DIALECTIC

Note: This is the first in a series of posts highlighting the differences between crypto-native investing and TradFi investing.

As we forge forward into the 4th major cycle in the history of crypto, we’ll again see an influx of TradFi folks taking the trip down the crypto rabbit hole and trying to apply their TradFi frameworks to crypto. In this post and related ones to follow, I offer some lessons learned and considerations on  the difference in the required paradigms between crypto and TradFi and how the unique heuristics required in crypto can unlock extraordinary value, but pose a different risk profile to investors.

There are four relevant investment categories in crypto assets:

1- Crypto Venture is characterized by early-stage pre-launch projects, usually with some combination of equity and tokens depending on the network and resultant value accrual mechanism. This includes both liquid and illiquid venture. Note: “liquid venture” is an opportunity whereby the given project’s token is live and openly tradable, but the project is still in its infancy and has the characteristics of an early-stage venture project. Liquid venture is truly unique to crypto (outside of the wild west of the Canadian TSX ventures exchange)

2- Late-Stage Liquid Tokens are mature tokens of fully formed communities with an operational peer-to-peer network. This category includes staking opportunities and single-sided yielding. These projects usually have some form of product-market-fit in their offering and offer arbitrage traders, fundamental investors and market-makers different opportunities. Examples are Bitcoin (digital gold) Ethereum (decentralized compute), or Filecoin (decentralized file-storage).

3- Fixed-Income Yield Farming is whereby fixed-income returns are driven by providing liquidity to on-chain capital markets and includes keepers, market-neutral yielding on stablecoins as well as risk-on yielding with risk-on pairs. Examples are Curve/Convex or Uniswap V3 pools. 

4- Late-Stage Private Equity (and Public Equities) are mature businesses that have established product-market-fit, and generally profitability and/or sustainability. This is the least interesting category in crypto from a return-profile perspective, but are important organizations in the space. Examples are COIN (public) or Kraken (private, for now, expected listing in the next year). The reason why this category is less compelling is that it is almost always easier to go from 0 to 1 than it is to go from 1 to 10 or 10 to 100. The larger a project is, the more difficult it becomes to deliver a multiple on capital. Given the overall risk profile of crypto, the returns should be expressive imho.

Do note that there is crossover between these categories and they should be thought of somewhat as intersecting venn diagrams. Below I outline a generalized mental map of return profile vs liquidity profile of the different categories.

I highlight crypto venture in this discussion as the delta between crypto venture and traditional venture are most extreme as many of the long-held heuristics of traditional venture get blown up with crypto. Some primary examples are below:

Certainly, the most remarkable advantage that early-stage crypto venture has over traditional venture is timeline to liquidity. In a traditional venture deal, if everything goes well, it will take 7-10 years to harvest via a complicated IPO process after many rounds of dilution. Conversely, crypto projects typically go from ‘seed stage” to effectively ‘public’ within months and not years. This allows investors to take a better risk-adjusted approach to early-stage investing by being able to pair back exposure as projects go live. The feedback loop driven from the market allows teams to iterate and evolve much more quickly. However, crypto investors then are faced with a very different harvesting decision process.

I am frequently asked why early-stage token-enabled projects command such a significant valuation premium to traditional venture-backed companies. Why are seed valuations well into eight-figure and even nine-figure territory and how does that make sense? It is important to note that a token-enabled network doesn’t have dilution outside of the inflation on the network post-launch. So each successive private round only dilutes the community and team and not previous investors. Due to superior dilution protection, it is natural that valuations be higher. Note a community could come together to change the inflation schedule, but this is exceedingly rare in the space and usually value destructive to a project due to the controversy and broken trust inherent in such a decision.

Crypto projects are uniquely enabled to tap a large community to support early-stage growth and development. Often early-stage rounds in crypto look more like “party rounds” whereby dozens of investors take a position instead of a defined lead with few participants. This is a superior capital model because A) a project can’t predict who will be their best value-add partner at the outset; and B) When an entrepreneur raises from a crowd instead of a select group of VCs, they get a massive amount of free work, product evangelism and support that they wouldn’t get from even the most well-intentioned institutional investor. In the 2020s communities will be some of the most valuable assets on the planet and crypto uniquely unlocks highly incentivized communities who passionately support their project. Conversely, in traditional venture, often the best a start-up can hope for from their community is that it’s a community of customers who are willing to do a single activity such as provide feedback

In traditional Venture, the moment of harvest is usually decided for the investors - it’s the acquisition or the IPO. However, with crypto, investors have to ask themselves tough questions about harvest strategy every single day once the token is live, typically early in the project's lifecycle.

Dialectic conducted a study looking at dozens of SAFTs and their resultant liquidity. We discovered that, overall, the superior harvesting strategy is to gradually sell the SAFT along the vesting schedule. The reason for this is because crypto goes through highly volatile cycles and typically one has future opportunities to invest in a market bottom sometime after a project has launched its open network. This harvesting strategy flies in the face of traditional venture heuristics of “double down on your winners” and power law. For example, almost every L1 and L2 since the dawn of Ethereum has bled value against Ethereum after a 90-180 day “honeymoon period”.

Investors may perform fine vs. standard benchmarks, but if a fund can’t outperform some ratio of ETH and BTC, then they are likely not going to have longevity. Therefore, crypto investors are presented with a more dynamic dilemma of when to harvest - both a compelling opportunity for the prudent data-driven capital allocator and a risk for the emotionally attached early-stage backer.

The timeless adage on Sand Hill Road is “concentration matters and double-down on your winners”. This has been true for most of Venture’s history. However, not with crypto. Since the delta in valuation is so expressive in such a short period of time, having exposure to experimental fields is more important than having significant concentration. It is exceedingly difficult to predict which project will win in a given category. A bet that is 1% of a portfolio will almost never be a fund-maker in traditional venture, but often is in crypto. Further, because the public market is an incredibly efficient market and there usually aren’t more than 2 rounds before public launch, more often than not, follow-on rounds are regularly quite dilutive and can be quite destructive to fund returns overall. Thus, diversification matters more in crypto than in TradFi and the results of diversified portfolios often outperform vs TradFi peers.

Given the aforementioned advantages, the hit rate, defined as the rate of highly successful outcomes over the total number of invested projects for a given investor, is considerably higher in crypto. According to Perplexity, in traditional Venture, the percentage of investments that return positive capital is around 25%, with about 5% returning 10X or more and .04% returning 50X or more. In crypto, the percentage of projects returning 10X or more is approximately 8% and nearly .25% of crypto projects return 50X or more. The quicker market feedback loop through improved liquidity profile are primary reasons for this marked increase. There has never been an industry on planet earth as profitable as programmable money.

We clearly see the advantages of early-stage crypto investing. The increased liquidity of early-stage investments, the faster feedback loop, the ability to recruit a community towards a cause are all reasons why eventually there will be a merging between crypto venture and traditional venture. In the not too distant future, we will see the renaissance of decentralized capital formation or ICO 2.0. With some reasonable legal frameworks in place, every start-up will have a token as their value accrual model and tokens will be the obvious bootstrapping mechanism for both novel companies and mid-market companies wanting to change their model to allow for community stewardship.

Note: this is not investment advice in any way and you should not buy tokens, either public or private, if you are prohibited from doing so under applicable law or regulation.