How do venture capital firms value crypto startups?
Author: Anne Sraders
Original Title: 《3 venture capital investors explain how they value crypto startups with the markets in turmoil》
Translated by: Cookie, Chain Catcher
Venture capital firms have valued crypto startups Blockchain.com, OpenSea, and Yuga Labs at $14 billion, $13.3 billion, and $4 billion, respectively. But with the cryptocurrency market in turmoil, onlookers are wondering if these high valuations have become a thing of the past.
Despite investors rushing to enter the rapidly growing blockchain and Web3 startup space over the past year, the situation is changing quickly. While deals are still happening, the current sell-off in the crypto market, along with the collapse of the Terra ecosystem's stablecoin UST and Luna, has led some in the venture capital community to point out that the valuations of crypto projects have exceeded their actual worth and are now retracting. Ethan Kurzweil, a partner at Bessemer Venture Partners, told Fortune, "The valuations of crypto projects were too hot for a while, and the likelihood of a return to more reasonable valuations this year is quite clear."
Looking back at the first few months of this year, cryptocurrency valuations soared. According to PitchBook data as of April 21, the post-money valuations of late-stage crypto and blockchain companies backed by venture capital increased by an average of 91%, reaching about $4 billion. Meanwhile, traditional late-stage company valuations fell by an average of 14% to about $698 million. Many of these crypto projects raised hundreds of millions of dollars, such as the January funding for the NFT marketplace OpenSea.
Kurzweil from Bessemer believes that current valuations of crypto startups are absolutely imprecise. "I think this correction might lead to greater accuracy," he suggested.
Venture capital firms typically value investments based on quarterly market capitalization or fair value. For equity investments in crypto companies, Kurzweil and Tushar Jain, co-founders and managing partners of Multicoin Capital, stated that they usually only value based on market cap when there is another transaction, such as when a company raises another round of funding. On one hand, Jain expects that there won't be too many valuation markdowns in the crypto startup space: "I would be very surprised to see that happen in the crypto space," he said, partly because many crypto companies raised significant funds over the past year. Instead, these companies may enter a "streamlining" mode to weather the crypto winter.
However, in cases where funds hold liquid tokens (like Multicoin), companies must mark these investments more frequently. Because crypto trading operates 24/7, Jain suggested marking them "every 30 seconds." Therefore, for venture capital firms investing in tokens, "the crypto liquidity portfolio will retract along with the market," he said.
But even if assessing the value of crypto startups is more art than science, how do venture capital firms calculate the valuation cap and assess the scale of their investments? How do they determine whether a crypto project can deliver a 10x return for their partners? Fortune interviewed three venture capitalists to find out.
How VCs Assess Crypto Startups
Like many cryptocurrency believers, Ravi Mhatre, founder and managing director of Lightspeed Venture Partners, believes that blockchain platforms could be the "next-generation computing storage network framework," similar in potential scale to other major technological transformations like the internet and the Web2 mobile revolution. Because the field is still in its "early stages," and with the increase in tokens, this leads investors to "be willing to pay relatively high valuations for crypto companies, even as the overall market declines, even as cryptocurrencies have fallen," Mhatre suggested. Lightspeed's job is to find visionary and execution-oriented founders, "If we are right in our selection in this situation, even at today's valuations, these companies will be able to generate venture capital-style returns," he said.
As of the end of April, Lightspeed has invested $600 million in blockchain and Web3 companies (most of which occurred in the past two years), which constitutes a significant portion of their approximately $1.5 billion invested broadly in the fintech sector since their inception, the company told Fortune. Their investments include the popular Layer 1 blockchain Solana and the cryptocurrency exchange FTX.
On the surface, part of these huge valuations for similar new projects may seem to be generated out of thin air. According to Eric Risley, founder and managing partner of digital asset mergers and investment consulting firm Architect Partners, there is certainly an element of intangible assets: "What is the market willing to pay? Ultimately, that is the most important logic at any given time."
Mhatre said that they find many intersections when evaluating cryptocurrencies and traditional companies: "It always comes down to some real foundational level: people, a specific idea or product vision, and then market opportunity."
Risley, Kurzweil, and Jain all agree that a large part of the process shares similar elements with typical venture capital. "Whether you are an investor or an acquirer, the factors driving valuations boil down to whether you can build a business that can provide returns on that valuation," Risley pointed out. "In other words, if you believe this business will be worth $10 billion in five years, would you be willing to pay $2 billion today? That's the basic calculation." He believes that "traditional valuation methods and approaches still apply."
This may include looking at the company's books, profit and loss statements, revenue growth, and performance (depending on the type of business and stage of development). Kurzweil said they would consider the performance of late-stage companies, but for early projects where performance may be less relevant, they would check "a rough range of valuations, depending on current progress, but they are very rough." However, others like Jain believe that performance is not as important in this field, claiming he rarely hears crypto startups use competitors' valuations "as a reason to support their own valuations."
Venture capitalists also invest in and use tokens for various reasons, including staking tokens (which involves putting tokens into pools and earning returns), using tokens to secure networks, and utilizing the project's products, such as DeFi products. Given that some startup tokens have skyrocketed by dozens of times, such as Solana's SOL token, they can be profitable for early investors.
In fact, Mhatre said that if a project has launched a token, Lightspeed will consider the token as an important factor. "Now there are some Web3 companies that have successfully launched tokens," he said, noting that tokens with high trading volumes have implicit market value, so they are carefully examining these tokens to infer what kind of value specific new projects and issued tokens can create.
Kurzweil from Bessemer stated that they also consider whether there is a token component in the investment round, "or if it is all tokens, what value token holders will receive," he said.
For many crypto projects, especially L1 and L2 (representing Layer 1 and Layer 2 blockchains), some mathematical aspects of these valuations are built-in. Token economics, which refers to the economic structure and supply-demand dynamics of tokens, is something VCs like Mhatre, Kurzweil, and Jain focus on. "These are some mathematical questions: what are the potential revenue sources from transactions in the network, and if you are a token holder earning staking fees, what is the total value of that network?" Mhatre pointed out, you "make some assumptions" and conduct unit economic analysis around it, ultimately arriving at revenue sources.
In fact, Mhatre believes that while some of these high valuations stem from enthusiasm for the long-term potential of cryptocurrencies (or hype), platforms like Solana or Polygon allow you to "really point to specific revenue scales and revenue growth rates." Both are projects supported by Lightspeed. He believes that "over time, these platforms have the potential to scale to millions of users."
TVL, or Total Value Locked, which measures the total value of cryptocurrencies in DeFi projects on the blockchain, is another important metric for Mhatre. He stated that TVL can give them an indication of market sentiment regarding "the total value of tokens in reserve and circulation."
A Rough Formula
Meanwhile, Jain from Multicoin stated that they use a rough formula when conducting valuations: "You multiply three numbers, market size times value capture times certain risk factors, such as execution risk and other types of risk. If you can very roughly estimate these three numbers, you can arrive at a reasonable valuation." Notably, he believes that the "most important attribute" among the three is figuring out the market size. "If there is a huge unmet market demand, I think that is more important than the team, more important than the timing of the investment," he said.
In addition, Jain said they are examining value capture mechanisms, or the project's ability to retain value from transactions. In cryptocurrencies, this is easier said than done. "Everything is open-source, you don't have IP, so you can't make money that way. Everything is permissionless," he said, noting that the design of the project token is "at the core of the value capture mechanism." Then, multiply these two numbers by a number representing risk, which he said could include execution risk, their understanding of the project's product, products that are being built and not yet built, the ability to deliver products, technical complexity, and whether there will be difficulties in assembling the team. He said that figuring this out requires talking to engineers and others on the team for background information.
Ultimately, however, "subjective judgment is needed," Jain said. After all, without a bit of speculation, cryptocurrency wouldn't be cryptocurrency.