Funds can focus on acquiring liquidity tokens and leverage their expertise and networks to scale projects from 'one to ten.'
Authors: hedgedhog7, c0xswain, 0xkinnif, 0xlaiyuen, 0xZhouYeMen
Translation: Deep Tide TechFlow
The Current State of Crypto Venture Capital
Recently, the performance of meme coins has surpassed that of many projects supported by venture capital (VC), prompting criticism from market participants toward venture capital and its investments. While some criticisms are valid, others lack a profound understanding of the complexities of the private market.
Typically, projects will scale their products through multiple funding rounds before the Token Generation Event (TGE). In return for the early high-risk capital investment, venture capitalists can participate in investments at lower token valuations. The resources obtained from strategic capital, including marketing support, token economics consulting, and access to the venture capital network, are typically unavailable to small ordinary investors. As fundraising progresses and valuations change, the types of participating venture capitalists may also vary, as each venture capitalist's risk appetite and fund size differ.
Segmentation of Crypto Venture Capital and Its Scale
Source: PitchBook
Most crypto venture capitals manage assets of less than $50 million, so they tend to invest in projects with lower valuations and products that have not yet been launched. To ensure alignment of interests between venture capitalists and other stakeholders over the long term, tokens acquired from private markets often have lock-up and vesting clauses.
The Trade-Off Between Venture Capital Risk and Return
During the token vesting period, venture capitalists often see significant unrealized gains, and they may realize profits through derivatives hedging or conducting OTC trades with private buyers. However, they face challenges in implementing hedging strategies due to investment authorization, capital requirements, and liquidity constraints. Additionally, some venture capitalists lack the execution knowledge and risk management framework needed to manage liquidity positions effectively, making effective hedging more difficult.
Therefore, OTC trading has become the primary means for venture capital to realize profits before token generation events (TGE). Unlike the information-transparent secondary market, OTC market trades are conducted privately, making it difficult to track global trading data uniformly. Although it is challenging to estimate the scale of the OTC market accurately, activity reports from OTC trading desks can reveal some trends.
STIX is an OTC trading desk supported by Fisher8 Capital, which has handled over $200 million in trading volume since its establishment at the end of 2023. STIX primarily trades assets of the top 200 altcoins. Over the past year, OTC activities have been frequent, including liquidations (such as FTX selling locked $WLD and $SOL) and direct trades from token foundations (like $SUI, $AVAX, etc.). We expect this market to continue to grow, primarily due to venture capitalists wanting to realize profits early and the demand for capital from projects post-TGE.
OTC Market: Price Discovery in Private Rounds
Below is a list of some venture-backed tokens and their performance since the TGE. Most tokens struggle to maintain high valuations three months later, making it difficult for venture capitalists to realize investments at the highest FDV when the vesting period begins. This price trend is unfavorable for market participants, as investors who bought at high prices together with venture capitalists become sellers at the end of the vesting period.
Performance After Token Issuance on Binance in 2024
Source: Artemis
The practice of frequently raising valuations during fundraising processes leads to market returns and optimism primarily concentrated in the private domain. This situation puts ordinary investors at risk of price declines primarily after the Token Generation Event (TGE). Without sufficient incentives to support the project, public market participants may find themselves in a lose-lose situation. As the market trends toward fair value, both venture capitalists and ordinary investors will face long-term challenges.
Examples of Token Performance
Source: 0xLouis
We believe that leaving room for the secondary market to rise helps build a stronger support base, thereby extending the project's lifespan. One existing method is to assist ordinary investors in price discovery before the TGE through spot and/or pre-market trading. In pre-market trading, tokens on the spot market are treated as a promissory note (i.e., IOU tokens) that can be exchanged for actual assets at TGE. On the other hand, the perpetual contract pre-market is a synthetic market designed to track asset price trends, typically hedged through call options issued by the foundation.
Pre-market trading can take place on accessible derivatives platforms such as Aevo, Whales Market, and major centralized exchanges (CEX). However, these products come with liquidity and delta risks. When liquid market buyers purchase tokens before TGE, the trading platform acts as the counterparty, and if the token performs well after TGE, it may incur significant losses. Additionally, participants must consider counterparty risks, such as the lack of legal claims to the underlying assets or the exchange's inability to cover losses from profitable pre-market participants.
Hypothetical Performance of Tokens through OTC Between Funding Rounds
Another way to promote price increases in the secondary market is to allow the private market to experience price declines before the Token Generation Event (TGE). This can reduce the valuation gap between funding rounds. The chart above presents a simplified comparison of two hypothetical projects, illustrating the potential benefits of OTC trading on post-TGE performance. If a down-round financing occurs between Series A and TGE, existing investors selling their holdings below cost may alert the team that their TGE price should be lower than originally planned. Such adjustments help align project valuation more closely with market expectations.
If the project ultimately succeeds and reaches the expected post-TGE price level, having more profit-making token holders from the liquid market can provide more sustainable support for the project.
In-depth Analysis of Crypto OTC Trading Desks
While allowing for more price declines in the private market may seem ideal, this process is not straightforward due to legal barriers and the complexity of transaction types. OTC trading primarily falls into two categories: pure self-directed purchases and funding rate arbitrage.
Self-directed purchases typically attract investors who are sensitive to valuations and seek direct market exposure to the underlying assets. This involves taking over SAFT/SAFE contracts from previous investors or purchasing tokens directly from the project team. When purchasing SAFT/SAFE contracts from early investors, transactions are usually priced at face value or come with a 25-30% premium prior to TGE.
The relationship between funding rate arbitrage buyers and valuation is relatively weak. Their profits depend on the difference between the spot discount and the hedging costs, which in turn are influenced by the funding rates of perpetual contracts during the token vesting period. According to the STIX report, these buyers can typically purchase at prices 60-65% lower than the spot price, executing a neutral risk strategy. However, this opportunity has three prerequisites: first, there must be perpetual contracts for the underlying assets; second, the market needs to have sufficient liquidity to execute trades; and finally, the hedging costs (i.e., the opportunity cost of collateral) should not exceed the returns gained from the spot discount. To avoid being liquidated while conducting short-term perpetual hedges, these buyers need to prepare a substantial amount of collateral, as any short squeeze leading to liquidation could render the trades unprofitable.
Due to the varying types of OTC buyers, large OTC trades announced by token foundations should be treated with caution. These trades may reflect arbitrage opportunities more than genuine long-term demand at the current price.
Challenges of the OTC Market
A complex issue facing OTC trading is the presence of reverse transfer clauses in contracts. These clauses restrict investors from transferring their shares to third parties (i.e., new OTC buyers) without the founders' consent. According to the STIX report, such clauses are present in 30%-45% of SAFTs.
If the foundation prohibits OTC trading, buyers will have to assume additional counterparty risk. In the absence of legal protections provided by 'formalized transactions,' buyers have very limited recourse against seller misconduct. This risk is particularly pronounced for smaller funds, as they may not face reputational risks like larger, well-known venture capital funds.
Crypto Venture Capital Fundraising Activities
Source: Pitchbook
In 2021 and 2022, driven by pandemic stimulus policies and high return promises from prior fundraising, fundraising levels reached historic highs. During this period, transactions progressed rapidly due to abundant and eager venture capital funds. However, the bear market of 2022/2023 brought significant changes. Down-round financing became more common, investor risk appetite decreased, and TGE delays became the norm. Changes in market dynamics and high-profile collapse events like Terra, FTX, and 3AC led to stagnation in fund performance and a reduction in capital flowing into crypto venture capital.
PitchBook's report shows that investors' interest in venture capital has declined, with the time for new funds to raise capital increasing from 6 months in 2021 to 21 months in 2024. Additionally, venture capital funds adopting a 4 + 2 structure in 2021 and 2022 will enter the exit phase, leading to structural sellers in the secondary market.
Due to the underperformance of crypto venture capital funds, they have begun exploring other strategies, such as investing in liquidity tokens or engaging in OTC trading. Although OTC trades usually have lock-up periods and vesting clauses, their investment horizons are often shorter than traditional venture capital, making them more suitable for investors focused on investment duration. If OTC trading becomes more common in the industry, platforms like STIX may benefit from the comprehensive services they offer, addressing the fragmentation issues in the market.
Future Directions of Venture Capital
The current trend of decreasing capital in crypto venture capital poses challenges for the industry. One possible way out is to adopt an active investment strategy. Instead of seeking the next 'zero to one' opportunity, funds can focus on acquiring liquidity tokens and leverage their expertise and networks to scale projects from 'one to ten.'
If you are interested in this active investment strategy, STIX is actively seeking more risk funds to join. If you are interested, please visit STIX.co or contact taran_ss on X for more information.
