Interpreting the Survival Strategies of Venture Capital Firms in Web 3

Author: Momir Amidzic, Investment Associate

Source: IOSG_VC

In 2021, Web 3.0 entered the public eye and became a buzzword, while NFTs brought millions of new users into the world of decentralized applications. Meanwhile, in terms of financing, many crypto-native funds have raised significant new capital, and large venture capital and private equity firms, such as Tiger and Coatue, have also expanded their digital asset divisions and begun actively investing in a variety of Web 3.0 projects.

This has led to two effects. First, if Web 3.0 is "owned" by venture capital firms, many top figures like Jack Dorsey (co-founder of Twitter) will further question the fundamental principles of Web 3.0. On the other hand, the intensifying competition among venture funds may force some funds to adopt unethical investment strategies to secure a share of the current round, or to sacrifice their reputation for short-term profits.

We can only expect research-driven venture capital firms that provide real value to projects to have a positive impact on the current market lifecycle. However, we have also heard some doubts about whether there is still a demand for professional funds from project parties in the Web 3.0 ecosystem. In response, we should first analyze the role of venture capital and private equity firms in the Web 3.0 world, as well as what value-added services these institutions provide to the decentralized economy.

The Secret of Value-Add

Market signaling - Reputation

Early projects often rely on the endorsement of investment institutions. Leading VC firms generally have strict due diligence processes. Their support for a project is usually understood by market participants as a positive signal, and these participants include not only users but also individual investors, and even exchanges and protocols on L1, as they also want to find valuable projects in the active and vibrant crypto market.

However, gaining a reputation requires years of effort and hard work, establishing a good track record and relationships with local communities. New portfolio projects can leverage the good reputation of investment institutions as support, while for venture capital firms, building a good reputation is the most time-consuming activity. For example, a16z is considered one of the most renowned investment firms in the field.

Therefore, regardless of whether a16z engages in any activities post-investment, the mere act of investing is already seen as a significant help to the project, as the vast majority of market participants will view it as a signal that this project may be outstanding and worthy of more attention.

Network

VC is an industry that values accumulation; in most cases, the longer a VC survives in the market, the greater its competitive advantage. Building a resource network requires hands-on practice, including organizing hackathons to support early developers, hosting summits and various meetings, connecting with security audit firms/financial institutions/other VCs in different regions, and speaking through media channels, among others. Overall, this is a process of continuously empowering this resource network.

A new project often needs referrals from peers in the industry, so project parties highly value the resources of excellent VCs. Referral resources, although requiring more time and effort from VCs compared to merely endorsing a project, can still be scaled. Typically, VCs are more willing to proactively introduce resources rather than purely satisfying the needs of project parties.

For VCs, the key to standing out in terms of resources lies in the weight of these resources. For example, they can introduce a security audit firm, connect to well-known centralized exchanges, help recruit talent, liaise with media channels, and communicate with portfolio companies.

Experience

Similarly, experience is proportional to time. For the founders of project parties, such experience is beneficial as it can play a role in long-term strategic decision-making and market orientation, especially in such a fast-paced market. In the emerging cryptocurrency market, there seems to be no right or wrong choice.

However, whether in terms of the timing/method of financing or the deployment of human resources, an experienced VC can definitely help project parties make more reasonable plans.

Deep Pockets

Some protocols require significant liquidity to support their operations and need substantial funding for long-term development; for them, deep pockets are crucial. Additionally, VCs need to form a more risk-tolerant investment logic to support these untested products and ideas in the market. VCs with a higher risk tolerance are willing to take on additional risks by locking funds in unproven smart contracts.

Hands-on approach

Finally, perhaps the most valuable yet hardest to scale service provided by excellent VCs is a hands-on approach. A practical solution can be interpreted as investors integrating with project parties and frequently participating in the daily progress of the project, while also collaborating deeply in areas such as marketing, R&D, and token economic models.

Examples of venture capital firms having a profound impact on portfolio companies through hands-on involvement include: Paradigm's participation in designing Uniswap v3 and Opyn Squeeth options, or Delphi Digital's involvement in designing the tokenomics of Axie Infinity, among others. Of course, if you have noticed, we (IOSG) also have many similar practices, spending considerable effort to assist in the post-investment growth of projects.

Certainly, considering various constraints such as time and human resource costs, along with a large number of investment projects, VCs often find it challenging to be hands-on with every project. Regardless, achieving consensus and shared goals is the foundation for long-term close collaboration.

Aligning the incentives

From the perspective of projects, it is essential to determine the type of partners they want. Some projects may be very strong in a specific area (such as market research) but lack experience in others (such as marketing), so they are looking for complementary VCs. Each project has its unique preferences; however, they should plan their financing based on these preferences.

For example, if a project is looking for a VC that can engage long-term, they should not let a large number of VCs enter this round of financing but ensure that they provide a sufficiently large investment scale for the collaborating VCs. Another option is that maximizing capital usage at the startup stage may require more investors; however, this will come at the cost of sacrificing some other value-added services.

Sizing-up

From the VC's perspective, reputation can be lost due to a few missteps or can gradually fade as VCs become complacent. While diversifying risks and supporting more projects is acceptable, it is not an optimal strategy, as it will affect the fund's reputation and its ability to compete in the future. Additionally, since each new investment dilutes the company's resources, the marginal value increases as the number of investments grows will decrease.

Evaluating and concentrating bets on funds can demonstrate the degree of belief and theoretical drive of the fund. In our view, venture capital occupies an important position in the Web 3.0 ecosystem. Ultimately, just like in any other field, market dynamics will naturally filter out the truly valuable VCs in the field, while value extractors will eventually be excluded from the primary market.