Early-Stage Investments in Crypto Start-Ups: What are Venture Capitalists Looking For?

• Anywhere from 20% to 50% of crypto-related pitches today are DeFi-focused.
• Following an all-time high regarding crypto VC funding in September 2022, venture capital investments in crypto startups plummeted over 70% over the past year.
• Positive language and a decent level of interactivity with the community on social media are linked to higher funding.
•  A well-known cryptocurrency VC firm, Andreessen Horowitz, invested over $7.6 billion in crypto start-ups and blockchain projects back in 2022.

What is Venture Capital (VC)?

Venture capital firms present an integral part of the startup ecosystem by providing funding and support for companies with growth potential in the early stages of development. 

Basically, venture capital firms are long-term investors that provide funding to startup companies in return for equity or tokens in the case of crypto companies. Spread across the globe, venture capitalists are typically experienced in providing funding to multiple industries and products they deem as promising.  

Venture capital can be provided at divergent stages of a startup’s evolution, yet it frequently includes early and seed round funding. The term stems from a niche activity at the end of the Second World War when it evolved into a sole industry that played a significant role in enhancing innovation. 

Venture capital within the crypto ecosystem has been on the rise. The main objective of any crypto venture capital firm is to make gains from promising crypto startups.

Understanding venture capitalists

Generally, VC firms are interested in startups and projects that encompass a long-term vision, along with the ability to produce a positive return on investment and high growth potential. Funds by venture capital firms are used to accelerate growth and enhance innovation. 

In relation to traditional businesses, financing usually comes in the form of private equity or in a form of expertise, such as technical knowledge or managerial practice. 

When it comes to early-stage startups, you can often hear the term angel investor as well. Keep in mind that venture capitalists differ from angel investors. The main difference between a venture capitalist and an angel investor is whose money is being invested. 

Basically, venture capital firms invest capital controlled by a venture capital fund while angel investors give away their own money. On the other hand, both angel and venture investors hope to recoup their investments through successful exits.

When it comes to the crypto world, crypto VC funding can be, for example, used to foster development, initiate a project, prepare for an Initial Coin Offering (ICO) or acquire talents.

The VC investment process in general

Any venture capital fund consists of a pool of investors interested in making gains through potentially successful projects. VC fund managers handle the participation of investors.

Who invests in VC funds? The investors are known as limited partner investors or LP investors. They differ from general partners or GPs that actively run the venture capital firm. Basically, VC firms typically control a pool of funds collected from high-net-worth individuals, insurance companies, pension funds and other general investors.

VC firms don’t risk putting all their eggs in one basket. Therefore, managers spend a lot of time reviewing projects. Startups typically take the VC funding route when they are not ready to go public or gather funds from independent investors.

In the beginning of the crypto journey, VC firms limited their interest to crypto unicorns or projects that have approximately a billion dollars in valuation. This trend has changed since many venture capital firms are adopting other business models by recognising novel opportunities.  

The first step any startup needs to take when seeking venture capital is to submit a proper business plan. A venture capital firm would perform due diligence as a thorough examination of the crypto company’s business model, operating history, and products. 

Any decision concerning crypto projects includes a number of analyses. If you’re interested in this topic, you can learn more by reading this article: ‘What is Fundamental Analysis?’. 

Once the due diligence process has been completed, the VC firm will pledge an investment in exchange for equity in the company or tokens when it comes to crypto startups. VC funding includes taking on an active role in the funded project by advising and monitoring its progress before releasing additional funds.

The VC investment process regarding crypto startups

When a venture capital firm approaches a crypto startup, it requires a thorough business plan with a detailed roadmap explaining all the timelines and important milestones. Therefore, the process mirrors the traditional procedure. Venture capitalists need to find out whether a crypto project is worth investing in; thereby, they need to evaluate and assess the feasibility of each project. 

Within the whole blockchain industry, the examination process is led by the same standards and practices that have been employed in traditional venture capital investments.  

However, there is one thing that sets crypto projects apart – the use of tokenization as a manner of generating funds for the startup. Venture capitalists examine the future value of the crypto token, the projected user base, team members behind the crypto project and other important details.  

To better understand the procedure of venture capital within the crypto industry, we are now going to examine different stages of VC funding.

Stages of VC funding

 Venture capital funding is typically categorised into five main stages. There is an option to include additional stages in case objectives have not been met in main rounds or if the founders seek further funding. 

Let’s take a look.

Stage Zero: The Pre Seed-Stage

This stage can be described as an unofficial stage of formation. In this phase, VC firms are not yet involved yet team members seek to determine whether the founder’s idea can be turned into a product with high growth potential.  

Funding in phase zero derives from the funders and their circle, and maybe angel investors.

Stage One: The Seed Capital Stage

This stage is an official one and presents the shortest funding round. It typically includes the testing of a product’s viability in a relevant market. A market potential analysis provides a solid ground for conducting further market research and determining whether the product has any potential in the marketplace.  

The first stage includes the involvement of venture capital firms and funding. During this phase, crypto startups can submit tools such as cash flow forecasts, a thorough business plan, and profit and loss statements.

Series A: The Startup Capital Stage

 Now things are getting serious. This stage refers to crypto companies that are already in their stage of growth and development meaning they have a validated product, a substantial user base and a decent cash flow.  

These crypto companies are seeking capital which will help them to expand further. The business is mostly focused on expanding the user base and marketing while venture capitalists are subject to less risk since the product has already been validated on the relevant market.

Series B: The Early-Stage Phase

The second official phase of funding is mainly devoted to further development and marketing. It is all about scalability; crypto businesses that make it to this phase are considered to be in a stage of development. Their product has been tested on the market but they need more capital to improve their market reach and expand operations. 

In this phase, a business generally utilises VC funds to create a capable development team and enhance their product, along with investing in marketing, customer service and business development.

Series C: The Expansion Stage

This phase refers to the last official round of VC funding. The business now seeks to expand its product to more markets or diversify it. Any business that reaches this stage of funding is already considered as established within their niche.  

It is not unusual that this phase introduces the possibility of the acquisition of other businesses. For example, a crypto marketplace has achieved substantial success and wants to acquire other companies under its umbrella to expand its market reach, gain more users and provide more versatile products and services.

What are venture capital firms looking for?

The crypto and blockchain industry is attracting large investments. Crypto venture funds provide financing to crypto companies when there exists an opportunity for such ventures to thrive. Many VC companies have formed strategic alliances with crypto startups to invest in crypto; this practice has led to heightened investment in blockchains and an increase in the adoption of crypto assets.

So, what are they looking for when it comes to early-stage crypto startups? Venture capital firms are generally using a combination of traditional investment criteria and factors unique to the crypto space. 

VC companies are more determined to invest if they see that the startup is run by an experienced team. Founders and key team members need to demonstrate a deep understanding of blockchain technology and the specific issue the startup is addressing to solve. Demonstrating a track record of successful projects in the past by founders and key team members could provide a good piece of evidence. 

Given that VC funding is about fostering innovation, groundbreaking technology is a huge plus; or at least, technology that solves a certain problem. Venture capitalists usually conduct a thorough investigation by evaluating the scalability of the technology and its potential to solve issues within a particular industry.

Since market analyses are a huge part of any examination conducted by investment firms, it is evident that VC firms are looking for a market opportunity and viable business model. They assess the growth potential and size of a target market, along with the fact whether or not the crypto startup is addressing a real issue or need within the crypto space. 

Another important aspect of early-stage crypto startups is assessing their tokenomics. For any crypto project that issues tokens or cryptocurrencies, venture capitalists need to examine the tokenomics model and assess vital factors such as utility, governance, distribution, and potential for token value appreciation. 

Tokenomics is a term frequently used within the crypto space. To gain more insight, why not read this article: ‘What are Tokenomics?’. 

Other vital components include community engagement and the potential for a positive exit strategy, Crypto startups that are able to demonstrate a higher level of user adoption are valued more. Main indicators of a crypto project’s potential regarding user adoption can be assessed using metrics such as transaction volume, active users, and network participation. 

Finally, regulatory compliance became another important aspect of the crypto startup valuation process. Given the rapid development of the regulatory landscape of the crypto space, venture capital firms often take into account startups’ proactivity in this area. 

While regulatory compliance can serve as a good asset for protecting investors and end-users, it has a particular beef with crypto. To find out more, check out this article: ‘What is the threat to crypto from regulation?’.

Downsides of crypto venture capital

Being funded by a VC firm is not all roses; there are some drawbacks that should be taken into account. Recently, a few VC firms have been among defendants in a new class action lawsuit by investors in the United States for their roles in the collapse of the notorious FTX.

Allegedly, these venture capital firms were vital in escalating the exchange's questionable endeavours and fostered its fraudulent scheme.

Scandals aside, there are certain facts each crypto start-up needs to know about VC funding.  

Venture capital is about investing and achieving returns. Therefore, VC-backed startups are more than often pressured to grow at a fast pace and achieve important milestones to justify the investment. Such a pressure may lead to premature development which could be detrimental in the long run. 

 Secondly, it can also mean losing flexibility since investment firms can impose particular conditions that limit a startup’s flexibility when it comes to decision-making. This also means losing the opportunity to make unconventional choices or experiment with innovative technologies.  

Venture capitalists need to set out an exit strategy that results in a return on investments. Prioritising VC companies above startups may lead to strategic differences or expectations of acquisition that may not align with the founders’ vision. 

The bottom line is that early-stage investments are significant for crypto startups because they provide the needed capital, expertise and guidance. On the other hand, it is also important to be knowledgeable of certain trade-offs that may happen along the way.