The cryptocurrency industry is rapidly maturing, with many quickly comparing it to a gold rush. As the industry's maturity increases, users are beginning to witness a wave of traditional and retail investors flooding into the crypto space.
Venture capital funds and other institutional investors are increasingly focusing on cryptocurrency businesses to see if providing financing is profitable. Crypto startups hold significant equity, and mainstream society is starting to view them as viable investment tools.
The decentralized finance (DeFi) sector and the non-fungible token (NFT) market are the hottest areas attracting venture capital funds within the cryptocurrency industry. Let’s explore venture capital financing in the crypto industry in this article.
Venture capital funds consist of a pool of investors looking to earn large amounts of money quickly. Fund managers send prospectuses to potential investors, inviting them to participate. Essentially, a prospectus is a document that pitches the investment fund to them.
VC fund managers spend considerable time reviewing thousands of projects to determine growth potential. Although they are cautious investors, venture capital firms prefer to diversify their bets. This way, they do not risk putting all their funds into one basket.
Startups often choose the VC financing route when they are not yet ready to go public. Alternatively, they may be unable to raise funds from retail investors. Due to the former, crypto startups had not previously sought VC financing, but this situation is changing rapidly.
VC funds are no longer limiting their interest to crypto unicorns—rare companies valued at least $1 billion as determined by VC firms. Many VCs are adopting a "pick and shovel" business model as they recognize emerging opportunities. Pick and shovel organizations are crypto-related businesses that provide ancillary services to the same user base. Such businesses include crypto tax reporting startups, cryptocurrency charting software, and more.
Venture capital financing is typically divided into five stages. However, if financing goals are not met in the earlier rounds, or if founders wish to seek additional funding, more stages may be added later.
Let’s outline these five stages below.
The pre-seed stage is the ideation phase. It is usually not included as a formal stage because, at this point, the team members involved aim to determine whether the founder's idea can be translated into a product. Funding typically comes from a close circle of family and friends, without equity involvement.
If the founder knows the right people, angel investors may get involved at this time. Compared to VC funds, angel investors are high-net-worth individuals who tend to operate independently. Unlike VCs, if angel investors have complete confidence in the founder's abilities, they may choose to overlook the project's soundness.
The seed funding round is brief and should be the shortest of all funding rounds. This stage involves testing the product's viability in the market. Startups determine market feasibility using tools such as market potential analysis. As the name suggests, market potential analysis tools help provide a framework for conducting market research and determining whether the product is worth bringing to market.
Startups may also need to convince VC funds that their product is worth investing in through pitch decks and financial documents such as income statements, cash flow forecasts, project roadmaps, and more. Notably, angel investors may still be involved at this stage.
The Series A round is when things start to get serious. This is when equity comes into play. Startups do not need to apply, as this round is reserved for cryptocurrency companies that are already in a growth phase. They have validated products and strong communities, with stable cash flow.
These companies seek capital that will help them iterate on their products and expand further. At this stage, the risks faced by investors are much lower because the company's product or service has already been validated. Additionally, the focus of the business is on customer acquisition as well as marketing and advertising.
Series B funding is dedicated to further iteration, sales, and marketing. Series B funding is all about scalability. Companies entering this round are in a development phase. They are looking for opportunities to expand operations and further increase market coverage. At this point, it goes without saying that they already have a large user base.
To accelerate expansion, companies plan to use the funds to build capable teams and solidify their products. Specifically, companies must invest in marketing and sales, human resources, business development, and customer service.
The last formal round of VC financing is the expansion stage. At this stage, businesses aim to expand into other markets and diversify their product lines. Companies that reach Series C funding have already established a position in their industry. Raising funds helps them create new products or services and bring their operations to international markets.
At this stage, expansion can also occur through the acquisition of other businesses. For example, a company providing crypto brokerage services may achieve success in the U.S. and wish to expand into the Canadian market. The company may also attempt to introduce other financial services beyond its traditional scope.
At this stage, investment risks are lower, but potential returns are also lower. Startups at this level should generate sufficient revenue through commercialized products—if not profits. Many recipients of expansion financing have been operating for 2 to 3 years.
This is why more external parties are entering the investment management process. In addition to VCs, hedge fund managers, private equity firms, and investment banks are all entering the competition, all eyeing the company's equity. Notably, many companies hold Series C funding to increase their valuation before an initial public offering (IPO).
In the pre-IPO phase, certain companies with validated products or services aim to go public for various reasons. Reasons for going public include better access to various types of investors and additional capital, increased public confidence, and significant publicity.
This funding round is dedicated to activities such as mergers and acquisitions, methods to squeeze out competitors, and financing to prepare for an IPO.
The cryptocurrency industry is still in its infancy, with unlimited growth potential. Many VC firms realize that the future belongs to cryptocurrency, and they do not want to miss out on what could be the biggest investment opportunity of our time.
Even so, the crypto market remains volatile, but VCs confident in blockchain and cryptocurrency companies are prepared to take on additional risks.
Venture capital financing in the crypto space is not different from typical VC financing, with one exception. The startups benefiting from the financing operate in the cryptocurrency market.
Although considered a traditional financing method, VC funds are increasingly focusing on cryptocurrency due to mainstream adoption. This is attributed to major advertising platforms like Facebook and Google deciding to lift their bans on crypto ads. Additionally, with the mainstream adoption of institutional investors, VCs view the crypto industry as a lower-risk investment.
However, this can be seen as a double-edged sword. After all, more investment encourages thousands of new projects to rush to market. Therefore, even if only a few may be intentional scams, most are high-risk investments.
But this has not deterred many VC funds, who are very familiar with the high risks that come with significant returns. Indeed, crypto startups can offer some of the highest returns in any industry. After all, taking calculated risks and managing risks are skills that VC fund managers possess.
Like general VC financing, the pros and cons in the cryptocurrency space are similar. VC firms pursue high returns, which translate into equity, with the potential for quick exits. This means there may be pressure for rapid delivery and the risk of relinquishing some control.
One major advantage of becoming a venture capital recipient is that it brings legitimacy to crypto startups. This legitimacy can also attract more funding from retail investors.
This is because ICOs and other crypto fundraising methods introduced lower market entry barriers. In many cases, a website and a decent white paper are all that is needed to launch an ICO.
In contrast, VC funds conduct more due diligence, such as reviewing the project's soundness and the team's ability to deliver on project commitments, as well as researching the community and the overall market to predict profitability. Additionally, VC funds include expert fund managers specializing in company valuation.
Despite the downsides, VC investment helps build good relationships and excels at making connections across various industries. Therefore, if any challenges arise in unfamiliar areas, contacts from VC firms may be helpful.
VCs understand that not all projects will succeed. Of course, their primary goal is to make money, but if a company fails, there is no obligation for the company to repay any funds. Experienced investors like VC funds try to remove emotion from the equation, which should alleviate some pressure.
Moreover, VC funds have long been taking calculated investment risks, so they understand the rules of the game. The experience they may be able to share could be invaluable investment advice for many crypto companies.
Legitimate cryptocurrency businesses may be reluctant to pursue the ICO route due to the bad reputation suffered in the past (mainly due to scams). However, since the ICO boom of 2017, ICOs have come a long way, and that boom flooded the market with subpar projects. If such businesses find that venture capital is not the financing route they wish to take, they may consider STOs, IEOs, and IDOs.
Notably, these methods attract retail investors with small amounts of funding. This contrasts with VCs and angel investors, who can bring in large amounts of funding at once.
Security Token Offerings (STOs) are the closest thing startups can get to a regulated environment. This method is attractive for several reasons. The most important reason is that it provides assurances to potential retail investors.
With the rapid growth of the crypto space, it is understandable that many new retail investors hesitate to jump in. Mainstream media is filled with negative stories involving scammers and rug pulls. A rug pull refers to project owners selling their tokens on the market and disappearing with investors' funds. This is why offering STOs to new retail investors may be a reliable financing method.
Initial Exchange Offerings (IEOs) are similar to ICOs but with one major difference: they are supported by exchanges. This method works when the project team approaches an exchange and reaches a closed-door agreement.
The exchange publicly supports and lists the project in exchange for listing fees and a certain percentage of tokens. Specific agreements will vary by situation. If the legitimacy from VCs is attractive to crypto startups without needing to rely on VC funds, the team may consider an IEO. Reputable cryptocurrency exchanges can also provide considerable legitimacy for the project.
Initial Decentralized Exchange Offerings (IDOs) are the latest fundraising tool available to crypto startups. Decentralized exchanges (DEXs) are the cornerstone of decentralized finance (DeFi). By eliminating the need for intermediaries, DEXs provide users with a private and cost-effective way to trade. DEXs can achieve this by combining smart contracts designed to execute through code when certain conditions are met.
Related: Coinbase CEO: The CLARITY Act will be unstoppable like a freight train leaving the station
Original article: Venture Capital Financing: A Beginner's Guide to VC Funding in the Crypto Space
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