The Breakdown - Why Crypto Fundraising Could Be in for a Painful Winter

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDess. What's going on, guys? It is Sunday, February 5th, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod.

Starting point is 00:00:40 All right, well, for this Long Read Sunday, we're doing something a little bit different in that there isn't really any sort of theme or connective tissue. We're just going to read three shorter pieces, each of which I found interesting for their own reasons. First up is a Twitter thread by investor Regan Bosman, who's at Lattice. And I thought it was valuable in that it provides a very different point of view of some of the bullishness you're seeing that Regan thinks might be a lot of. little suspect. Regan writes,

Starting point is 00:01:08 The current popular narrative pushed by crypto thought leaders and VCs is that builders are continuing unabated. Bears are for building, teams don't care about token prices, etc., etc. This is utter bullshit, and we'd all be better off if we were more honest. Let's talk about why this view is wrong, why it matters that it's wrong, and where are the bright spots. Now, there is some truth to the narrative that the industry is in a better place than token prices suggest. Developer activity continues to grow, and the industry is clearly on much more solid footing than it was during the 2018 to 2020 bear market. I'll talk our book because

Starting point is 00:01:41 I know it best. The majority of our portfolio is well capitalized and excited about the future. But in the last six months, we've had really talented team shut down, plan to leave crypto, piecemeal M&A, or just struggle to find product market fit. It's possible that we're just bad investors in every other VC fund is sitting on a gold mine. But I've seen data that we're at least average and I'm very confident that most funds are in the same boat. I bet that zero-seed crypto VC funds have 50% plus product market fit in portfolio. It's really fucking hard to build in crypto right now. If you're selling into Web3 companies, your target market has shrunk meaningfully.

Starting point is 00:02:16 If you're selling outside of crypto, good luck. Last year, our industry put cement shoes on most of its users and kick them off a dock. I spent a lot of time with a bunch of smart investors over the last month, and my main takeaway is that no one knows anything. I have yet to hear a succinct explanation for how we get out of these duldrums. I have no idea where the liquid market is going, but anyone who thinks we've bottomed out is just delusional. Less than 10% of 2020-2020-2020 vintage crypto seed stage companies have run out of money and been

Starting point is 00:02:43 sold for parts. This number will be 75% by the end of 2024. There is a bloodbath coming to private markets, and we are in the first inning. This is probably true for all of VC. At this point, Regan points to a thread from another venture capitalist outside of the Web3 space named Tom Lovero who writes, prediction, there's a mass extinction event coming for early and mid-stage companies. Late 23 and 24 will make the 08 financial crisis look quaint for startups. But back to Regan. I call out this bullshit because it hurts the industry and it hurts founders.

Starting point is 00:03:14 One of our founders this week described it succinctly. There's a lot of wrong signals in crypto for founders. I think you can kind of just boil it to follow the money, but it's not always that clear. There is generally very little honest discourse within crypto. This has real consequence It's insane that billions were deployed on the assumption that play to earn was the future of gaming without much critical thought. There are talented teams working in that space and some may make something work, but come on, this is not good. I'm seeing this play out again now where investors are, quote, refocusing on infrastructure. This is so intellectually boring. Look at any tangible metric, block space, eth fees. It's just so obvious that infrastructure is

Starting point is 00:03:51 not what's holding the industry back. We have not focused on building products that people want, and so people don't use our products. It's that simple. If we revert back to funding infrastructure every time a bull market subsides, we'll be chasing our tail for the next decade. Now that we have all that out of the way, where do we go from here? Build products people want. Reasonable-funded teams focused on small market wedges where they can solve real problems will flourish. They'll be able to pick up great talent, grow revenues, and stay focused. Reasonable funded is key. The worst place to be is having $20 million on your balance sheet, a sky-high valuation, and zero idea of product market fit. You won't be able to raise more money, employees know their options are

Starting point is 00:04:28 underwater, and it's hard to be nimble and lean with 10 years of runway. Pick a small market wedge that you know you can serve well and grow from there. This is how startups have found product market fit for the past decade, and this is how crypto companies will survive through the bare market. The era of build it and they will come is clearly dead. Find a market niche, build, iterate, repeat. I'm actually quite optimistic about where the industry is headed. a lot of leverage and bad actors have been wiped out. But if we're not honest about what's not working and why, we're going to end up back in the same place.

Starting point is 00:04:58 All right, so that is the thread from Regan, and I saw a bunch of different discourse around this. On the one hand, I definitely think that a lot of people appreciated that he's providing a counter-narrative to the sort of, we're all going to make it W-A-G-M-I that characterize the last bull market, and just isn't the case. At the same time, I also saw a lot of folks say,

Starting point is 00:05:15 hey, man, this is basically you're just describing the challenges of startups. product market fit is hard for any industry, not crypto alone. A huge percentage of even funded startups fail. So is it really that depressing a situation? Or do we just have to acknowledge that, yeah, most of the startup companies that try to build anything meaningful in Web3 aren't going to work? Now, I do think that Regan is also probably identifying something that's pretty important for crypto venture capital going forward, which is the fact that even relative to other types

Starting point is 00:05:44 of venture capital, it can be extremely meme-driven. in that the sort of X to earn or whatever the latest fat is can concentrate resources even faster than in other types of early risk-sage capital spaces. That might not be the best aspect of the crypto venture sector. I also do think that this idea that there's going to be a specific moment where a lot of privately funded companies run out of runway is true. Companies that raised at the peak of the last cycle just structurally are going to have a hard time. Capital is sitting on its hands. there may be less dry capital than it actually seems, because a lot of funds don't feel like they could actually call the capital that they technically have allocated to them from LPs right now,

Starting point is 00:06:25 and just in general, a lot of the dynamics of the last rounds that companies raised were the peak and end of the post-GFC world of easy money. We've clearly switched to something different, at least for the time being, and that's going to make every new round raised a lot harder than the last ones. Most companies won't be able to do it. So anyways, I think there's a lot a truth here, and I think it was a worthy read, and I appreciate Regan for sticking his neck out and saying something that was likely to be unpopular, even if it brings up some pretty important conversations. Next up, we're reading What's Holding Dow's Back? By Scott Fitzimones, the co-founder of City Dow. Scott writes, in 2021, Dow's broke out of their blockchain confines and spilled out into

Starting point is 00:07:03 the real world. Up until that point, many decentralized autonomous organizations stuck to managing financial protocols or stewarding digital assets, buoyed by a new set of Dow laws in Wyoming, Vermont, in Tennessee, a wave of crypto collectives began pursuing audacious acquisitions of real-world assets, including rare art, a golf course, a copy of the U.S. Constitution, a national basketball association team, and real estate. Disclaimer, your author founded Citi Dow, which purchased 40 acres of land in Wyoming. However, it became evident as soon as Daos collided with the real world that these powerful new vehicles for crowdfunding and organization are constrained by immense coordination and regulatory costs that can negate the benefits of using a Dow in the first place. By understanding these

Starting point is 00:07:41 costs, entrepreneurs, researchers, and regulators have the opportunity to help DOWs deliver on their promise to create a fairer internet. On the coordination side, DOWs add friction to using resources by requiring members to pass proposals. By default, most Dows of today are at risk of being what Ethereum co-founder of Italic Buterin would call a vietocracy, where the default outcome is no unless a proposal sponsor rounds up sufficient support for their project. In some cases, the fact that democratic process adds friction is a feature, not a bug. For financial protocols that steward millions in user deposits, it should be difficult to change settings that could impact tens of thousands of users. In the earlier stages of value creation, however, a core team should have authority

Starting point is 00:08:18 to take dozens of small actions towards a goal without the friction of writing proposals. Many projects were eager to cede that authority and adopt the Dow moniker earlier in their life cycle in an attempt to garner community enthusiasm, saddling themselves with the burden of coordinating hundreds of people, just to take baby steps. Plus, most Dow infrastructure and tooling is built on the assumption that Dow's will be primarily interacting with smart contracts, meaning that there is a dearth of thought put into enabling members to take action in the real world. On the regulatory side, starting a DAO is easy. You can create a multi-sig in minutes. The cost of starting a compliant DAO, however, is immense.

Starting point is 00:08:50 Everything from incorporating an entity to paying contributors and jurisdictions around the world can take weeks of legal work and rack up hefty bills, making the idea of starting a DAO seem like a fool's errand. If a DAO needs a lawyer and an accountant just to operate, that's an immense barrier to entry. When it comes to raising money, vague securities laws can make crowdfunding a risky endeavor. When it comes to spending money on anything off-chain, a Dow will need to open an institutional trading account or off-ramp, which can be a multi-month affair. And if the Dow owns real-world assets like land and trademarks, the cherished property of forking, which allows a group that disagrees with the main group to branch off, becomes even harder or impossible. Many of these

Starting point is 00:09:25 coordination and regulatory costs can be solved with innovation. Entrepreneurs are building tools to ease burdens of Dow payroll, compliance and governance. Some of these barriers must be addressed at the policy level, for example, by clarifying Dow statutes and securities laws. More research is also needed on governance mechanisms in order to move Dao's away from vittocracies and towards meritocracies. Sometimes, though, the high coordination and regulatory costs are simply worth paying. For example, important pieces of internet infrastructure that touch the lives of many ought to be decentralized. MakerDAO, which acts as a sort of Federal Reserve guardian of the stable coin die, is a great example of something that should be very decentralized because trust in the protocol is established by the fact that it's,

Starting point is 00:10:02 theoretically, stewarded by a large group and immune to the whims of a single person. The success of Bitcoin, Ethereum, and the internet itself is largely due to decentralization, which has brought them robustness and passionate communities. Making Dow's work is an important project for humanity because they promise us a more democratic future, where we own and govern the town squares of tomorrow. One thing is certainly clear. Demand for democratic systems is increasing, and people are skeptical of a few platforms ruling the internet. By lowering the coordination and regulatory costs, we can make Dow's more viable and help them

Starting point is 00:10:32 them fulfill their original vision to create a more level playing field and a more democratic internet. Back to NLW here. My two cents on DAWS is that I cannot believe that in an internet-native world, there will not be internet-native organizational forms. DOWs have always struck me as something that was at once incredibly interesting, but at the same time extremely susceptible to complexity creep. I've always thought that the first use case for DAWS was going to be kind of exactly what we've seen, which is resource or asset coordination doubts where the only decision is what thing to buy or hold. However, I want to point out that while Scott's conclusion is nominally that we must lower coordination and regulatory costs, which I think is fine, I think his most salient

Starting point is 00:11:14 point is the idea that in some cases, as he puts it, the fact that democratic processes add friction is a feature, not a bug. Democracy didn't become the system of government it became because it was easy and efficient. The most efficient form of government is authoritarianism or fascism, where there's just one person making all decisions. The fact that it's efficient doesn't make it good. Democracy is designed to be messy. It is designed to slow down change in many ways, while also creating a mechanism for it.

Starting point is 00:11:47 The idea that there may be circumstances, contexts, where that sort of messy process is actually better than a more efficient process is something that's worth. thinking about. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web3, happening April 26th through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Emmerse yourself in all that blockchain technology has to offer creators, builders, founders, brand leaders, entrepreneurs, and more. Use code Breakdown to get 15% off your paths. Visit Consensus, coin desk.com or check the link in the show notes.

Starting point is 00:12:39 All right, last up today, and I had to just because of the boldness and hot-takingness of the headline, initial coin offerings, ICOs, deserve a rethink. This one is by Don Fan, who manages the cryptocurrency business at Amazon Web Services. Don writes, in the fallout over FTX, U.S. Senate Banking Committee Chairman Sherrod Brown recently announced he is considering legislation aimed at protecting retail investors from cryptocurrency fraud. Legislators and regulators should proceed with caution. Casual observers may be skeptical of the innovation of cryptocurrencies, but the clearest innovation has been ICOs. ICOs have allowed entrepreneurs to raise money, circumventing the thicket of decades-old

Starting point is 00:13:16 Sarbanes-Oxley regulations. Members of Congress serious about economic growth should be encouraging initial coin offerings and rein in the U.S. Securities and Exchange Commission's regulatory overreach. Initial coin offerings are a technical innovation that disrupts the current fundraising apparatus calcified after the passage of Sarbanes-Oxley. Sarbanes-Oxley should serve as a cautionary tale. Passed in the aftermath of the Enron Arthur Anderson accounting scandal, Sarbanes-Oxley was meant to boost investor confidence and protect retail investors. Instead, it has made it more difficult for entrepreneurs to access public capital markets. Startups are now staying private longer, precisely because accessing money from the public markets has become so burdensome.

Starting point is 00:13:54 The U.S. Congress took a step in the right direction with the Jump Start Our Business Startups Act, the Jobs Act of 2013, which promoted equity crowdfunding, the kind most associated with platforms such as Kickstarter and Angel List. The intent of Congress was to allow more investors to take part in the growth of early-stage startups and for startup founders to be able to raise money from a much wider range of people. Congress pushed in the right direction by promoting equity crowdfunding, but Congress could not foresee how much bigger the ICO market would be. According to data compiled from CB Insights, 19 billion has been raised since 2013 through initial coin offerings, while only $9.69 million has been raised through equity crowdfunding. Clearly, ICOs have won out.

Starting point is 00:14:30 While Angelist and Kickstarter were innovative for their time and paved the way for our understanding of equity crowdfunding, they are centralized platforms that were ultimately limited in their scale. The intent of Congress was to make fundraising easier for founders to raise from small investors, exactly what ICOs do so well. The SEC bears the most responsibilities for giving ICOs a bad name and has vastly overstepped its authority as an executive regulatory agency. The SEC does not have final say over cryptocurrency regulation. Congress does. While the Jobs Act intended to make fundraising easier, the SEC is pushing for an over-regulated regime that replicates the worst features of Sarbanes-Oxley. If the SEC gets its way, fewer retail investors will be able to take

Starting point is 00:15:07 part in the growth of early-stage startups and startup founders will only be able to raise from a limited range of sources. The chilling effects of possible SEC enforcement can be seen in how cryptocurrency entrepreneurs must contort themselves to avoid the ICO term for fear of an SEC crackdown. Founders now use incomprehensible terms, such as initially centralized offering and token generation event, to disguise what would otherwise be a simple fundraising exercise. Congress should use the provisions of the Jobs Act to provide ICO entrepreneurs with a safe haven of legal protection from SEC enforcement. Further SEC regulation of ICOs should be viewed as protectionism over initial public offerings or IPOs, in which an agency led by a former Goldman Sachs partner protects the IPO ecosystem of

Starting point is 00:15:44 investment bankers, auditors, corporate lawyers, and regulators who bear the most risk of ICO disruption. A regularly quoted statistic is that most ICO-backed ventures shut down within four months. Legislators and regulators need to convincingly distinguish between fraud and failure. Business failure is not a crime and should be encouraged by lawmakers attempting to encourage economic growth. Regulation is often a zero-sum game because rules aimed at protecting retail investors, the proverbial grandmother who has lost her life savings in the latest crypto fad come at a real cost to entrepreneurs, who must contend with more rules while being starved at the capital needed to grow their businesses. Chairman Brown and Gensler may be sincere in their desires to support growth

Starting point is 00:16:20 and tech entrepreneurship, but they risk strangling the clear source of funding for future innovation. Most potential retail investors have heard that cryptocurrencies are largely scams they should avoid, so the benefits of regulation will likely be minimal. On the downside, another layer of regulation will make it more difficult for entrepreneurs to raise the money needed to grow their businesses. If more regulations pass, it is foreseeable the innovative startups of the future will be built in foreign countries far away from Silicon Valley, far from American shores. Who, boy, howdy, haven't seen a pro-ICO argument in quite some time. Go Don. If for no other reason than getting the conversation flowing. Now, there's actually a lot if you wanted to unpack this

Starting point is 00:16:59 seriously. One piece of this is the question of should retail investors be able to invest in risky startups? And I think many, if not most of the folks in crypto have a wider view than the average, say, regulator view of what people should be allowed to do with their own money. That is one part of the libertarian kind of mentality that I think is pretty present in crypto, whether people come from the left or the right of the political aisle. I think it's likely true that part of the reason there was such pent-up demand for ICOs when they happened in 2017 was that accredited investor rules had cut people out of other types of opportunities. There's likely some reasonable middle that Congress could figure out if it wanted to

Starting point is 00:17:37 that didn't just say that the only people who got to invest in risky stuff are people who are already rich. Another piece is the efficacy of ICOs as a fundraising mechanism, And that's the piece that I think is hard to deny. ICOs were an incredible advancement in terms of how friction-free, effortless, and costless capital raises could be, which is highly disruptive to the way that money is raised now. However, there were problems with that. The biggest reason to not be so keen on ICOs just coming back is the shi-coin waterfall dynamics we saw at work last time.

Starting point is 00:18:09 Because there was instant liquidity, you effectively had a scenario where some number of influencers or investors would be effectively given tokens for free to put their name on a project. Another tier of investors who maybe weren't as important would then be in the next round, and maybe they'd have something like a 75 or 80% discount to what the ICO price was going to be. Maybe then you'd have another round of people who had a 25 or 50% discount and they added more social proof to the investment. Well, and then there was the ICO, the moment when regular retail investors got to get involved. At that point, you already had a set of privileged investors, who were guaranteed to make their money back and then some.

Starting point is 00:18:49 Because of the discount they were able to buy at, the second the ICO started, holding aside entirely any sort of value pop that happened that day because of demand from retail investors. This was a flywheel that tons of people took advantage of in that 2017, early 2018 period, and it's hard to say that it was good for a lot of the retail investors that got dumped on.

Starting point is 00:19:10 However, of course, I do think that if one were to take a serious look, there are ways to solve some of those issues and take advantage of the lower friction of ICO fundraising. And then, of course, we haven't gotten into any of the issues about securities designation, which is obviously a big topic for Congress in this session. But in any case, like I said, kudos to Don for a hot take, even for the crypto industry. And we'll see if anyone wants to pick up this cause. For now, I hope you are having a great weekend.

Starting point is 00:19:35 I appreciate you listening. And until tomorrow, be safe and take care of each other. Peace.

The Breakdown - Why Crypto Fundraising Could Be in for a Painful Winter

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