Hello,
Some life-updates. I fell sick with Covid-like symptoms a week after sending the last newsletter. And then had the opportunity to sign on with LedgerPrime - a US-based hedge fund. Between transitioning into the new role and an on-going research fellowship, I figured a break would be best. Now that things are more settled, I intend on being back to routine writing. I will be sharing more on my findings from the research fellowship towards the end of the quarter. (Its some exciting stuff)

Side note: If you are building for DeFi, make sure you reach out to me at joel@ledgerprime.com or on Twitter. We invest and co-build across stages with ventures building for capital markets.

Today’s issue has been in the works for the past few weeks. One of the biggest questions most founders have in whats seems like a bull-market is often “Am I doing something wrong”. It looks as though money is falling out of the sky on everyone with a dot finance domain and many founders building on sound economics often get lost in the hubris. There is also a data-problem when it comes to reporting on blockchain financing. A large chunk of the figures reported for total funding is over-represented due to ICOs, and then there are deals involving large enterprises that use blockchains as a small part of their tech-stack. Keeping this in mind, I spent a considerable amount of time cleaning out data from non-identifiable venture rounds and large-firms with no clear connection to blockchain. For this piece, we will look solely at Pre-seed to Series E venture rounds and not include ICO data. The reason for this is simple. Equity markets are a sign of what could eventually be the public token markets. Take Uniswap for instance. Before it could be the darling of the industry for retroactively dropping tokens and building a very sticky product, the team raised from investors. A similar dynamic is visible across multiple successful network launches. So even in the presence of a dynamic public funding market like the one we are in today - venture capital plays as an excellent relative gauge of how investor interests are playing out. 

Let’s get into the numbers. (I have missed saying that..)

2020 to see a 60% Contraction In Money Invested

2018 saw close to $3.8 billion in venture capital financing going into blockchain-related deals. For 2020, that figure is estimated to be at around $1.4 billion. 2018 benefitted from the bull markets of 2017 but even by 2020 Q1 standards, there has been a considerable dip. One of the reasoning here could be that late-stage ventures closed larger rounds than what they had initially planned for as news related to Covid took off. This is especially relevant in the context of Bakkt who closed a $300 million Series B. Since then, the market has more or less trended towards mergers and acquisitions for large-ticket plays. But more on that later. In Q2 and Q3 the most massive raises were Bitcoin Suisse and BlockFi, both of which managed to raise only about $50 million. We see more capital concentrating on fewer deals as was predicted in my previous state of fundraising article. This flight to quality is not something to necessarily be alarmed by As the sector evolves, we will see larger raises going to fewer founders. We will likely see more community-driven fundraisers such as retroactive airdrops and fair-launches.

The decline in venture financing frequency is not necessarily covid linked either. The number of deals closed per quarter has gone from a high of 350 in 2018 Q2 to under 100 this quarter. We should see only about 400 deals closed in 2020 in comparison to 1077 in 2018. This is not necessarily a fair comparison given that in 2018, investors were increasingly rushing to SAFT/SAFE based deals in anticipation of making a return when projects tokenised. However, in 2020, there has been no apparent rush to similar deals regardless of the hubris we see in DeFi today. Part of the reason for this declining interest in seed-stage bets is the time to liquidity and risk involved for an early-stage venture. An investor making ~3 to ~4x on a venture investment may not necessarily be doing that much better when compared to someone betting on liquid opportunities. Accounting for the high chances that ventures never make it to tokenising (regulatory, technical and especially people risks), the risk does not necessarily pay off in many instances for blockchain native funds to tie up their capital in illiquid opportunities. This is why we will see increasingly “full-stack” VC’s owning the early stage deal-flow pipeline. They will be able to provide solutions ranging from design to legal assistance in-house the way Y Combinator did and negotiate better deals for themselves in a market that is rich in terms of liquid market valuations. This may not necessarily be good on the short run as founders will be forced to look at alternative forms of financing (e.g.: tokenising) even when it does not necessarily serve the best interest of the firm. This “gap” in early-stage financing is the opportunity for DAOs or digital cooperatives to take over. We will explore that in another issue.

Series A and B Deals Take 65% of All Fund Raise Dollars.

The lack of financing in the earlier stages becomes more evident once we look at how capital is distributed within the industry in terms of venture funding. Pre-seed deals attract less than 1% of the total money invested but are responsible for close to one in every five deals. A similar dynamic plays out for seed-stage deals too. Inspite of accounting for over 55% of all deals, in total they bring in only about a fifth of the capital invested. It is far harder than one would think to raise meaningful amounts of capital at the early stages in the token ecosystem today. Also, Q2 2020 attracted roughly half the amount seed-stage deals did and 1/5th the amount Series A deals did for the same period in 2019. One place to see this play out is the ratio of startups that go from seed to Series C in the course of 3 years. I take series C as a benchmark here because that is when startups typically cross the billion-dollar valuation figure. For the 1204 seed-stage deals we saw since 2018, there’s barely about 3 that did a series E . These Series E ventures launched before 2018, and so had sufficient time to grow into who they are today. In other words, the possibility of them growing to be a billion-dollar company is one in 400. This is excluding the fact that about 95% of ventures barely raise any capital at all in this space. (An optimistic estimate based on multiple deal-flow pipelines I have seen over the past few years). In percentage terms, the odds of you going on to build a series C venture based on that comes to about 0.000125%. The odds are still better than winning a lottery ticket of similar sizes, and you do have a meaningful influence on the outcome as a founder. That is why the venture game exists. But founders must know the probabilities they are working with.

Financial Applications Rule Every Deal Around Me

All of this made me wonder which sectors are the “hottest” in terms of raising capital. For the chart below, I took both ICOs and equity-based raises but excluded some large bank merger transactions.

As you can see, 8 of the 10 largest investments were financial applications that raised later-stage financing from banks and similar entities. Even when we consider beyond them - the largest raises outside core digital asset businesses are Proxy, and Anchorage, both of which are identity-related solutions are therefore associated with financing. Excluding finance, the largest raises are typically for protocol layers (e.g., Polkadot, Ava, NEO) and typically done in the form of ICOs. The average ICO for late-stage ventures in these instances is generally closed with a small number of accredited investors through platforms like Coinlist today unlike the hay days of 2017. One of the things this indicates for me is that maturity in terms of CeFI applications involving Digital assets is almost here. The idea that “institutions” are on the sidelines is no longer valid. They are here. On the cap-tables of the largest exchanges, sometimes acquiring tokens from the market (e.g., Microstrategy) and eventually integrating it directly into their product (e.g., Square). This is also why we see a Cambrian explosion in DeFi. The more experimental, early-stage and risky ventures are being built there instead of the more traditional, web 2.0 stacks. In terms of early-stage investments - the likelihood of finding a non-financial application that is B2C focused with a low enough valuation is far higher for a value investor than a risk-off, low valuation digital asset-based financial application.

This focus on financial applications and associated industries is also replicated in terms of how mergers and acquisitions play out. For starters - Kraken, Coinbase and Binance have been the most active acquirers (excluding banks) in the blockchain ecosystem. Exchanges have an incentive to acquire extremely sticky and habit forming data sources such as Coinmarketcap and Blockfolio as they are an excellent source for traffic. Premiums paid for acquiring them is justified as they reduce the cost of customer acquisition for exchanges. Similarily, Cryptofacilities was acquired by Kraken to accelerate the pace at which they could offer derivatives. A gaming group in South Korea purchased Korbit out. Expanding beyond existing product suites in breakneck speeds is hard, so financial players tend to acquire associated products.

Okay, so what’s next?

It does not take a rocket scientist to figure out that private market funding in the blockchain ecosystem is directly in correlation to how liquid assets are performing. Or maybe you do. I don’t know. With Bitcoin forming somewhat meaningful support at $10,000 and being acquired by multiple corporate treasuries as an asset, it is safe to suggest that we may hit a new all-time high in the year to come. In the event that it does happen, ecosystem funding will boom again as risk-on venture investing from backers with returns increase. Broadly, excluding the possibility of that occurring, I see three likelihoods occurring

1. SPACs and IPOs - Given the scale and maturity of large blockchain-related ventures like Coinbase and Greyscale, it is likely that a listing is in the horizon within the next two years. This will give much-needed liquidity to early backers and in exchange convert to capital funnelled towards funds, and from there to startups. The new “millionaires” minted by a listing will also be the ones doing much of the angel and seed-stage venture investing in the year to come. One example of this is with tokens that have listed in the recent past that have founders actively investing in new ventures (eg: Compound’s Robert Leshner). They are able to bring a wealth of expertise, capital and a network that was required in the first place to create their success.
   

2. Compliance Tech Becomes Hot - While things like self-sovereign identity have been great concepts on-paper, their real-life usage is not to be seen in a meaningful enough impact yet when observed from a market-share perspective. Small pockets in niches using it does not necessarily translate to traction. However, as the industry “institutionalises” and players like the SEC and CFTC along with the FATF increase their scrutiny in the space, the need to back compliance-related ventures will increase. Shyft.network and Notabene offer a glimpse of what compliance technologies will look like for exchanges. The FATF’s travel rule being implemented in 2021 will be a catalyst for this. The situation at Bitmex is an early indication of what is to come. This also makes me think we will have an acquisition from exchanges in this space in the months to come.
   

3. DeFi blends with CeFi and Fintech - DeFi is hot and exciting right now. No doubt. But at some point (or maybe we are already there), yield becomes less exciting and true growth will be a function of on-ramps and expanding the market. There are two ways this could go. One is the institutional route where DeFi products look primarily at the hedge funds that are in the space today. Products can be built to on-ramp them towards yield farming and assisting them with expanding the TVL (total value locked) in DeFi projects. Players like Alkemi.network are already doing this by making it easier for institutions to park capital in vetted, yield generating projects. There are also attempts to plug traditional exchanges to DeFi in a meaningfully good enough fashion. Serum and Hashflow are two instances of this. The flip side is that DeFi goes the fintech route to expand the reach to retail users. Applications like cross-border remittances and lending are where this will be most visible. Stablecoin usage is by miles a far better experience than traditional banks. Under the right regulatory environment, the future of Venmo and PayPal will be built on Crypto. One example we have for this today is Gilded. They have enabled businesses to collect over a million dollars in volume recently.

Ultimately, what founders ought to know is that even when it looks like money is falling out of the sky, venture capitalists and backers have liquidity preferences. This in turn skews how investments in the industry work today. There is a massive opening for a more traditional VC firm with distribution in place to enable the next generation of unicorns. In fact, Y Combinator and A16z have already been porting their learnings to the web3.0 world but the gap still seems major for early-stage bets. It would serve founders best to observe where the money is going and in what frequency and sizes. Investors on the other hand also seem to have a preference for financial applications over other B2C plays given that transactional velocity is often lower there. In 2021, my bet is that the highest venture scale returns will be made on investments that look beyond just fintech applications because competition and volume of deals seem lower there. Also because we are increasingly at the cusp of consumer-grade blockchain applications if experiments with L2 actually work.

I’ll see you in the coming days with more.

Joel John

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Disclosure: I have equity exposure to some of the startups mentioned in this piece as an advisor. Unless stated otherwise, nothing shared above is to be considered financial advice.