Venture Capital in Cryptocurrency

Once considered the wild west of asset management and primarily speculative, cryptocurrency investments have gained wider acceptance and started to draw institutional attention at a record pace.

At $33 billion, venture capital investment in cryptocurrency during 2021 was higher than in previous years combined. Noticeable trends surfaced amidst the rapid dealmaking, with valuations and deal sizes reflecting avid interest and outpacing the broader venture capital market.

Trends In Cryptocurrency Venture Capital

Deal Maturity

The playbook for cryptocurrency investing used to be finding the most promising early-stage projects and investing in their initial coin offerings (ICOs). Investing in these projects could net returns of over 20x, though funding check sizes also were generally limited to $3-5 million. Funds had to be sized accordingly because deals could not absorb larger amounts of capital.

However, out of over 2000 deals in 2021, the number of pre-seed stage deals in the cryptocurrency space continued a multi-month decline. This paved the way for Series A and later stage fundraisings to increase. As the cryptocurrency space has matured, so has the investment opportunity set, especially with startups from the bear market of 2018-20. Having achieved successful growth, later-stage startups are likely considered more attractive and less speculative investments for venture capital.

Infrastructure Plays

VC cryptocurrency investments are now primarily focused on the “picks and shovels” elements of the sector – companies offering trading, investing, exchange, and lending services. Accounting for 41% of capital allocated in 2021, these blockchain infrastructures plays could address barriers to entry for institutional participants. For example, $6.4 billion went to crypto exchanges and brokerages, while investments in crypto custody and wallet providers reached $6.3 billion. More institutions participating in crypto drives wider adoption and higher demand for crypto products and services.

Heavy Capital Flows

Given record low-interest rates and the broad availability of capital, investors are eager for higher-yielding investments. Not surprisingly, leading crypto funds raised billions of dollars in 2021, with many managers that raised funds in 2020 coming back to raise new funds faster than expected. The average crypto fund size was $300 million, which was double the size of the previous year’s funds. 

Where capital flows, valuations also tend to rise. In the 4th quarter of 2021, crypto/blockchain valuations were 141% higher than the average for the rest of the venture capital sector.

Maximizing Returns While Minimizing Risks

Despite breaking funding records, crypto is a nascent industry with pending regulatory, tax, and compliance questions. Regulators have the added challenge of contending with decentralized applications built on blockchain networks operating without any central authority. 

Current financial regulation relies on supervising intermediaries. Private companies can be held responsible, for example, for fulfilling anti-money laundering or know-your-customer requirements. However, a global framework does not yet exist for fighting financial crime in the crypto space. In the meantime, regulators will likely take a fragmented approach.

As an asset class, cryptocurrencies are also relatively new, and investment regulation will adapt accordingly. From the legality of cryptocurrency ventures to the structure of VC crypto funds, many legal obligations require clarity. 

For example, fund managers often use exemptions to avoid investment restrictions and high administrative costs. Companies regulated as Exempt Reporting Advisers have to limit non-qualifying investments like crypto to 20% of assets. Applying to become a Registered Investment Advisor eliminates the 20% investment cap, but annual compliance costs could be eight times more. Cryptocurrency funds still have to carve out a space within existing securities and investment law.

While regulators seek to fill the legal and regulatory void, cryptocurrency consulting services can provide guidance to navigate uncertainty. As attorneys with decades of experience in electronic payments, Crypto Consultant provides expert counsel on fund formations, ICOs, whitepapers, and blockchain-related legal issues. Schedule a call today.

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