By Jeff Davis
Ever since its inception, venture capital has two silos. In one silo, there’s the management which makes the day-to-day decisions about the fund’s investments. The second, there are the limited partners – the investors that provide the capital the managers invest.
Limited partners in venture capital funds are passive. They are not involved in the selection of investments, or the day-to-day management of a portfolio. Fund managers are paid a management fee and a carried interest for their active, hands-on construction of the fund’s investments. This opaque investment process works in a bull market where positive returns keep the limited partners happy. However, when the market turns red, investors start wondering why they are paying fees to their managers and start questioning the investments they had no voice in selecting.
But now, passive investors and active manager models are beginning to change due to the rise of Web3. Web3 has challenged how the traditional venture capital structure works with the creation decentralized autonomous organizations known as venture DAOs. Venture DAOs are investment vehicles where members of the DAO are active in the selection of projects they support. DAO members participate in sourcing and completing due diligence on projects they see as promising. When it comes time to invest, they pool their own funds to support the project. The result is the same as the traditional venture capital model in that a target project has been identified and funded, but the level of involvement is quite different. DAO investors themselves are selecting which projects they are going to support, not the fund's general partners and investment committee. The decision making has become decentralized and as a result, the outcome is transparency in what, how, and when investment decisions are made by the collective.
Venture capital investors are taking notice and are seeking similar transparent investment opportunities. One transparent investment is the sidecar, where an investor provides additional capital in a project and rides alongside pooled capital. It allows for a larger investment in a single known opportunity versus the pooled capital which is typically blind. However, sidecar opportunities are limited and typical reserved for the most tenured investors in the fund. Venture DAOs are offering sidecars - lots of sidecars - and they don’t have to play favorites either. More traditional investors are seeking these known (see: transparent) sidecar opportunities. We should expect funds of all types to begin listening to this growing mandate in order to satisfy their investors that will look elsewhere if their directives aren’t met.
The decentralization found in venture DAOs isn’t limited to the financial realm. Web3 has decentralized applications (dApps) for art and collectibles, gaming, and technology. People liken Web3 to when the internet was in the dial-up modem phase. But the internet of today is nothing like it was 20 years ago. Web3 is following the growth trajectory of the early internet as new utility is created. Mass adoption of Web3 will occur as more use cases are developed; the speed at which that adoption occurs, will depend on the capital that is available for creators in this “crypto winter.”
Many pundits have compared the current “crypto winter” to the bursting of the dot-com bubble. I would say they have a good argument, except this isn’t the only crypto winter we have experienced. There have been multiple crypto winters; and as the name suggests, they are seasonal. After each of the previous crypto winters we have seen new highs. People in the space have come to expect these seasonal valuation changes. The dot-com crash wasn’t expected, and many investors were exposed when the tide went out.
Additionally, the dot-com era came to an end when there was an epiphany that all the projects hemorrhaging cash were unlikely to be profitable for years, if not a decade. And that’s if they actually had a business plan or a product. The speculation in this era was so frothy that funding was available for nearly any concept that ended with .com. What we are experiencing now is a correction which is correlated with other risk assets. These other risk assets, notably tech stocks, are correcting because of higher interest rates – not because the projects don’t have merit or a pathway to profitability. Web3 has businesses that make money and others that will very soon.
Yes, there was a ton of capital chasing Web3 deals just like in over twenty years ago, and valuations got wonky. But those Web3 valuations will soon be using trailing 12 EBITDA multipliers, not projections like in the dot-com era.
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