Authors: hedgedhog7, c0xswain, 0xkinnif, 0xlaiyuen, 0xZhouYeMen

Translation: Deep Tide TechFlow

The current state of cryptocurrency venture capital

Recently, the performance of meme coins has outpaced many VC-backed projects, leading to criticism from market participants regarding venture capital and its investments. While some criticisms are warranted, others lack a profound understanding of the complexities of the private market.

Typically, projects scale their products through multiple rounds of financing before the token generation event (TGE). In return for early high-risk capital investments, VCs can participate in investments at lower token valuations. Resources obtained from strategic capital, including marketing support, token economics consulting, and access to VC networks, are not typically available to small ordinary investors. As fundraising progresses and valuations change, the types of participating VCs may vary, as each VC'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, leading them to invest in projects with low valuations and products yet to be launched. To ensure alignment of long-term interests between VCs and other stakeholders, tokens acquired through private markets typically have lock-up periods and vesting terms set.

The trade-off between VC risk and return

During the token vesting period, venture capitalists often see significant unrealized gains, which they may realize through derivatives hedging or over-the-counter (OTC) trades with private buyers. However, they face challenges in implementing hedging strategies due to investment authorizations, capital requirements, and liquidity constraints. Additionally, some VCs lack the execution knowledge and risk management frameworks needed to manage liquid positions, making effective hedging more difficult.

Therefore, OTC trading has become the primary means for VCs to realize profits before the token generation event (TGE). Unlike the information-transparent secondary market, OTC market transactions are conducted privately, making it difficult to uniformly track global trading data. While estimating the scale of the OTC market is challenging, activity reports from OTC trading desks can reveal some trends.

STIX is an OTC trading desk supported by Fisher8 Capital, which has processed over $200 million in trading volume since its establishment at the end of 2023. STIX mainly trades assets of the top 200 altcoins. In the past year, OTC activity has been frequent, including liquidations (such as FTX selling locked $WLD and $SOL) and direct trades from token foundations (such as $SUI, $AVAX, etc.). We expect this market to continue to grow, mainly due to VCs wanting to realize profits early and the demand for capital from projects post-TGE.

OTC Market: Price Discovery in Private Rounds

Below are some VC-backed tokens and their performance since TGE. Most tokens struggle to maintain high valuations three months later, making it difficult for VCs to realize investments at the highest FDV at the beginning of the vesting period. Such price trends are unfavorable to market participants, as investors who bought at high prices at the end of the vesting period become sellers alongside VCs.

Performance of tokens post-issuance on Binance in 2024

Source: Artemis

The practice of frequently raising valuations during the fundraising process has led to market returns and optimism mainly concentrated in the private sector. This situation has resulted in ordinary investors primarily facing the risk of price declines post-token generation event (TGE). Without sufficient incentives to support projects, public market participants may find themselves in a lose-lose situation. As the market trends towards fair value, both VCs and ordinary investors will face challenges in the long term.

Examples of token performance

Source: 0xLouis

We believe that leaving room for an increase in the secondary market helps build a stronger support base, thereby extending the lifespan of projects. One existing method is to assist ordinary investors in price discovery before TGE through spot and/or pre-market trading. In pre-market trading, tokens in the spot market are viewed as a type of commitment note (i.e., IOU tokens) that can be redeemed for actual assets at TGE. On the other hand, perpetual contract pre-markets are synthetic markets designed to track asset price movements, 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 involve liquidity and delta risks. When liquid market buyers purchase tokens before TGE, the trading platform acts as the counterparty, and if the tokens perform well after TGE, it could incur significant losses. Additionally, participants must consider counterparty risks, such as the lack of legal claims to the underlying asset or the exchange's inability to cover losses from profitable pre-market participants.

The assumed performance of tokens via OTC between funding rounds

Another way to facilitate price increases in the secondary market is to allow the private market to experience price declines before the token generation event (TGE). This can help 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 occurs between Round A and TGE, existing investors selling their holdings below cost could remind the team that their TGE price should be lower than originally planned. Such adjustments help align project valuations more closely with market expectations.

If a project ultimately succeeds and reaches the expected price level after TGE, having more profit-seeking token holders from the liquid market can provide more sustained support for the project.

In-depth analysis of crypto OTC trading desks

While allowing 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 is primarily divided into two types: pure self-directed buying and funding rate arbitrage.

Self-directed buying typically attracts investors sensitive to valuations, who 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 buying SAFT/SAFE contracts from early investors, transactions are usually priced at face value, or with a 25-30% premium before TGE.

The relationship between funding rate arbitrage buyers and valuations is relatively weak. Their profits depend on the difference between spot discounts and hedging costs, which are in turn influenced by the perpetual contract funding rates during the token vesting period. According to STIX's report, such 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 asset; second, the market needs sufficient liquidity to execute trades; and finally, the hedging costs (i.e., the opportunity cost of collateral) must not exceed the gains from the spot discount. To avoid liquidation when conducting short-term perpetual hedges, these buyers need to prepare a large amount of collateral, as any forced liquidation due to a short squeeze could render the trade unprofitable.

Due to the varying types of OTC buyers, large OTC trades announced by token foundations should be approached with caution. These trades may reflect more of an arbitrage opportunity than the true long-term demand at the current price.

Challenges of the OTC market

A complex issue faced by 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 STIX's report, such clauses exist in 30%-45% of SAFTs.

If the foundation blocks OTC trading, buyers will have to bear additional counterparty risks. In the absence of the legal protections provided by 'formalized trades', buyers have very limited recourse against sellers' misconduct. This risk is particularly acute for smaller funds, as they may not face the same reputational risks as larger, well-known VC funds.

Crypto venture capital fundraising activity

Source: Pitchbook

In 2021 and 2022, driven by pandemic stimulus policies and the high return promises of prior fundraising, fundraising levels reached historical highs. During this period, with ample venture capital funds eager to invest, transactions progressed quickly. However, the bear market of 2022/2023 brought significant changes. Down rounds became more common, investor risk tolerance decreased, and delays in TGE 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 decrease in capital flowing into crypto venture capital.

PitchBook's report shows that investor interest in venture capital has declined, with the time taken to raise new funds extending 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 divestment phase, leading to structural sellers in the secondary market.

Due to underperformance of crypto venture capital funds, they are beginning to explore other strategies, such as investing in liquid tokens or engaging in OTC trading. Although OTC trades typically have lock-up periods and vesting terms, their investment horizons are generally 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 could benefit from the comprehensive services they provide, addressing the fragmentation issue in the market.

The future direction of venture capital

The current trend of decreasing crypto venture capital funds poses challenges for the industry. One possible way out is to adopt proactive investment strategies. Instead of seeking the next 'from zero to one' opportunity, funds can focus on acquiring liquid tokens and leveraging their expertise and networks to scale projects from '1 to 10'.

If you are interested in this proactive investment strategy, STIX is actively seeking more risk funds to join. If you are interested, please visit STIX.co or contact taran_ss via X for more information.