Foreword
Another article about capital allocation—but this time it’s different.
Uncertainty always slows things down, forcing people to reflect on where they are, their past, and their future. The cryptocurrency investment community was caught off guard by the interest rate hikes of recent years, as well as the uncertainty surrounding global trade and geopolitics. However, in addition to external factors, there are other factors that pose a crucial threat to cryptocurrencies. This silent disaster continues to consume people’s time, money, and beliefs: shadow investing.
(Shadow investing = supporting competitors after missing out on industry leaders, usually to maintain exposure rather than based on a belief in differentiation.)
The Talent Problem
The search for exceptional talent is the pursuit of every company in the world, but the source of talent is not infinite. Genius is extremely difficult to find, even more difficult to force, and to some extent completely accidental. Companies that suddenly hit upon a bright idea fail to predict unexpected outcomes and instead focus their energy and time on creating as many opportunities as possible for talented people to flourish.
Similarly, venture capital firms face the same problem, because venture capital is not a linear game. More money invested does not mean more talent is produced. This was well known in the early 80s/early 90s and early 2000s when modern venture capital emerged, but as investor expectations and appetites grew, so did venture capital budgets and the pursuit of talent. But this is in fundamental conflict with the philosophy of venture capital - "If opportunities do not exist, how can you find more opportunities?"
Shadow Investing Enters
Every few years, we encounter a new cryptocurrency protocol, project, or business that truly changes the rules of the game and creates meaningful value. This is the joy of every investor and the goal of every team's work. However, the speed and scale of these investments make them (intrinsically) scarce, and the lack of original thinking causes investors to start focusing on existing trends, choosing the hottest option of the moment as their next investment. In simple terms, investors see new trends in the industry and choose to support weaker "competitors" to the projects they missed.
Why This Happens
It is well known that I have many criticisms of the crypto venture capital space. You can find my complaints in old podcasts, tweets, or articles, but all of them touch on the same starting point - the crypto venture capital supernova theory (the idea that there is too much money in the crypto space, and in turn too much venture capital). This abnormal state of affairs has created many negative externalities in the industry, but the continued funding of cheap copies of excellent companies is one of the worst.
The current capital allocation process in crypto (or any market) is simple:
Limited partners (LPs) invest capital in venture firms
VC firms use that capital to invest in startups at different stages
Startups use that capital to grow and build their companies
This model is simple, but it breaks down when LPs have too much capital in their hands, and they over-fund crypto VCs by giving large amounts of money to many investors. Today, in the crypto space, there are more than 20 firms with nine-digit capital, ranging from seed rounds to later rounds. If each investment firm (even if we only consider 20 VC firms) only did one deal per quarter, that would still be 80 investments in a year. But in reality, the number of deals is much higher, hundreds per year. There aren’t hundreds of worthwhile crypto companies worth investing in every year. And there aren’t dozens of worthwhile meta-stories or narratives in crypto every year.
Instead, we face two truths:
There is too much money in crypto venture capital
There are too few quality companies to invest in
But these funds still need to get to market somehow, because they are funds that are earmarked for companies. Therefore, these funds flow to companies that match the recent investment hotspots: shadow investments.
In the markets of first layer, second layer, wallets, perpetual decentralized exchanges, lending protocols, and cross-chain bridges, many projects are poor imitations of each other because the value of the original projects drives the demand that cannot be funded. Take Uniswap, for example, a pioneer and leader in the field of decentralized exchanges. Hundreds of millions or even billions of dollars have fueled cheap imitations of Uniswap, but have failed to deliver meaningful value or vision iterations. Instead, we are left with an industry landscape destroyed by token inflation. Of course, there are companies that build high-quality iterative products, and not every spin-off is a cheap imitation, but these tend to be exceptions rather than the rule.
"The imitator can only follow the footsteps of the leader. He cannot surpass." ——Peter Thiel (From Zero to One)
A major problem with the cheap imitation strategy in cryptocurrency venture capital is also the upgrading and maintenance of the product. Many of the best projects in cryptocurrency started out promising, but always promised greater growth visions and a lot of maintenance work. This brings many problems from protocol security to building a clear product vision. How many times have project forks resulted in millions of dollars of funds being hacked or exploited?
The end point of the problem points to the venture capital companies that funded these transactions. Inevitably, shadow investing tarnishes the reputation of an industry when the industry as a whole and its best investors cannot distinguish between quality investments and poor imitations.
We can see how many funds, how many teams are ultimately funded because of real product launches. Imitation is flattering, but not when the imitation market pays too high a price for a "good thing" that is about to die. If crypto is to become a serious industry committed to even a semblance of capital preservation, the space and its investors must grow out of their fundraising practices and strictly invest in teams that are truly committed to innovation... at least that's what I hope.
Kikyo
Weatherly
Catherine
Anais