Transparency, sidecars and the crypto winter
By Jeff Davis
Since its inception, venture capital has had two silos. In a silo, there is the management which makes the day-to-day decisions regarding the investments of the fund. Second, there are the limited partners – the investors who provide the capital that the managers invest.
Sponsors of venture capital funds are passive. They are not involved in the selection of investments, nor in the day-to-day management of a portfolio. Fund managers receive management fees and deferred interest for their active and hands-on construction of fund investments. This opaque investment process works in a bull market where positive returns satisfy sponsors. However, when the market turns red, investors begin to wonder why they are paying fees to their managers and begin to question the investments they had been unable to select.
But now the models of passive investors and active managers are starting to change due to the rise of Web3. Web3 challenged how the traditional venture capital structure worked with the creation of decentralized autonomous organizations called venture DAOs. Venture DAOs are investment vehicles where DAO members are active in selecting the projects they support. Members of the DAO participate in the research and due diligence of projects that they consider to be promising. When the time comes to invest, they pool their own funds to support the project. The result is the same as the traditional venture capital model in that a target project has been identified and funded, but the level of involvement is quite different. DAO investors select the projects they will support themselves, not the general partners and the fund’s investment committee. Decision making has become decentralized and therefore the result is transparency on what, how and when investment decisions are made by the collective.
Venture capitalists are aware of this and are looking for similar transparent investment opportunities. A transparent investment is the sidecar, where an investor provides additional capital in a project and rises alongside the pooled capital. It allows for greater investment in a single known opportunity compared to pooled capital which is usually blind. However, sidecar opportunities are limited and generally reserved for the oldest investors in the fund. The Venture DAOs offer sidecars – lots of sidecars – and they don’t have to play favorites either. More traditional investors seek out these known (see: transparent) parallel opportunities. It is to be expected that funds of all types will begin to listen to this growing mandate in order to satisfy their investors who will look elsewhere if their directives are not respected.
The decentralization found in risk DAOs is not limited to the financial realm. Web3 has decentralized applications (dApps) for art and collectibles, games, and technology. People compare Web3 to when the Internet was in the dial-up phase. But today’s internet is nothing like what it was 20 years ago. Web3 follows the growth trajectory of the early Internet as new public services are created. Mass adoption of Web3 will occur as new use cases are developed; how quickly this adoption happens will depend on the capital available to creators in this “crypto winter”.
Many experts have compared the current “crypto winter” to the bursting of the dot-com bubble. I would say they have a good point, except this is not the only crypto winter we have had. There have been several crypto winters; and as their name suggests, they are seasonal. After each of the previous crypto winters, we have seen new highs. People in space expect these seasonal valuation changes. The dot-com crash was not expected and many investors were left exposed when the tide receded.
Additionally, the dot-com era ended when there was an epiphany that all cash hemorrhagic projects were unlikely to be profitable for years, if not a decade. And that’s if they actually had a business plan or a product. Speculation at that time was so frothy that funding was available for almost any concept ending in .com. What we are currently experiencing is a correction that is correlated to other risky assets. These other risky assets, notably tech stocks, are correcting because of higher interest rates, not because the projects lack merit or a path to profitability. Web3 has companies that are making money and others that will be very soon.
Yes, there was a ton of capital looking for Web3 offerings like over twenty years ago, and valuations have gone wobbly. But those Web3 valuations will soon use 12 EBITDA multipliers, not projections like in the dot-com era.