Original authors: hedgedhog 7, c 0x swain, 0x kinnif, 0x laiyuen, 0x ZhouYeMen

Original translation: Deep Tide TechFlow

Current state of cryptocurrency venture capital

Recently, the performance of meme coins has outperformed many projects backed by venture capital (VC), leading to criticisms from market participants regarding venture capital and its investments. While some criticisms are warranted, others lack a deep understanding of the complexities of private markets.

Typically, projects scale their products through multiple rounds of financing before the token generation event (TGE). In return for the early high-risk capital investment, venture capitalists are able to participate in investments at lower token valuations. Resources gained from strategic capital, including marketing support, token economics consulting, and access to venture capital networks, are often unavailable to small retail investors. As fundraising progresses and valuations change, the types of participating venture capitalists may differ, as each venture capitalist has varying risk preferences and fund sizes.

Segmentation of crypto venture capital and its scale

Source: PitchBook

Most crypto venture capital firms manage assets of less than $50 million, so they tend to invest in projects that have not yet launched products and have lower valuations. To ensure that the long-term interests of venture capitalists align with those of other stakeholders, tokens acquired through private markets typically come with lock-up periods and vesting terms.

The trade-off between venture capital risks and returns

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

Therefore, OTC trading has become the primary means for venture capitalists to realize profits before token generation events (TGE). Unlike the transparent information in the secondary market, OTC market transactions are conducted privately, making it difficult to unify global trading data. While it's challenging to accurately estimate the scale of the OTC market, activity reports from OTC trading desks can reveal some trends.

STIX is an OTC trading desk supported by Fisher 8 Capital, which has processed 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 activity has been frequent, including liquidations (such as the sale of locked $WLD and $SOL by FTX) and direct trades from token foundations (such as $SUI, $AVAX, etc.). We expect this market to continue growing, primarily due to venture capital's desire to realize profits early and projects' need for capital post-TGE.

OTC market: price discovery in private rounds

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

Performance of tokens after issuance on Binance in 2024

Source: Artemis

The frequent practice of raising valuations during fundraising processes has led to market returns and optimism being primarily concentrated in the private sector. This situation means that ordinary investors mainly face the risk of price declines after token generation events (TGE). Without sufficient incentive mechanisms to support projects, public market participants may find themselves in a lose-lose situation. As the market trends towards fair value, both venture capitalists and ordinary investors will face challenges in the long term.

Token performance examples

Source: 0x Louis

We believe that allowing for secondary market upside helps build a stronger support base, thereby extending the project's lifespan. One existing approach is to help retail investors with price discovery before TGE through spot and/or pre-market trading. In pre-market trading, tokens on the spot market are viewed as a form of promissory note (i.e., IOU tokens) that can be exchanged for actual assets at TGE. On the other hand, perpetual contract pre-markets are synthetic markets designed to track asset price movements, usually hedged through call options issued by the foundation.

Pre-market trading can take place on accessible derivatives platforms like Aevo, Whales Market, and major centralized exchanges (CEX). However, these products carry liquidity and delta risks. When buyers in the liquid market purchase tokens before TGE, trading platforms act as counterparties and may incur significant losses if tokens perform well post-TGE. Additionally, participants need to consider counterparty risks, such as the lack of legal claims on the underlying assets or the exchange's inability to cover losses from profit-making pre-market participants.

Hypothetical performance of tokens through OTC between financing rounds

Another method to promote price increases in the secondary market is to allow the private market to experience price declines before token generation events (TGE). This can reduce the valuation gap between rounds of financing. The chart above shows a simplified comparison of two hypothetical projects, illustrating the potential benefits of OTC trading on post-TGE performance. If a down round of financing occurs between Series A and TGE, existing investors selling their holdings below cost may 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 post-TGE price levels, having more profit-seeking 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 private markets may seem ideal, this process is not straightforward due to legal barriers and the complexity of transaction types. OTC trading mainly falls into two categories: pure self-buying and capital rate arbitrage.

Self-buying typically attracts those investors who are sensitive to valuations and wish to gain direct market exposure to the underlying assets. This involves taking over SAFT/SAFE contracts from previous investors or purchasing tokens directly from project teams. When buying SAFT/SAFE contracts from early investors, transactions are often priced at face value or come with a 25-30% premium before the TGE.

Capital rate arbitrage buyers have a weaker relationship with valuations. Their profits depend on the difference between spot discounts and 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 usually purchase at prices 60-65% lower than spot prices, thus executing a market-neutral risk strategy. However, this opportunity has three prerequisites: first, there must be perpetual contracts for the underlying assets; second, the market needs sufficient liquidity to execute trades; and finally, hedging costs (i.e., the opportunity cost of collateral) cannot exceed the gains from the spot discount. To avoid being liquidated while conducting short-term perpetual hedging, these buyers need to prepare a large amount of collateral, as any forced liquidation could render the trade unprofitable.

Due to the diverse types of OTC buyers, large OTC trades announced by token foundations should be viewed with caution. These trades may reflect arbitrage opportunities more than the actual 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 consent of the founders. According to the STIX report, such clauses exist in 30%-45% of SAFTs.

If the foundation prevents OTC trading, buyers will have to bear additional counterparty risks. In the absence of the legal protections provided by 'formalized trading,' the measures buyers can take in the face of seller misconduct are very limited. This risk is particularly pronounced for smaller funds, as they may not face the same reputational risks as larger well-known venture capital funds.

Crypto venture capital fundraising activities

Source: Pitchbook

In 2021 and 2022, driven by pandemic stimulus policies and the high return promises of previous fundraising, the fundraising levels reached historical highs. During this period, transactions progressed rapidly due to the abundance of venture capital funds eager to invest. However, the bear market of 2022/2023 brought significant changes. Subsequent rounds of financing became more common, investor risk appetite decreased, and delays in TGE became the norm. Changes in market dynamics and high-profile collapses such as Terra, FTX, and 3AC led to stagnant fund performance and reduced capital inflows into crypto venture capital.

PitchBook's report shows that investor interest in venture capital has declined, and the time taken to raise new funds has increased 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 the poor performance 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 durations are usually shorter than traditional venture capital, making them more suitable for investors focused on investment timeframes. If OTC trading becomes more common in the industry, platforms like STIX may benefit from the comprehensive services they provide, addressing the fragmentation of the market.

Future directions 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 looking for the next 'from zero to one' opportunity, funds can focus on acquiring liquid tokens and leverage their expertise and network to scale projects from '1 to 10'.

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