Crypto startups, beware the 'dry powder fallacy'

Great crypto and web3 startups will be fine in this bear market, considering there’s so much dry powder, right?  

One-liners about “dry powder” positioned alongside emojis of rocket ships and dollar signs might make for fun tweets — but veteran venture capitalists are warning crypto founders not to fall for "the dry powder fallacy."

Dry powder is a slang term used to refer to cash at hand. In venture capital, it refers to the collective amount of capital that venture firms can deploy over a particular schedule.  

Last year, investors raised $99.3 billion for crypto funds, according to data from The Block Research. In aggregate, investors have raised $162.2 billion into crypto funds. Some of the industry's most significant funds have launched within the last two years, including Haun Ventures' $1.5 billion raise — split across two funds — and a16z's $4.5 billion crypto fund. 

The Block Research estimates that $32 billion was allocated to crypto projects in 2022. The bottom line? There would appear to be billions of dollars held by crypto funds yet to be deployed.  

Dry powder is a murky measure, however, as not every venture deal gets publicly announced. Nevertheless, Edvinas Rupkus, an analyst at The Block Research, said tens of billions remaining in dry powder is a safe estimate.  

Still, veteran venture investors warn that founders should view those billions of dollars as only a directional measure of investor appetite for the industry rather than an absolute. “The current dry powder estimate is a great starting point to understand upstream funding or crypto startups but must be adjusted,” said Paul Hsu, founder and CEO of venture firm Decasonic. 

An abundance of dry powder

Figures from investment firms across the crypto industry support the idea that dry powder is abundant. Top-tier venture firm Sequoia has only deployed 10% from its $600 million crypto fund, which launched in early 2022, a Sequoia spokesperson said. A16z partner Chris Dixon told The Block in December that the firm had deployed less than 50% of its $4.5 billion crypto fund. 

“We are still, certainly, majority dry powder, and we continue to be thinking in terms of years, not months,” said Haun Ventures’ Sam Rosenblum about the $1.5 billion in capital raised at the start of 2022. “I think the key thing in terms of the two funds is we thus far are deploying them, not in lockstep, but very similar pacing across the two,” he added.  

Likewise, crypto native asset management firm BlockTower has overseen a $150 million fund for just over a year. It's deployed less than 20% thus far, said Thomas Klocanas, general partner and head of venture at BlockTower. 

Amount raised for crypto funds from The Block Research

This isn’t just a trend for top-tier venture firms. A well-known corporate venture fund told The Block it had deployed less than 50% of its multi-million-dollar fund, launched at the tail-end of 2021, and is looking to raise a second fund. While Dao5, a venture firm that aims to convert to an investment DAO eventually, has only deployed between 20% to 25% of its $125 million fund, launched in the spring of 2022. It plans to be fully deployed within three years.  

“We currently sit on 28% deployed, or 72% ‘dry powder,’ or $35 million of our $48 million seed venture and digital assets fund,” said Decasonic’s Hsu. “Our deployment schedule has 24 to 36 months remaining (January 2025 to January 2026) for our 10-year fund.” 

So, is this abundance of dry powder a cause for celebration?

Not so fast. 

Too hot, too cold or just right

Dry powder can be misleading, said Michal Benedykcinski, senior vice president of research at Arca. Capital gets called in tranches, so it’s not ready to deploy from day one, he added. 

In some cases, VCs, particularly those that run liquid token funds, might even opt to return their dry powder to LPs and exit, which reduces the overall reserves, Decasonic’s Hsu said. 

“The problem is it’s not a static measure,” said Tom Loverro, a general partner at venture firm IVP. “People will say, ‘Hey, it’s not gonna get that bad because there’s all this dry powder,’ and cite some number in the billions of dollars. Here’s the problem: that dry powder assumes a certain pacing and that it can be replenished.” 

Just like with goldilocks and the three bears, deployment pacing can either be too hot, too cold or just right. 

“If the dry powder isn’t being deployed, it could be a warning sign that a VC isn’t optimistic about valuations or industry prospects,” said Joe Marenda, Cambridge Associates’ global head of digital assets investing. “On the other hand, if the dry powder is shrinking quickly, it indicates that valuations and industry prospects are attractive.”  

Suppose a venture capital firm promised limited partners a slower deployment schedule and tore through its capital in the bull market. In that case, it could now be in a pinch to raise again in the era of high-interest rates and regulatory scrutiny. 

“When the fund goes back to raise their next fund, the LPs may say, ‘Hey, crypto was cool when it was going up, but we don’t want any more crypto exposure,’” Loverro said. “Family offices, in particular, who, I think, have been funding many crypto early-stage funds, tend to recoil the fastest for asset classes when they go down.” 

The more-considerable funds may raise smaller subsequent funds, Loverro said. Polychain, which previously closed its third fund at $750 million in early 2022, is reportedly raising a $400 million fund. 

“Katie Haun, I'm sure, will be fine — she'll raise another fund, but she's certainly not going to deploy the capital quickly,” Loverro said. “The dry powder shrinks when people deploy it slower, and then it isn't replenished. It melts or sublimates away, and then the next funds are smaller.” 

Crypto's dry powder fallacy

These issues don’t even consider the intricacies of the crypto venture market, which includes new paradigms — such as token investing and the rapid evolution of paper millionaires into angel investors. 

“There's what we call the dry powder fallacy,” said Samantha Lewis, a partner at venture firm Mercury. Some limited partners will have used their paper wealth in the bull market to commit to funds. Now with bellwether tokens struggling — such as ether down 67% from its Nov. 2021 peak — many of these players don’t have the same cash to commit, Lewis said. 

“In the recent bull market, some investors had eyes too big for their stomachs and overcommitted. Then, with the correction in equity and fixed-income markets, suddenly those commitments are outsized, leading to LP indigestion,” Marenda said. “In other instances, investors, who made a lot of money in crypto, may not have taken enough off the table, and the significant correction in crypto prices has dented their ability to meet capital calls,” he added. 

Though not all doom and gloom, Marenda expects this will create a vibrant secondary market for limited partner stakes. Meanwhile, Benedykcinski thinks the impact of default in capital calls might be overblown. High net-worth individuals and family offices are the most likely group to curtail their allocations, with smaller first-time managers the most likely to be exposed, he added. 

There is also a wider net of investors in crypto — such as investment DAOs, trading firms and launchpads — that could top up the current estimates of dry powder, Hsu said. VCs that recycle token holdings could also boost the dry powder stock, he added. 

But if that same fresh capital is used to defend positions in companies struggling in the bear market, then it could dwindle just as quickly, Loverro said. 

 “I think there's just a lot of people who don't want to accept reality, and so they're looking for some reason things will be okay and go back to how they were,” Loverro said. 

“There was a lot of dry powder after the Dot Com bubble,” he added. “There was a ton. All these VC firms had raised a lot of money and it was still terrible. All these VC firms went out of business because they never raised another fund.”