freeze in crypto investing:

"To me, this is the way that crypto can have billions of dollars flow in is to make that checkbox the same as it is for the web 2 world, which is like, yeah, there's a business model. Yeah, customers are willing to pay for this. Yeah, there's positive unit economics in a way where the company can accrue enterprise value over time because it has free cash flow."

David draws a parallel to the early days of Google, which raised capital at high valuations without a clear business model for years before figuring out its advertising revenue strategy.

The Future of Crypto Venture Investing

As the conversation wraps up, the hosts speculate on the future of crypto venture investing. They note that while many big tech companies have made significant moves in AI, there hasn't been the same level of urgency around blockchain and crypto technologies.

Ben and David suggest that for crypto to attract significant venture capital again, projects will need to demonstrate clear utility and potential for revenue generation. They remain optimistic about the long-term potential of blockchain technology but emphasize the need for patience and perseverance in the current market conditions.

Solana's Position in the Crypto Ecosystem

While the conversation doesn't focus specifically on Solana, the insights provided by Ben and David are particularly relevant to the Solana ecosystem. As one of the leading high-performance blockchain platforms, Solana is well-positioned to benefit from the eventual recovery in crypto venture investing.

Solana's technical advantages, including its high throughput and low transaction costs, make it an attractive platform for developers building decentralized applications. As the venture capital market stabilizes and investors regain confidence in the crypto space, Solana-based projects are likely to be among the beneficiaries of renewed funding interest.

Moreover, Solana's focus on scalability and user experience aligns well with the evolving expectations of venture investors looking for Web3 projects that can demonstrate clear utility and potential for mainstream adoption. As the crypto industry matures and moves towards more sustainable business models, Solana's ecosystem is poised to play a significant role in the next wave of blockchain innovation and investment.

Conclusion

The insights provided by Ben Gilbert and David Rosenthal offer a nuanced perspective on the current state of crypto venture investing. While the market has undoubtedly cooled from its peak, the underlying potential of blockchain technology and decentralized systems remains strong.

For the Solana ecosystem and the broader Web3 space, the current market conditions present both challenges and opportunities. Projects that can demonstrate clear utility, potential for revenue generation, and a path to mainstream adoption are likely to attract investor interest even in a more cautious funding environment.

As the industry continues to evolve and mature, platforms like Solana, with their focus on performance and user experience, are well-positioned to lead the next wave of blockchain innovation. The lessons learned from this market cycle will undoubtedly shape the future of crypto venture investing, potentially leading to more sustainable and impactful projects in the long run.

Facts + Figures

• Ben Gilbert's exposure to crypto began during his college years from 2008 to 2012.
• David Rosenthal was introduced to crypto through Fred Wilson's AVC blog and Union Square Ventures' early investments.
• A significant turning point in crypto venture investing occurred around 2019.
• Pre-seed valuations for crypto companies during the market peak reached 50-150 million, compared to current valuations of around 6 million.
• The current 12-month CD rate is around 5%, providing an attractive low-risk investment option.
• The average venture return over a 10-year period is close to zero or slightly negative.
• Some of the best-performing crypto funds, like Dragonfly Capital and Paradigm, have engineers as general partners.
• Ethereum has struggled to generate significant protocol revenue, with the reduction rate at low single-digit percentages.
• Google raised capital at high valuations without a clear business model for years before figuring out its advertising revenue strategy.
• The numerator effect refers to the reduced value of liquid assets in LP portfolios due to market downturns.
• The denominator effect describes how market downturns increase the proportion of illiquid assets in LP portfolios.
• LPs' exposure to alternative assets has jumped from around 15% to 30% of their portfolios due to market conditions.
• Venture capital exhibits a persistence of returns, meaning top-performing firms tend to continue performing well in subsequent funds.
• The technical focus in crypto investing might evolve to look more like the business model-first approach seen in traditional venture capital.
• Big tech companies have made significant moves in AI, but haven't shown the same urgency around blockchain and crypto technologies.

Questions Answered

What caused the recent downturn in crypto venture investing?

The recent downturn in crypto venture investing was primarily caused by changes in the macro environment, particularly rising interest rates. With low-risk investments like CDs offering guaranteed returns of around 5%, there's less incentive for investors to chase high-risk opportunities in the crypto space. Additionally, the overall venture capital market has experienced a slowdown, affecting crypto investments along with other sectors.

How does the current state of crypto venture investing compare to traditional venture capital?

While crypto venture investing has been hit particularly hard, the entire venture capital industry is experiencing a slowdown. Pre-seed valuations for crypto companies have dropped significantly from their peak, but this is part of a broader trend in venture capital. The key difference is that crypto investing often requires more technical expertise, with some of the best-performing funds having engineers as general partners to analyze projects in depth.

What is the numerator and denominator effect in venture capital?

The numerator and denominator effect refers to the impact of market downturns on limited partners' (LPs) portfolios. The numerator effect is the reduced value of liquid assets due to market declines, while the denominator effect describes how this reduction increases the proportion of illiquid assets (like venture investments) in the overall portfolio. This dynamic has led to LPs being reluctant to make new commitments and VCs hesitating to call capital for new investments.

Why do venture capital funds continue to exist despite low average returns?

Venture capital funds continue to exist because when they get investments right, the returns can be extremely high. While the average venture return over a 10-year period is close to zero or slightly negative, top-performing funds can generate significant returns. Additionally, venture capital exhibits a persistence of returns, meaning that top-performing firms tend to continue performing well in subsequent funds, creating intense competition among LPs to invest in these top-tier firms.

How has the technical nature of crypto investing differed from traditional venture capital?

Crypto investing has been more technically focused compared to traditional venture capital, with some of the best-performing funds having engineers as general partners. This is partly due to the current stage of the crypto industry, where deep technical understanding is necessary to evaluate projects. However, as the industry matures, it's expected that crypto investing may evolve to look more like the business model-first approach seen in traditional venture capital.

What is the main challenge for Web3 projects in attracting venture capital?

The main challenge for Web3 projects in attracting venture capital is the lack of clear revenue models. Many crypto platforms, including successful ones like Ethereum, have struggled to generate significant protocol revenue. For crypto to attract significant venture capital again, projects will need to demonstrate clear utility and potential for revenue generation, similar to how Web2 companies operate.

How does the principal-agent problem manifest in venture investing?

The principal-agent problem in venture investing arises from the misalignment of incentives between general partners (GPs) and limited partners (LPs). GPs may be incentivized to deploy capital quickly in boom times to raise the next fund, while in challenging markets, they might be more hesitant to deploy capital to avoid putting pressure on their LPs. This misalignment can lead to different behaviors depending on market conditions, potentially affecting investment decisions and fund performance.

How does Solana fit into the current landscape of crypto venture investing?

While not explicitly discussed in the podcast, Solana's position in the crypto ecosystem is relevant to the current landscape of venture investing. As a high-performance blockchain platform, Solana offers technical advantages that make it attractive for developers building decentralized applications. As the venture capital market stabilizes and investors regain confidence in the crypto space, Solana-based projects are likely to benefit from renewed funding interest, particularly given the platform's focus on scalability and user experience.

What parallels can be drawn between early crypto investing and other tech sectors?

The podcast draws parallels between early crypto investing and the early days of other tech sectors, particularly SaaS (Software as a Service). In both cases, a deep technical understanding was initially necessary before business models became more standardized and widely understood. Another parallel is drawn to the early days of Google, which raised capital at high valuations without a clear business model for years before figuring out its advertising revenue strategy. These comparisons suggest that the crypto industry may follow a similar pattern of maturation over time.

How might the future of crypto venture investing evolve?

The future of crypto venture investing is likely to evolve towards a greater focus on clear utility and potential for revenue generation. As the industry matures, investors may shift from a purely technical evaluation of projects to a more balanced approach that considers both technological innovation and business viability. Projects that can demonstrate a path to mainstream adoption and sustainable business models are likely to attract investor interest, even in a more cautious funding environment. The lessons learned from the current market cycle will likely shape investment strategies, potentially leading to more sustainable and impactful projects in the long run.