The Current Crypto VC Landscape

The most recent outperformance of meme coins relative to venture capital (VC)-backed projects has led to many market participants criticising VCs and their investments. While some criticisms are valid, others lack a deeper understanding of nuances in the private market.

It is common for projects to raise multiple rounds of funding to scale their product before token generation events (TGE). In exchange for contributing more risky early-stage capital, VCs are given lower token valuations. Projects benefit from strategic capital, such as marketing support, tokenomics advisory, and access to the VC’s network: resources that smaller retail investors usually cannot provide. As fundraising progresses and valuations shift, the type of VCs that participate will also change as every VC has a different risk profile and fund size.

Breakdown of Crypto VCs And Their Sizes

Source(s): PitchBook

The majority of crypto VCs have assets under management under $50 million which leads them to investing in projects at the pre-product stage with lower valuations. To align the long-term interests of VCs and other stakeholders, tokens acquired through the private market are subject to cliff and vesting terms.

Generalised VC Risk-Return Tradeoff Illustrated

During the vesting period, VCs often see significant unrealised gains which they may hedge through derivatives or arrange over-the-counter (OTC) deals with private buyers. However, they face limitations in deploying hedging strategies as limited by investment mandates, capital requirements, and liquidity constraints. Some VCs may also lack the execution knowledge and risk management framework necessary for the management of liquid positions, posing an additional barrier to effective hedging.

Consequently, OTC desks have become the most viable option for VCs to realise their profits before TGE. Unlike secondary markets, where information regarding global trade volumes and valuations are public, OTC markets operate differently. Deals are conducted privately, making it difficult for a unified platform to track global trading data. Estimating the size of the OTC market is difficult, but reported activity from OTC desks can reveal trends.

STIX, an OTC desk backed by Fisher8 Capital, has processed over $200 million in OTC trade volume since its inception in late 2023. STIX mainly deals with assets in the top 200 altcoins (both primaries and secondaries). The past year has seen large OTC activity, including liquidations (FTX estate selling locked $WLD and $SOL) and direct treasury deals from token foundations ($SUI, $AVAX, and others). We anticipate a secular growth trend for this market, underpinned by the desire for VCs to realise their gains early and the demand for capital for post-TGE projects.

The Case for OTC: Price Discovery Happening in Private Rounds

Attached below is a list of VC-backed tokens and their performance since TGE. The majority of these tokens struggled to sustain their high valuations after three months, making it unlikely for VCs to realise their investments at peak FDVs when vesting began. This type of price action is detrimental to all market participants. Liquid market participants who purchase at higher prices eventually become structural sellers alongside VCs when they receive their vested tokens.

Performance of Tokens TGE On Binance In 2024

Source(s): Artemis

The common practice of marking up valuations throughout the fundraising lifecycle has largely privatised upside capture and market optimism. This phenomenon exposes retail investors to predominantly negative price discovery after TGE. Without sufficient incentives for public market participants to support a project, a lose-lose scenario emerges. Both VCs and retail investors face challenges over the long term as markets converge to fair value.

Illustrative Performance of Coins

Source(s):0xLouisT

We firmly believe that leaving room for upward price discovery in the secondary market will help in building a stronger support base, ultimately extending the project’s longevity. One existing method that aims to facilitate pre-TGE price discovery for retail participants includes spot and/or pre-market trading. In pre-market trading, a spot token listed on the spot pre-market acts as a promissory note (i.e. IOU token), redeemable for the underlying asset upon TGE. On the other hand, perps pre-market is a synthetic market that aims to track the price action of the underlying asset (usually hedged with a call option issued by foundations).

Pre-market trading is available on easy-to-access derivatives platforms like Aevo, Whales Market, and leading CEXes. However, these products come with liquidity and delta risks. Trading venues, by taking the opposite side of the trade when liquid market buyers purchase pre-TGE tokens, can face significant losses if the token performs well post-TGE. Additionally, participants must consider counterparty risks, such as the lack of a legal claim to the underlying assets or the possibility of the exchange being unable to absorb the losses from profitable pre-market participants.

Hypothetical Performance of Tokens With OTC Between Rounds

Another approach to promote upward price discovery in secondary markets is to expose private markets to downside price discovery before TGE. This could reduce the markups between fundraising rounds. The diagram above is a simplified comparison between two hypothetical projects to illustrate the potential benefits of OTC transactions for post-TGE performance. If a down round occurred between Series A and TGE where existing investors sold their allocation at a loss, it might signal to the team that their TGE should be lower than initially intended. This adjustment will help align project valuations with market expectations.

If a project ultimately succeeds and reaches the same post-TGE equilibrium price, having a larger proportion of profitable token holders from the liquid markets can help sustain support for the project.

An Insider’s Look Into Crypto OTC Desks

While allowing for more downward price discovery in private markets sounds ideal, complexities arise due to legal barriers and types of transactions. There are two primary types of OTC transactions: pure discretionary buying and funding rate arbitrage.

Discretionary buying typically attracts valuation-sensitive investors who seek directional exposure to the underlying asset. This process involves taking over SAFT/SAFE contracts from previous investors or directly acquiring tokens from project teams. When buying over SAFT/SAFE contracts from earlier investors, the deals are typically priced at par or carry a 25-30% premium pre-TGE.

In contrast, funding rate arbitrage buyers are less sensitive to valuations. Their profits hinge on the spread between the discount-to-spot and the cost of hedging, which is determined by the funding rates of perpetual contracts over the vesting period of these tokens. STIX reports that such buyers are often able to secure discounts of 60-65% from spot prices to execute this delta-neutral strategy. However, this opportunity comes with three caveats: the availability of perpetual contracts for the underlying asset, sufficient liquidity for execution, and the view that hedging costs (opportunity cost of the collateral) will not exceed the gains from the discount-to-spot. Such buyers will need large amounts of collateral to avoid liquidations for their short perpetual hedge as any liquidations from short squeezes could make the trade unprofitable.

Due to the different types of OTC buyers, announcements of large OTC rounds by token foundations should be viewed critically. Such deals may reflect arbitrage opportunities rather than genuine long-term demand at prevailing prices.

Challenges for OTC markets

One complication facing OTC transactions is the presence of anti-transfer clauses in contracts. These clauses prevent investors from transferring their shares to third parties (new OTC buyers) without the founder’s approval. STIX reports that such clauses are present in 30%-45% of SAFTs.

If a foundation blocks an OTC deal, buyers will have to assume additional counterparty risks. Without the robust legal framework that accompanies “formalised deals”, buyers have limited recourse in cases of seller misconduct. This risk is exacerbated with smaller funds, which may not face the same reputational repercussions as the larger, more prominent VC funds.

Crypto VC Fundraising Activity

Source(s): Pitchbook

In 2021 and 2022, fundraising levels reached record highs, fueled by pandemic-era stimulus and the promise of outsized returns from earlier fundraises in 2019 and 2020. During this period of euphoria, deals closed rapidly due to abundant VC funds and the rush to deploy their capital. However, the subsequent bear market in 2022/2023 brought a sharp shift. Down rounds became more common, risk appetite dwindled, and delays in TGE became the norm. These shifting market dynamics and several high-profile collapses (i.e., Terra, FTX, 3AC) contributed to stagnant fund performance, creating a regressive pattern that saw reduced capital flows into crypto VCs.

The decline in investor appetite for VC is highlighted in a PitchBook report, which found that new funds are taking longer to raise capital (21 months in 2024) relative to past vintages (6 months in 2021). Additionally, the cohort of VC funds that were raised in 2021 and 2022 with a 4 + 2 structure will soon enter their divestment stages, introducing structural sellers into the secondary market.

The underperformance of crypto VC funds drove them to explore alternative strategies such as liquid tokens or OTC deals. While the latter usually comes with cliff and vesting terms, the investment horizon is typically shorter than traditional VC structures, favouring duration-sensitive investors. Should OTC deals become a more common practice in the industry, platforms like STIX may stand to benefit from the surge in demand due to their value proposition of being a full-service desk that solves what is otherwise a fragmented market.

A Path Forward for Venture Capital

The current trend of crypto VC funding drying up raises an existential question for the industry. One possible path forward is an activist approach. Instead of betting on the next “0 to 1” opportunity, funds could focus on acquiring liquid tokens and using their expertise and networks to scale projects from “1 to 10”.

If this form of activist investing resonates with you, STIX is actively seeking to onboard more venture funds. If you are interested, visit STIX.co or reach out to @taran_ss on X for further information.

Disclaimer：

1. This article is reprinted from [Fisher8]. All copyrights belong to the original author [@hedgedhog7, @c0xswain, @0xkinnif, 0xlaiyuen and @0xZhouYeMen]. If there are objections to this reprint, please contact the Gate Learn team, and they will handle it promptly.
2. Liability Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute investment advice.
3. The Gate Learn team translated the article into other languages. Copying, distributing, or plagiarizing the translated articles is prohibited unless mentioned.