Tl;dr
In short, VC Signal is an application that aims to create fairer token distributions by allowing both retail investors and venture capitalists to participate in crypto project funding at reasonable valuations, while retail investors benefit from VC signal.
Note: This is not financial, legal, or technical advice. This post is purely speculative in nature. In fact, I don’t even remember writing it, someone must have hacked into my computer. Proceed at your own risk.
Motivation
One challenge that arises for many teams building in what one would call the crypto industry or startups more broadly is fundraising. Typically, to build a startup that is designed to build developer or consumer-facing products, an entrepreneur may need to raise funds from private investors. These investors are often venture capitalists. VCs specialize in building a portfolio of companies that are moonshot bets, companies that become unicorns or decacorns. The reason is that most of the companies in their portfolio will not work out. In fact, the majority of companies will fail and cease to be companies. As a result, VCs make strategic bets that allow them to acquire particular levels of company ownership (often the earlier stage, the better) in startups. The math can be a bit more nuanced (it’s basically middle school math, but its application may have complexities), but as a simple example, let’s assume Bob VC invests $1M in Alice’s business for a 20% stake. The company is now worth $5M. The venture investor can exit this position in three ways: initial public offering (IPO), acquisition by another firm, or selling the equity (or rights to it) on the secondary markets. For simplicity, let’s assume Alice has an offer for her startup at $100M because her MRR (monthly recurring revenue) for her subscription-based business is growing exponentially, and she has quickly found product-market fit.
Alice and Bob VC mutually agree that it would be a good time to sell her business, as Alice is not interested in taking the company public; she doesn’t like the spotlight and is burned out. Assuming Bob VC has not been diluted, Bob’s stake is now worth $20M. Bob VC has achieved a 20x multiple on this exit. Since Bob VC’s Venture Fund 1 is only $10M, Bob VC has now doubled the entire fund without any successes from his nine other portfolio companies in Venture Fund 1. Since Bob VC is using a European waterfall structure (with clawbacks) he gets to take a cut of the $19M in profits based on the limited partnership agreement. Note that in an American waterfall structure, Bob VC would need to wait until all LP paid-in-capital in the fund are returned before realizing any gains. Also note that Bob VC has a vesting schedule for employees and general partners designed to keep Bob VC employees and partners away from the Champagne weekends in Cannes, but close to the action of helping their portfolio companies find exits and generate “carry”.
In crypto VC, there is a similar set of dynamics at play. One difference is that limited partners who provide the actual capital the fund invests in portfolio companies at the discretion of the GP or internal investment committee, are typically not pension funds and endowments. Crypto LPs are typically family offices and high-net worth individuals. In crypto VC, there is also the ability to manufacture exits. Tokens can be created as needed, there is no underwriting process of a traditional IPO, there is no roadshow, and buyers do not need to be lined up at token launch (though that does sometimes happen). Because crypto startups can access liquidity much faster than they would in the public equity markets, crypto venture fund exits can happen much faster. Recently, crypto VCs have been funding projects and bringing them to market in the span of 18 months or less. In this process crypto startups often raise funding over multiple investment rounds. They may raise a pre-seed/seed round and then an additional Series A or B before launching a token. As the rounds progress, the overall valuation of the project typically increases to a valuation that is based more on hope and not reality (think realistic growth projections or actual cashflows).
As such, tokens often launch at very high valuations. Since there is a low float of tokens available to trade initially, it’s relatively easy to make the market at a certain price during the launch period (1-3 weeks). Eventually, though, without organic demand, these tokens often have more sellers than buyers. Why? Certain investors and team insiders often unlock tokens once the token is live for trading. If the project doesn’t have demand, then it typically will be a slow bleed down towards zero over the course of weeks, months, or years. There are many examples of all three. As time progresses, insiders will vest more tokens. These token unlocks allow the investors to cash out and realize their gains. If the investment starts at a multi-billion dollar valuation and there is some amount of hope, optimism, and future roadmap for the project, there will be some retail traders or high-net worth individuals who see the dip in price as an opportunity to buy. If the project does deliver the goods in terms of product, then the buyers will be rewarded in the future. If the project does not, the hopium created gives investors enough time to exit at a multiple, which still makes their investment profitable, even if the token is currently trading at an all-time low valuation. This happens because, as discussed, all the price discovery takes place on the secondary markets. Crypto traders often do not have access to the secondary markets because they are intentionally opaque, geographically locked out, or do not possess the requisite size to participate.
It should also be noted that the crypto VC in our example will sometimes sell their entire position at a 50-75% discount on secondary markets to the spot price of the token post token generation event. The discounted price is pricing in the unlocks and a lower future spot price; eventually the two prices will converge. dao5 reportedly exited their BERA position in the fashion described here. Indeed, even at these discounted valuations to spot, investors can still manage to exit the position profitably, return money to LPs and earn carry (not always though).
As a result, there exist a peculiar set of incentives for crypto VCs to fund projects with no real plan on how to execute and even outright scams by design. It has become challenging for retail investors to tell the difference between legitimate projects and architected scams. Professional traders who typically only trade the major tokens (spot) and perps, outright avoid these venture-backed projects at all costs. The trader community has done an excellent job in working with builders to expose some of these scam projects. The community has done such an effective job of getting this message out that by default, people assume any VC backed crypto project is a scam because regardless of merit projects and VCs will dump a low-float high fully diluted value token on the market in an attempt to profit.
This did not always used to be the case. In a previous era, projects would turn directly to the “internet capital markets” (crypto) to raise money. Ethereum raised $18.6M at ~ $37M FDV. Ethereum’s current FDV ~ $217B. Anyone who purchased $1000 of ETH in the ICO in and held (didn’t lose key) now has ~ $58M. There was no further fundraise beyond the ICO, retail was able to participate and buy at the same valuation as everyone else. Price discovery happened in the public crypto markets where anyone had an opportunity to participate. ICOs had downsides though; many of the projects that raised via ICO failed, their tokens went to zero and the teams quit. Other corpulently funded projects from that era have become zombie-like entities with little activity or innovation on their platforms. Yet other projects went on to be successful and thrive, like Ethereum. The Securities and Exchange commission began to regulate ICOs by enforcement in 2018 signaled in 2017. This threat combined with the crypto cycle top and onset of the bear market, put ICOs to rest for some time. The People’s Bank of China also banned ICOs on September 4, 2017.
Different flavors of ICOs still persisted, however. One could even argue that today’s fair launches and those of the last few years are basically ICOs by a different name with a particular bonding curve. No matter, they have become less popular for funding large-scale infrastructure projects like Ethereum. Most large-scale infrastructure projects are backed by venture capitalists. Indeed, during the ICO era it was effortless to get duped into buying a coin with a white paper and a dream. Many retail participants lost money. Venture capitalists, on the other hand, can provide a useful signal of projects to invest in. Tier I and II venture capital firms typically have a lot of reputational skin in the game and only back the best projects (at least that is their incentive). Given the scenario’s laid out above, though, it’s clear that not all venture capital signals are credible and retail traders do not have access to project tokens or warrants to them at lower valuations.
Problem Space
Venture capital investing does clearly provide useful signal, that can help the public avoid some of the ICO scams. However, retail needs to have better access to these lower project valuations. Currently, retail stands to gain no upside from making any investments in VC backed projects until they sell-off significantly from their launch prices and show tangible progress towards finding product-market fit. Let’s examine this through a story.
Typically, when lower-level illegal narcotics organizations need their products distributed to paying customers, they need points of distribution. To acquire said distribution, they must have some territory (a place to sell the narcotics) and a team of agents willing to sell such narcotics (even is the team is in house). As such, there is often a revenue split for the product, points on the package, so to speak. This allows the agent contractor or in-house employee to share in profits with the supplier while managing payroll and operating expenses (you need runners, touts, and look-outs as well as a steady supply of lake trout carryout). After all, the retailer takes on legal risk and expends significantly more time standing around dangerous neighborhoods where there may be attempted robbery or murder. Such is life in this line of business. The key is the revenue sharing split, sometimes its 50/50 supplier/retailer other times 60/40. A lot depends on if the retailer is talented, in house employed, or can negotiate a better deal. One could consider this a form of bargaining. This type of negotiation is also seen in collective bargaining agreements similar to the ones seen in professional sports leagues like the National Basketball Association (NBA) or Natioanl Football League (NFL) where players and owners agree on how to share revenue. The revenue share has to be just enough to satisfy both parties. These analogies eventually break down. However, they should provide a useful mental model to think about profit sharing between VCs and retail.
From first principles, could we design a mechanism such that venture capital and retail investors can participate in funding projects together at fair valuations? Yes, we can. Both Echo and Legion today demonstrate examples of this. We’ll save an analysis of these wonderful projects for a later post. One key thing to note is that they require some form of intermediation. Projects need to be vetted before being listed and users may need to KYC or answer survey questions to participate in the platform’s public sale offerings. One of the goals of crypto has been disintermediation. With Bitcoin, Satoshi Nakamoto figured out how to solve the double spend problem without relying on a mint to check every coin creation and spend. Where we can preserve these ideals and make our systems and applications verifiable, permissionless, and censorship-resistant, we should.
From first principles, should we strive for token launches that provide both investor and retail signals that are fair? Yes, we should. Until retail can access coins backing credible teams at reasonable valuations, we will continue to see a bloodbath in price action for pure venture-backed coins (see all the Ethereum L2 charts as an example). More profit sharing between retail and investors is critical to the long-term sustainability of these projects. Without strong token distribution to community members who will trade, HODL, stake, participate in governance, re-stake, and use their receipt tokens in DeFi (exaggerating for effect) most of these VC projects will fail (the crypto economic flywheel needs to turn).
And that is a shame because many projects have strong teams with great ideas and the ability to deliver high-quality products given enough time and investment. But a continued failure of venture capital backed projects will push entrepreneurs to pivot to Silicon Valley backed startup product verticals like AI. If the crypto industry has fewer quality projects to back, we will see less innovation and disruption. This may also mean that the dream of fully programmable crypto systems where we redistribute trust in society never fully mature or develop on a relevant timelines. It also means more practically that there will be less “crypto native” liquidity sloshing around, and it will get soaked up almost entirely by Bitcoin and stable coins. For some, this maybe an acceptable outcome, but in my view such an outcome doesn’t speak to the full potential of crypto, which can provide individuals and communities (in the world) with the autonomy to be free.
Solution Space
In 2023, I wrote about an application called Public Signal. It was described as;
The basic idea is to build an intent-centric version of Kickstarter which, in addition to being supply-side driven, can be demand-side driven. In Kickstarter only the producers can interact with the platform, while the backer has no ability to express their preferences for what projects they want to see offered on the platform.
One specific use case of this application could be to back projects that both retail and VC backs. Retail users could have an intent that says if this array of Venture Capital projects back this startup, I will invest $XXXXXX.
For more color (from the article);
Intent Examples
- Identity based; you submit an intent that says you will donate 1 ETH to any project Vitalik donates at least 10 ETH to.
- Information based; you submit an intent that says you will donate 1 ETH to any project doing superconductivity research.
- Incentive based; you submit an intent that says you will donate 10 ETH to any project offering a refund bonus.
- Threshold based; you submit an intent that says you will donate 10,000 NAM to any project that raises > 50% of their campaign goal in 1 week or less.
In this type of game, a startup could decide to reserve a specific portion of the token allocation for venture investors, an allocation for public sale, an allocation for team and foundation, or DAO. For reference, Ethereum sold 60 million/72 million tokens in its ICO. (which could be legitimately autonomous; no DAO politics). Think about the typical pizza pie. You try and split the pie in the optimal way. For example, you could even have a prediction market on what the pie should look like for the split between private investors and the public before having a crowd sale. Maybe the optimal split is 1/3 for team/dao/foundation, 1/3 private investors, 1/3 public investors. Perhaps the optimal split is 40% VC, 40% retail, and 20% team and foundation/DAO.
From the demand side, another feature could be users via voting aggregate their demand into one intent that says we will commit 1/3 of funding (pizza) up to $10M (arbitrary amount) to any project backed by a combination of this array [investor 1, investor 2, investor 3.... ] of investors. This would give retail the ability to signal their preferences credibly.
There are many ways to split the pie. The most important outcome is finding the right allocation between venture capital and public sale investors or retail. Discovering the optimal pie allocation will come as a positive side effect of VC signal. This application could be built on top of public signal (should it exist prior) or as a minimum viable version of Public Signal as an intent-centric application on Anoma on Ethereum (Resource Plasma).
As an example, here is the type of front-end interface that could be exposed to users. There is a drop-down menu showing the different VCs, an amount to enter or input your ccy and a create intent button.
Indeed, one should also be able to filter by projects similar to the public signal design sketch. One can see the ability to search for projects that are actively fundraising and those yet to fundraise. Users should also have the ability to see how the token allocation pizza is split, shown above by the blue, purple, and green dots with percentages listed. VC Signal users may also want the ability to filter out particular venture capitalists based on past behavior as a way to not reward them, which will tip founders not to accept investment from these firms in the future. As such, venture capitalists will actually receive some shorter-term accountability because they now need to share the cap table with retail.
Challenges
- Bootstrapping VC and trader participation (need both)
- Sourcing Deal Flow for the platform
- Pricing mechanism
- Game-theoretic challenges
- Regulatory or legal hurdles
- Reputation systems (slow game)
There are significant challenges in bootstrapping a new marketplace like this. More thought should be given to product requirements for a minimal viable version. Thinking through dominant strategies and edge cases of the game will also be important.
Conclusion
Undoubtedly, this thinking may be highfalutin idealism. The skeptical reader may see this post as not pragmatic. However, one should note this proposal is only one such variation of this idea. There are many more combinations possible. The objective of this hypothetical application is to better align incentives with retail, venture capitalists, and teams building moonshot technology. With the era of regulation by enforcement coming to a close, it’s time to try some experiments that have the potential to not only save crypto but the other malfunctioning industry called Venture Capital.