Blockchain technology and cryptocurrencies have had their fair share of ups and downs in the past few years and for many they remain a mystery, poorly understood, and even feared. But since the recent bubble and crash of 2017/2018 there have been three years of soul searching, greater regulatory scrutiny, and a great deal of cleaning up of acts.
Often for any startup seeking funds, their overwhelming desire is to get funded and they’ll overlook any due diligence that they themselves should undertake on the people who may provide them with their much-needed capital. Instead, it is crucial that they query what their investors’ motives are, for example, are they in for short, medium or long-term? What are their credentials and history of making investments? But this goes beyond just providing capital for good tech projects. In most cases, they need advice and guidance about how to deploy fresh capital, which often means they need a sound treasury service as well.
Then there’s the other big question of what technology should the startup build on? Entrepreneurs shouldn’t put all their eggs in one basket and be wedded to just one technology provider or blockchain protocol.
Looking back at the last big tech boom of the early 1990s, it was the behemoths of today such as Apple, Intel, and Microsoft that were opening up so-called Corporate Venture Capital (CVC) arms. Soon, as the “dot com” bubble grew, by the late 1990s there were dozens more CVCs launched, only to see huge losses as the bubble burst. But just look at the value the successful ones have created over the past two decades, following the lessons they learned from this boom and bust, namely financial return, education and experimentation, and strategic alignment.
Today there are now almost 1,000 CVC funds around the world and it’s the turn of some of the blockchain protocols to drive the next wave of technology innovation. In crypto, there are now about 40 ecosystem funds that mostly try to do the same things, which is to get applications to use their layer-1 platforms. Unfortunately, very few – if any – benefitted from the learnings from the 1990s tech world. They’ve mostly been both financial and strategic failures for the same reasons:
- Issuer adverse selection: Strategic investors want strategic alliances and put demands on potential investees which pure financial investors wouldn’t, and for good reasons. After all, which companies are interested in taking strategic money that has additional terms? Those that are having a hard time raising money. Said another way – if a startup is ‘hot’ and has lots of investor interest, they have no need to take money with additional obligations – so those ecosystem funds miss out on exactly those deals. If a company is desperate, they are fine taking money with restrictions as it is often a decision between shutting down the company and altering the business vision. What most of the strategic investment funds learned quickly is that giving money to a weak startup makes for good press at the time, but leads to write-offs, which is helpful for nobody except gleaming competitors.
- Other investor’s moral hazard: A lot of the ecosystem funds are ‘easy checks’ so long as a company will accept that it must use the fund’s platform. So, they commit to deals early and often fund quickly. The problem is this very behaviour became a negative signal to other financial investors once they started seeing how onerous the side letters were and how much these restrictions impaired the company. Once a startup takes money from a strategic fund it then has a much harder time getting capital from other financial investors – impairing the startup even further.
- Poor deal selection: Too often CVCs in crypto make bets on the basis of ‘if this works, then it will generate tons of activity on our blockchain’ – but failed to properly understand that the startups’ model wasn’t tenable.
- Lack of support post-investment: Too many of the strategic funds fail to support portfolio companies with the necessary resources to offset the above. Protocol funds are OK at providing technical help, but most fall down when it comes to more general support – like introductions to other investors (which is probably the most critical role for an early-stage VC) and enterprises.
- Lack of proper diligence and processes: Many of the crypto CVCs were motivated to make many investments quickly to generate lots of news about the blockchain’s adoption, but too many corners were cut in the process. Often, CVCs made investments only to see the startups shut down within months.
Learning from our failures is one of the best ways to improve. The new IOHK / Wave Financial Group cFund will be deployed in accordance with our investment strategy that will ensure we avoid falling into one of the above categories. Management will be measured purely on financial returns, rather than blockchain utility. Beyond not placing restrictions on investees, cFund will also leverage IOHK’s corporate development arm to an extent rarely seen in the investing world.
The good thing is that the VC and investment management experience of the team at Wave exceeds 50 years combined. In order to achieve broader adoption of blockchain technology, the importance of these ecosystem funds cannot be understated, as they will drive the future growth of startups and early-stage tech firms. The key is to learn from the mistakes of the past and in doing so, help those businesses that will become the tech behemoths of the future thrive.
David Siemer is CEO of Los Angeles and London-based digital asset management firm Wave Financial Group.