What Is Cryptocurrency and Why Does It Matter for Venture Capitalists?
We may be exiting a crypto winter, but that hasn’t stopped piles of private money from flowing into the market over the past year. According to a survey conducted by Custom Research Lab, nearly 60% of crypto-exposed institutional investors plan to increase their holdings over the next three years. For venture capitalists, cryptocurrency presents an exciting new investment opportunity.
Despite all the activity in crypto markets, however, few private investors actually understand cryptocurrency. Venture Capitalists (VCs) typically perceive crypto as an alternative investment product that offers novel opportunities often unavailable with thoroughly-regulated traditional investments.
But when it comes to cryptocurrency, it’s important to understand exactly what you’re investing in and why the technology deserves investment consideration—without getting distracted by the hype.
In this article, we’ll explain what cryptocurrency is, why it has become an attractive investment option, and how it can help VCs and budding businesses with their funding.
What Is Cryptocurrency?
Cryptocurrency (or “crypto”) is just one of the many terms venture capitalists need to be familiar with. Cryptocurrency is a type of digital asset that you can own and spend without involving any third-party centralized intermediaries like payment processors, banks, etc. Unlike conventional fiat currencies like British Pound Sterling (GBP) and United States Dollar (USD), which are created and controlled by national governments, cryptocurrencies can be circulated and traded without any centralized authority like a central bank.
Cryptocurrency transactions are recorded as digital entries on the blockchain—an online public database or ledger. The transactions are recorded in groups called “blocks” that are chronologically linked using cryptography, creating a chain of records that cannot be tampered with.
Nodes participating in the network validate transactions and store records. From verifying transactions to releasing new cryptocurrencies, everything is controlled by the underlying protocol of the blockchain, leaving less room for corruption.
All of these properties—decentralized distribution, transparency, and security—when put together, enable users to confidently send and receive cryptocurrencies.
Why Do People Invest in Crypto?
Many crypto assets, such as Bitcoin, are regarded as long-term stores of value. Unlike fiat money, cryptocurrencies can be designed to have a limited supply programmatically. In this way, no government can manipulate or dilute a cryptocurrency’s valuation by minting more.
Cryptocurrencies also allow investors to diversify their investment portfolios by veering away from traditional financial assets like stocks and bonds.
Transaction costs, privacy, transparency, security, accessibility, and transaction speeds are other reasons many people invest in crypto assets.
Why Does Crypto Matter to Venture Capitalists?
Many VC firms actively and aggressively fund crypto startups. Several VC firms have even created dedicated subsidiaries to handle their crypto-related funding. Now, you may wonder, what drives these investors to the crypto market? Well, here are the top four reasons why VCs want exposure to crypto assets:
1. Growth Potential
Even though crypto investment has its fair share of risks, crypto is a high-growth industry. For instance, Andreessen Horowitz’s $20 million investment in Coinbase, the US-based crypto exchange, in 2013 turned into $11 billion by December 2021. And the best part is that this industry is just getting started. With constantly emerging innovations such as NFTs and decentralized finance, there’s plenty more room for growth.
2. Opportunity to Spearhead the Next Generation of Innovations
Cryptocurrencies and blockchain technology have the potential to revolutionize industries such as finance, supply chain management, and even voting systems. Venture Capitalists have always been the first to new technologies, and crypto is easily one of the most promising ones. By investing in projects and companies that are working on these disruptive technologies, venture capitalists can gain exposure to the potential upside of these innovations.
3. High Flexibility and Liquidity
Cryptocurrency has opened up new ways of raising funds, like Initial Coin Offerings (ICOs), an alternative to traditional fundraising methods like IPOs or venture capital rounds. As crypto investments are usually executed through token issuances and not shares (as with traditional businesses), VCs enjoy far more flexibility than conventional VC funding methods. Furthermore, they can liquidate their investments after the initial vesting period (which is usually pretty low) and quickly exit.
4. Portfolio Diversification
Performance of cryptocurrencies is not affected by traditional assets such as stocks, bonds, or real estate. Although there can be a slight influence on the crypto market based on the overall investment sentiment of the macro market, cryptocurrencies are generally considered a hedge against inflation. VCs looking to diversify their portfolios often add cryptocurrencies as a high-risk, high-reward bet.
How Can Crypto be Used in VC Funding for Startups?
Cryptocurrencies can facilitate frictionless funding rounds across borders. For instance, a venture capitalist firm in the U.S. can instantly fund a crypto startup in another country by sending cryptocurrencies to their wallet address without using an intermediary like a bank. This flexibility, coupled with comparatively less strict regulatory norms, makes crypto funding a superior option for startups compared to accepting dollar-based funding.
Crypto projects can easily raise funds via their token presale exclusively for early supporters, where investors can purchase the project’s crypto tokens at a discounted price. Typically, this is done through an Initial Exchange Offering (IEO), which is coordinated by crypto exchanges, or an Initial DEX offering (IDO), where the startup is accessed by crypto launchpads.
Benefits of Funding Cryptocurrency Startups for Venture Capitalists
From a VC point of view, funding a crypto startup is having a first-mover advantage in an industry that is rapidly evolving and being adopted by established companies like Stripe, PayPal, a16z, and many others.
While early investments in credible crypto startups can be seen as a once-in-a-lifetime opportunity for VCs, investing in crypto companies has its own nuances. Unlike traditional investments, crypto startups provide their native crypto tokens for raising funds and are not vetted by regulatory authorities like the SEC.
Add Crypto Investments To Your VC Portfolio
Many investors compare the current interest in the crypto market to the next gold rush. Venture capitalists have shown increasing interest in this market, and this trend was confirmed in July 2022 by Steven Alexopoulos, a J.P. Morgan analyst. With the crypto market still far from its 2021 highs, it may be the right time for VC firms to start exploring crypto investments.