Crypto growth opportunities emerge in a bear market

A bear market can signal change in the way institutional investors view crypto investments, and that’s not necessarily a bad thing for an asset class that is sometimes mistaken for consisting entirely of volatile currencies.

“A misconception about the crypto space is that there is a single thing – cryptocurrency – to allocate to, but that couldn’t be further from the truth,” said Scott Army, CEO, CIO of Galaxy Digital. “There is massive segmentation and specialization. Often the early days of a decades-old technology map well to venture allocations, and it’s the easiest way for institutions to get into the space.”

In other words, the real potential in crypto is on a longer time horizon than many investors may realize based on the history of the asset class. In 2018, ICOs [initial coin offering] bubble burst because investors fundamentally lost confidence in crypto. That’s not the case today, and institutional investors eyeing the space with headline-generated fear may be reconsidering what could be rare opportunities.

“The longer the time horizon, the easier it is to focus on building great technology and useful products,” said Ben Forman, founder and managing partner, ParaFi Capital, a firm focused on investing across the crypto ecosystem. “We are long-term focused, and investors have a multi-decade view of crypto. However, in the short term, crypto has evolved into a volatile, macro-driven asset class.”

Changes for the better in early investments

The crypto ecosystem has developed by leaps and bounds in a relatively short time, attracting huge amounts of venture capital and private equity. In its short history, the space has shown a capacity for innovation – especially in challenging times, highlighting projects that have longevity and the ability to grow.

“At moments like this, there are select opportunities to make investments in large companies with time-sensitive financing needs,” says Forman. “It’s natural in times of fear to freeze until you know the markets will pick up again, but if you look back at the last cycle, the 2018/2019 vintage turned out to be the best.”

As Army noted, being an early mover in crypto-related technology that evolves over many years is natural for institutional investors. But early stage venture investing has evolved from the “early days” deals (think five years ago) that were structured as simple agreements for future tokens (SAFTs). The owner of a SAFT is not a shareholder, leaving them vulnerable and without the protections normally offered to shareholders.

Much more common today are structures that include a SAFE – simple agreement for future equity – with a symbolic warrant attached.

When tokens are expected to make up the majority of the value in an equity investment, a pre-existing equation in SAFE determines how many tokens are issued pro rata to equity holders. This creates protection for investors (notably supported by significant existing case law).

Identify quality

The use of tokens is one area that can help separate quality investments from less desirable opportunities. It is not uncommon for token vesting plans to allow a founder to risk their entire token stake within 18 months. It can quickly become messy for a decentralized autonomous organization (DAO), and become a major obstacle to communities reaching their full potential. Some argue that such actions are detrimental to the creation of quality companies and products.

“Token earning plans are too short and not aligned to the long term,” says Forman. “It’s a trigger for selling in the market. Capital formation is the foundation of capitalism. If you’re a founder and you’re building a company, you don’t have the ability to reduce risk – you have to build for an eventual exit. That long-term incentive alignment with investors and builders is extremely important. Neither party can really sell. Instead, you have to create value.”

Another consideration in the search for quality investments is anonymous founders or team members, especially in decentralized finance. It is contrary to the investors’ need to be comfortable with the management team. Investors should insist that everyone in the management team make themselves known for scrutiny purposes. Of course, claims about the effectiveness of technological innovations must also be accurate.

However, for smart investors who understand how to approach the nuances of the space, opportunities abound in crypto, and the asset class has a consistently improving track record.

“Top crypto assets and crypto companies are real products that actually work,” says Haseeb Qureshi, Managing Partner, Dragonfly Capital, a global crypto asset management firm with venture and hedge fund strategies. “Huge numbers of people have interacted with them and understand what crypto is and why it’s going to be useful,” he says. “DeFi [decentralized finance] is real. NFTs [non-fungible tokens] is real. Investors continue to interact with them despite the downturn. Most of the shocks that have affected crypto prices have been exogenous.”

Focus on early strength

While it’s easy to get hung up on red flags while doing due diligence on early-stage investments, Qureshi suggests flipping the lens and looking from the opposite point of view.

“In early stages, we tend to invest more for strength than for lack of weakness,” says Qureshi. “It is easier to plug a hole than to build a world-class force where none exists. We’re more likely to invest in something amazing with a glaring flaw than something that has no flaws but doesn’t excite us.”

Could early prospects developing today eventually be seen as a legendary vintage? It is impossible to say anything for sure, but the Army has done benchmarking on vintages that provide something like a rearview mirror for the future. The work wasn’t limited to crypto either.

“The best vintage returns have come through investing during previous bear markets,” he says. “Many of the public assets that are becoming household names are early venture investments when things seem dark. The year 2021, early 2022 and maybe even 2023 could end up being classic for investing in venture crypto.”

With the amount of technological build-up happening in the space, large capital stocks that can be directed towards it, and the growing recognition that blockchain-related products are more than viable, the space looks set to produce highly sought-after vintages for many years to come.