Key Points: Nine Major Challenges for Institutional Investors in Web3 World

Author: Edith Yeung, Partner at Race Capital

Original Title: 《Web 2.0 Investors Aren't Cut Out for the Web3 World》

Translation by: Gu Yu, Chain Catcher

Solana was my first token investment, and it wasn't easy.

Back in 2018, when I first met Solana co-founder Anatoly Yakovenko, my then-fund 500 Mobile Collective was legally prohibited from investing in digital assets. To support Yakovenko's company (then called Loom), I had to get two-thirds of the limited partners to agree to amend the fund's LP agreement. I wondered, was I too far down the rabbit hole? Was I taking on too much risk for the fund? Or was Web 2.0 so different from Web3 that my LPs couldn't understand?

Fast forward four years—every bit of trouble was worth it. Solana has become one of my most successful investments, yielding a 4,000x return. However, what now feels normal to me—dealing with pseudonyms, betting on founders on the other side of the world who don't want to give investors any control—still confuses my colleagues who emerged during the Web 2.0 boom.

With a total market cap of $1.7 trillion and over $30 billion in venture capital flooding into the space in 2021, cryptocurrency is an industry that no investor can ignore. Yet, even as some big firms like Sequoia and a16z's recent Bain Capital are building their crypto businesses, many smaller firms are entering the Web3 world unprepared.

A bunch of big companies can't sustain an industry on their own. More quality investors supporting founders equals a stronger crypto ecosystem. Therefore, it's time to take a step back and reflect on what I've learned from experience—more importantly, to open the door for new investors in the Web3 world.

Investing in Web3 companies requires a top-to-bottom rethink of investment models, from how to allocate to LPs to how to set up funds.

1. Investing in Web3 projects can be legally tricky

Venture capital firms can invest a maximum of 20% of their fund in liquid assets—exceeding this number means you must become a registered investment advisor according to the SEC. If you include the salary of the compliance officer you will need to hire, the process can take up to 12 months and cost around $500,000.

For Sequoia Capital or a16z, this might not be a big deal, but if you're running a $10 million fund, the cost of becoming an RIA will exceed your annual management fees. Another option is to set up a hedge fund focused on token trading, which brings a whole new set of fund management requirements.

2. Control in Web3 is a very nebulous concept

Web3 founders do everything they can to ensure their communities feel ownership of the project—not the investors, and not even the founders themselves. Most venture funds require their portfolio companies to have at least 10% equity, but Web3 founders don't want any single investor to hold more than 5% equity. This spirit of distribution extends to Web3 governance structures. Web 2.0 companies have a board of directors, while decentralized autonomous organizations allow anyone holding company shares to vote on decisions, weighted by the size of their shares. The collective may decide to move in a direction you as an investor never envisioned or would never approve. The founder you initially supported may lose control over the project's direction, but you must be able to go with the flow.

3. Crypto founders don't want to show their faces, or even use their real names

Protecting pseudonyms is a core part of crypto culture, but it also makes Web 2.0 investors uneasy. Founders may want to hide their true identities for various reasons, from not wanting to be judged based on their gender, race, job, or school background to wanting to minimize potential legal and personal safety risks.

4. Lawyers don't understand Web3

Web3 terms are not simple agreements for future equity but rather simple agreements for future tokens, or sometimes a SAFE plus warrants that allow investors to receive discounts in future funding rounds (which will be elaborated on later). These concepts are so new that most legal advisors are unsure how to handle them. Finding those— or at least those willing to keep an open mind during legal reviews— is always a challenge.

5. No pro-rata rights

Most Web 2.0 investors fight for pro-rata rights to ensure they can participate in future funding rounds and maintain their ownership in the company. In the Web3 world, this concept does not exist. Why? Because raising more funds does not mean issuing more tokens. If I buy 5% of a crypto startup's tokens early on, I still own 5% regardless of how much the company raises. Therefore, larger funds will ultimately invest in the public market or buy tokens from the company treasury—for example, a16z invested in Solana in June 2021, more than a year before its public listing.

6. Exit strategies for Web3 investors are completely different

Young companies that achieve certain revenue, growth, and valuation levels typically seek to graduate from startup status through a public listing, whether via an IPO, direct listing, or SPAC. If they are in the U.S., they might choose to list on NASDAQ or the New York Stock Exchange. In Asia, they would choose the Hong Kong Stock Exchange, and so on.

Similarly, this concept does not exist in the Web3 world. Most token projects will list on centralized exchanges like FTX or Coinbase, or directly on decentralized exchanges like Uniswap or Serum. There are no specific growth or valuation requirements for listing, nor are there limits on where or how many exchanges you can list tokens.

7. Web3 companies list much faster…

For a Web 2.0 company, a $30 million seed valuation is quite high. You could even call it expensive. In Web3, seed round financing of $10 million to $70 million is reasonable. Most investors are willing to accept such large numbers because the time to list on a cryptocurrency exchange is much shorter compared to listing on a stock exchange, providing investors with quicker liquidity and exit routes. For example, we invested in FTX in July 2019, and its token was listed less than two months later. (Yes, we still hold those tokens.)

8. …but the lock-up periods are much longer

It may take 10 years or more for a successful Web 2.0 startup to go public. In Web3, it's not uncommon for a project to go public within months—for example, Solana took about 16 months, and even longer in some cases. On the other hand, the standard lock-up period for a stock IPO is usually 90 to 180 days, while the lock-up period for Web3 tokens is at least one year, sometimes up to three years.

9. Distribution mechanisms are completely different

In the case of liquidity events for Web 2.0, venture fund managers may choose to distribute cash or stock to their LPs. Web3 fund managers want to distribute tokens. These may have greater advantages compared to Web 2.0 distributions, as Web3 projects sometimes take months or even years to achieve real community adoption and drive.

Unfortunately, most LPs are not set up to handle tokens—they don't know what a crypto wallet is and don't want to bother figuring it out. It took about nine months for one of my LPs to finally open an account on a cryptocurrency exchange to receive the tokens from my investment in Solana. Since then, the value of those tokens has increased by about 700%, making all the trouble worthwhile.

The Web3 world is exciting, but it does break many orthodox notions we expect in venture capital. However, I truly believe that great founders still need patient investors to support them and help them through the upcoming crypto winter. The best Web 2.0 VC spirit is still relevant to Web3, but it is far from a simple copy-paste of what we know.