The cryptocurrency industry has come a long way in a few short years. It appears that ICOs (Initial Coin Offerings) as a means of fundraising, has been too good to be true – the benefits of a non-dilutive funding source for founder teams, has not withstood the pressures of crypto-investor community engagement, market moving strategies from crypto-speculators, and sustained regulatory attack from the U.S. Securities commission/other securities laws regulators. Yet, on closer inspection, there is still a hive of investor activity, including venture capital being deployed in the token layer.
With so many different variants on how successful crypto companies seem to be put together and operate, a growing number of venture capital investors, seeking to stay relevant and capture value across the blockchain ecosystem have also had to rethink the ways in which they deploy capital.
Yet there are still some surprisingly low-tech and common themes when it comes to assessing which crypto companies viewed by venture capitalists as providing a good home to generate stellar investor returns – whether the investment instrument is equity, tokens or a mixture of the two.
From KWM’s extensive work representing both investors and blockchain companies attracting investment in SE Asia and Australia, here is our view of the top 5 criteria for successful venture capital-backed blockchain companies:
Traditionally, there appeared to be an almost binary choice for fundraising structures for crypto companies – either adopt a traditional shareholder-investor base, or crowd fund through an ICO. Only the most specialised venture capital funds could invest across the token and equity spectrum and their expected returns came from token economics, sometimes leading to an unsustainable demand for product development or user growth.
We are starting to see a growing openness from more mainstream venture capital investors to make a blended investment in targets where there is a strong blockchain component, such as a token that has been issued by a foundation. These cases require careful consideration to ensure that the structure and terms of the investment (especially the token economics) are consistent with the fundamental investment thesis and do not significantly erode equity investors’ returns.
Where there is also an equity investment component to a deal, if a target has already separated the technology from the product layer, this can help to provide structural stability to such an investment structure. It also offers the chance for venture capital funds, who are still getting to grips with token investing to participate at the equity level only, safe in the knowledge that this is where the bulk of investor returns will accrue. For most targets this is still a work in progress and it can be as much of a value proposition for investors to invest with a view to helping overhaul this part of a crypto company’s structure, thereby attracting additional investors at higher equity valuations.
Limits of Regulatory Arbitrage
It is no secret that in 2022, the most valuable crypto companies are those that take regulatory compliance seriously. There is a fine line to tread though between jurisdiction hunting to tick a regulatory box at the product level, to what may be viewed by investors as an unsustainable regulatory strategy.
We tend to see greater success for companies that choose to serve a national or regional market very well from a compliance and local law perspective, rather than those who try to push products that may be questionable from a regulatory perspective across a large number of jurisdictions.
For those companies whose regulatory strategy relies on offshoring parts of the product flow to a single jurisdiction, which may have regulatory ambivalence to a particular practice, then this can quickly become seen as a single point of failure for the entire product flow/revenue stream. Laws and regulators’ interpretation of law changes so quickly in the cryptocurrency space, that there needs to be inbuilt resilience in the product’s design to adapt to this regulatory and operational risk.
Valuation - Challenges and Opportunities
With so many deals in the crypto sector – both from an investment perspective and also outright acquisitions, it is very easy for valuations to become distorted.
When valuation metrics such as monthly active users or transaction volumes are used, then the fluctuations in valuations can become significant.
If there is a large token holding – whether in Bitcoin, Ethereum or a native coin that supports the business, then the distortive effect of this line item can also become a major distraction to getting a deal done.
Another frequent issue is the valuation gap between a priced equity round and unsolicited bids to acquire a company outright. This can be distracting for management – especially if they stand to obtain significant liquidity from an early liquidity event. From an investor’s perspective, helping to define clear exit parameters up-front may be a helpful guide to keep founder and management teams motivated to develop the business to its full potential prior. We’ve seen very large ESOP plans also be deployed with significant sets of milestones and metrics and incredibly large exit value hurdles, all designed to keep everyone in the tent and their eyes on the fire.
Whose IP? Whose Users? Whose Transactions?
Linked with the question of the structure of the investee company, is a deeper dive into how the company operates and whether the use of blockchain means that claims of IP ownership and customer numbers are illusory.
This is particularly important if there are various commercial partnerships or JVs with other industry participants. If IP ownership and ownership of customer relationships are key drivers to a blockchain business’ success, then these matters should already have been fully addressed in the commercial terms of the partnership.
Depending on the type of company, transaction flows may also be distorted by round-tripping or wash trades from the blockchain community or at the very least, are susceptible to manipulation. This can become a practical concern if these metrics are being used to peg earn-outs, vesting of ESOPs or milestones in a commercial partnership.
Systems and Controls or Just Systems?
Most crypto companies are focussed on putting in place systems to deal with sanctions and anti-money laundering screening, governance, financial and data privacy matters.
Yet during investor due diligence, there is also an investor focus on whether the company is implementing the systems by acting appropriately on its outputs. Getting to the bottom of these issues can unnecessarily extend investor due diligence and demands for contractual protection – especially if the business is regulated and a regulator has expressed similar concerns.
This is an area where investees and investors frequently wish that sufficient attention had been paid at a much earlier stage rather than trying to mend fences and repair collateral damage or a busted M&A process after an issue has arisen.
It is hard to get everything right first time when moving at the speed of blockchain technology. However, focussing on the key legal and regulatory issues can be just as important to investors as the commercial rationale for a venture capital investment in the crypto sector. Rather than the venture capital model being disrupted, investors are adapting and raising their game. Venture capital investor expectations and investment have never been so high, and the most successful crypto-companies are those who have their house in order.