How venture capitalists are adjusting to the brave new world of DeFi

The venture capitalists have discovered decentralized finance.

Blockchain-based financial services (commonly known as “DeFi”) platforms accounted for 26% of the roughly $3.18 billion that private investors poured into crypto and blockchain projects during the first quarter of 2021.

For VCs, the emergence of DeFi offers enticing new opportunities to put capital to work. But betting on this new breed of project is far from straightforward — especially for investors unfamiliar with these new markets.

“It is definitely a different animal,” said Logan Allin, managing general partner and founder of Fin VC. For Allin, one of the key issues for venture capitalists is to “evaluate the scale and integrity” of a brand new type of technology stack. But he also pointed to regulatory risks and the need to manage tokens as major hurdles for investors.

When VCs invest in a DeFi project, they often say they are backing a “protocol” as opposed to a company. What exactly that means depends on the project. But unlike investing in a startup, investing in a protocol generally involves purchasing crypto-tokens with a floating price.

So what are the adjustments that venture capital firms have to make to jump aboard the DeFi bandwagon? The Block spoke with half a dozen venture investors who have recently put money behind DeFi projects to learn about how they are approaching the new field.

Same, but different The first obvious question: what are they actually investing in? After all, by design decentralized projects don’t have an owner or traditional CEO. Companies may form to develop the protocols, but the technology is open source.

Silicon Valley investment firm Accel (founded in 1983) is among those exploring the space, from the protocols themselves to "exciting developments in the infrastructure layer," said Andrei Brasoveanu, a partner at the firm.

But Brasoveanu acknowledged that investing in so-called Decentralized Autonomous Organizations (DAOs) can be challenging, because “sometimes the full value of the innovation may not accrue to the protocol, some of it is distributed to the community.”

When compared to traditional startup structures, there is a clear difference — at least theoretically — in the level of power those founding teams will go on to wield within the networks they help construct. The very mantra of DeFi is that its protocols grow in accordance with the wishes of a community of developers rather than at the whims of a single person or small group of people.

A common model within DeFi is that holders of the tokens native to a given network are entitled to vote on the direction of its development. Token holders, liquidity providers, and software developers building applications on top of the protocol all have a stake in — and influence over — the development of protocol.

The bottom line is that the relationship between investor and founder “can be a bit diluted” in DeFi venture capital, said Brasoveanu.

On the other hand, some venture capitalists believe that there are very few differences between backing these two different types of organizational structure. “In our view, protocols and organizations are both ways to successfully organize people to address a market opportunity,” said Wendy Xiao Shadeck, partner at Northzone.

Northzone has been investing in seed to Series B stage businesses since 1996. In March, it participated in a £5.2 million raise by Gro , a startup attempting to build DeFi products that are simpler to interact with.

“As long as the investors’ objectives and the team are fully aligned, we take a flexible approach to investing in structures that empower the team to realize value, and best suits the problem they’re solving for their customers,” said Xiao Shadeck.

Tokenomics DeFi venture deals often involve purchasing large amounts of the given platform’s tokens. That requires venturing into largely uncharted waters. Equity shares, after all, have been around for centuries.

“Here instead of buying equity, which is the same as essentially buying IP rights in a project, capital allocators are purchasing a percentage of a decentralized open-source network by way of a token,” explained George McDonaugh, CEO of the London-listed DeFi investor KR1.

KR1 was an early backer of Polkadot, a project focused on interoperability between different blockchains. As of March, KR1 held roughly 3.5 million of Polkadot’s native DOT tokens (worth roughly $140 million at today’s prices).

Buying tokens also entails certain responsibilities which venture capitalists and other investors in private shares may not be accustomed to.

“The token investors’ roles are different from the shareholders’ roles played in the traditional venture space,” said Mable Jiang, partner at the crypto and blockchain investment firm Multicoin Capital.

For instance, sometimes those tokens give holders the power to vote on proposed changes to the protocol.

“Governance tokens allow holders to vote on changes to a protocol — somewhat akin to holding equity and having a board seat if you have a large enough position to have some influence,” said Ellen Logan, an investment associate at London Stock Exchange-listed investment firm Augmentum Fintech.

Somewhat akin, perhaps, but a considerable departure from keeping a close eye on a founding team from the comfort of a board seat.

Sometimes crypto investors have to take an even more hands-on approach. Jiang’s colleague Tushar Jain, managing partner at Multicoin, penned a blog post on the evolving role of crypto investors back in 2018. In it, Jain argued that crypto-native investors are uniquely placed to support the development of the protocols they have backed.

He gave the example of Livepeer, a decentralized video transcoding network in which Multicoin is an investor. Early in its development, Livepeer faced a classic chicken and egg situation in which it was not, in Jain’s words, “economically rational for people who are interested in providing transcoding services to buy and stake LPT tokens (Livepeer’s native token) to participate in the network.”

Multicoin, therefore, tried to help boost supply by operating transcoders on the Livepeer network. “By acting as a supplier in the Livepeer network, we are able to assist the founders in their sales efforts and get the flywheel spinning,” Jain added.

It is easy to see why directly participating in the network might be in the best interest of DeFi investors. Indeed, this need to kickstart economic activity is the reason that venture capitalists in DeFi “are constantly deal sharing as it makes the collective traction on a project stronger,” according to McDonaugh.

What is less clear is whether traditional investors entering the market have the technical expertise needed to directly participate in DeFi networks.

Jumping in the deep end In January of this year, Augmentum Fintech announced that it would begin investing in DeFi protocols through a partnership with ParaFi Capital, the San Francisco-based blockchain specialist. Augmentum allocated an undisclosed sum of money to ParaFi.

The plan was to co-invest in DeFi development teams in Europe and the US prior to their launch. Augmentum ordinarily invests directly in startups, but CEO Tim Levene told The Block at the time that DeFi was a special case because of the “huge depth of understanding” required to wade into the sector.

Ellen Logan is Augmentum’s in-house DeFi expert. Now several months on from the ParaFi announcement, she is ideally placed to speak to some of the challenges facing DeFi-curious investors.

She pointed out that token investing may sit outside a fund’s investment policies and so may require approval from Limited Partners (LPs) on a change in strategy. But regulatory ambiguity around tokens make “getting that sign-off challenging for some,” she added.

Logan also said that a different approach is required for modeling returns. Key metrics in DeFi, she suggested, are “aggregate network value," token economics (whether the token will grow in value as usage of the protocol increases), and token supply and liquidity levels.

Drier considerations include how tokens will be stored and managed once acquired — the same challenge that many wholesale institutional investors in the wider crypto market have been confronting in recent years. Finoa and Copper are examples of custodians who might be able to help with DeFi custody.

Funds specializing in DeFi investments tend to manage the staking and trading of their holdings in-house. But Logan suggested newcomers to the space would be likely “to outsource this to a service provider.”

Finally, she pointed to a change that may be a breath of fresh air for early-stage investors: the availability of market data. Many if not all DeFi projects stage token sales to fund their development. These tokens are destined to become the native currency of their network as it develops, but often also get listed on crypto exchanges for trading in secondary markets.

“For investments made post-token launch there is market data available for any incoming investor to audit — potentially an advantage over standard equity raises where less market data is publicly available,” said Logan.

The general sentiment among the venture capitalists who spoke with The Block is that DeFi has become difficult to ignore. Challenging it may be, but worth the trouble of getting to grips with.

Take, as a case in point, the U.K.’s Passion Capital, a venture firm renowned for bets on fintech firms Monzo and GoCardless. Eileen Burbidge, a partner at the company, has personally invested in early-stage Web3 and DeFi fund Ethereal Ventures, according to two people familiar with the matter — in part to learn from experts in the sector.

At the other end of the spectrum are traditional VCs like a16z, which employs 26 crypto experts and has $865 million under management across two crypto funds investing in both crypto companies and protocols, including several DeFi projects.

In sum, DeFi, with all its quirks and unfamiliar elements, is no longer just a sideshow — at least not in the world of venture investing.

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How venture capitalists are adjusting to the brave new world of DeFi

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