The blockchain sector created the opportunity for retail investors to access early stage and private deals, which has a lot of benefits as long as we recognise the risks. And, while venture capital (VC) usually refers to any private funding up to Series E, here, we will examine the earliest opportunities, because, according to statistics, 81% of all VC investments went to early-stage blockchain startups in Q2 2022.
You’ve probably heard the saying: “The higher the risk, the higher the return”, so compared to listed projects, investing at an early stage is much riskier. Therefore, one firstly needs to evaluate if they are comfortable with such a level of risk and what portion of their portfolio can be allocated to these riskier investments.
Ideally, a risk-balanced, efficient portfolio would include 5% risky or alternative assets – a nice benchmark to allocate to pre-launch projects.
Investment thesis
To start with, VCs have an investment thesis, which is formed based on the manager's market outlook for the next 5-10 years when we talk about equity, and 3-5 years considering token investment. So start with deep market research, thorough reading of the news and investor newsletters, released by funds and all other relevant information to form a mid-term outlook. For this purpose, I find listening to interviews with top project founders or joining events to listen to industry leaders very beneficial.
Hedge fund company, Polychain Capital, says: “Over the next decade, new and existing asset classes will be ported natively onto the internet, with all value transfer settling on blockchains. What’s more:
- Financial services and marketplaces will become automated with self-executing software called smart contracts
- This will lead to both disintermediation of existing financial services and novel applications uniquely enabled by crypto technologies
- Deeply technical investors with massive networks and a participatory approach are best situated to create and capture outlier value”
Investment mandate
Based on the investment thesis, we derive the investment mandate, which sets out a specific target for the investments, as well as a set of rules to guide the investment process.
Pantera Capital Fund III says: “Fund III focused on companies enabling the institutionalisation of digital assets as an asset class.”
After the area of focus is known, next comes the qualifying criteria. Usually, VCs have a large list of requirements, but also, as a retail investor, checking those might save you from making incorrect decisions and falling for scams.
Examples of initial project screening criteria are as follows:
Team and experience
As a retail investor, one probably won’t have direct access to the founders, but you may still focus on reviewing the founders’ public profiles, examining if they have both the technical and professional expertise to run a business. VCs would usually run a background check, too.
Positioning and comparative analysis
How is the project positioned in the current market, is the idea way too ahead of its time? Sometimes, I see impressive projects, but either the market is not developed for their product yet or the infrastructure is missing. Competitors’ analysis can help to investigate if there is an existing market. If there are zero competitors there are two things to consider: if there is Proof of Concept (PoC) and existing traction. Most probably, the product is unique and well positioned, but if it's still at the idea stage, no competition would probably mean that the market is not ready for it.
Revenue and business model
Is the business model agile and sustainable? Are there enough revenue streams to cover the expenses, and are they scalable? This is a bit more difficult to answer without having access to the full financial data of the company, but try examining how the revenue is generated.
Valuation
Always calculate what valuation you are entering at and do comparative analysis with similar projects. If no similar project exists, maybe compare to the top liquid assets at the time to see if the valuation is too high or not. For instance, if the highest, fully-diluted valuation in the same ecosystem is $2bn, how much upside would you have entering a new project at $900mn?
Security and Tech Stack
As much as this requires specific technical knowledge, it is important to study if there was an external security audit on the smart contract to avoid cases like the Ronin Bridge network, which lost $600mn in an attack overnight.
Regulation and possible regulatory challenges
After multiple misconducts from Terra, Voyager, Celsius, 3AC to FTX, regulation will become stricter and inevitable, so when we examine a project we always try to foresee any potential regulatory challenges.
Based on the investment mandate, a particular criteria can be developed to cover the industry specifics.
Due diligence and diversification
Please keep in mind that we do similar due diligence on both tokens or equity, but since tokens are offered more often for retail investors, you might want to get a deeper understanding about how tokenomics work and focus a large part of your analysis there. This also should be reflected in the revenue model; you probably hear a lot about “utility” when it comes to tokens, and utility is a particular use in the ecosystem. If the token is not designed to serve a specific purpose or it doesn’t reflect the product's revenue, no matter how successful the project gets, this probably won’t have an impact on the token’s price action.
VC backing can be also considered, because VC firms usually advise and deploy resources that increase the chances of success for the project. Also, every VC does its own due diligence and interviews the founders, partially serving as a proof of concept. You will probably doubt the VCs’ analysis skills after the FTX fiasco, but still, on average, projects with proper backing tend to perform better.
Diversification is a key risk management strategy implemented in all types of investing and venture capital – the early stage is no exception. VCs mainly profit from asymmetric returns, that’s why it is important to not put all your eggs in one basket – all investments should be considered as a portfolio rather than individual assets. For example, if you already invested in five DEXs, you would want to stay away from the sector and maybe add security solutions or gamefi, for example. The average VC aims for 500% returns on its investments in a 2-3 year span. This is achieved through intense diversification, so even if 60% of the startups invested in failed, the rest return the revenue.
Ticket size is also an important risk measurement. Keeping the allocation per subsector almost equal can help with diversification and also ensure that there is no overexposure to a particular asset.
Such early-stage opportunities can be currently accessed through investment decentralised autonomous organisation (DAO) and launchpads. And, as the majority of the platforms offer only tokens at an early stage, the next layer of digitalisation is coming to equity. We broadly expect equity to also be directly accessible by the community, which is why SwissBorg pioneered the sector by offering, in future, exclusive access to equity as well as tokens.
In a nutshell, early-stage investment is riskier and has a longer investment horizon. That is why, until today, it was mostly reserved to institutions only: they have the resources to evaluate those risks. However, as I mentioned, blockchain made – and is making – such opportunities accessible to the retail investor.
