The Ponzi scheme of crypto VCs in a bear market, demanding refunds from invested companies is becoming increasingly common

Original Title: 《Thoughts on the current crypto VC landscape》

Author: RICHARD CHEN, Partner at 1confirmation

Compiled by: Deep Tide TechFlow

First, we need to define two important metrics.

DPI (Distributions to Paid-In). This is the cash distributed to LPs after deducting management fees and performance fees. This is by far the most important metric for LPs, as it cannot be manipulated, and it is the most accurate measure of fund performance.

TVPI (Total Value to Paid-In). This is the value of all assets in the fund calculated at market price, also known as "paper returns." Venture capital firms have significant discretion in how they mark their assets (see below), so TVPI is often inflated. Savvy LPs can easily dig deep during due diligence and see through the inflated TVPI.

1. Most funds with high TVPI have low DPI.

This is the famous "VC Ponzi scheme" described by Chamath, where you show LPs your paper returns to raise large mega funds and earn hefty management fees.

Especially in the cryptocurrency space, venture capitalists have a lot of leeway in deciding how to account for their investments. For example, a venture capital firm invests in a project whose tokens have a lock-up period of several years and very low liquidity on exchanges. Many will choose to mark their investments at the current spot price of the tokens without any discount, even though they cannot sell the tokens to realize such returns. This is why new shiny L1 VC chains keep getting funded.

Therefore, a prudent approach is to achieve good DPI over time to show that your returns are real. Having a high TVPI is nice, but you should let it fluctuate with the market and write down investments when appropriate.

2. Most funds from 2017-18 have a lower DPI than a16z crypto Fund I.

Clearly, I cannot share exact numbers, but a16z's ability to scale the fund by X times is very impressive.

a16z is a strong brand, and for large institutional LP investment committees that must reach consensus in decision-making, investing in a16z is akin to "no one gets fired for choosing IBM."

For other lesser-known funds, if their returns might be worse and LPs have to bear more reputational risk, why would LPs choose them over a16z? This is especially true for individual GPs currently raising a second fund while their first fund has underperformed.

3. The one-year funds from the 2021 bull market are among the worst-performing funds.

A one-year fund refers to a fund that quickly raises and deploys all its capital within a year, then raises the next fund the following year. By inquiring with institutional LPs who have been investing in venture capital for decades, I cannot find historical cases of one-year venture capital funds performing well.

Any institutional LP will tell you that the most important factor for fund returns is the year, not the ability to get good deal flow or pick good companies. But as a venture capitalist, you cannot control the macro environment. Your job is to find the best founders and themes within your expertise and deploy slowly over multiple years to diversify macro risks.

For cryptocurrency venture capital, 2021 was particularly bad. Seed rounds were completed at crazy valuations over $50 million before products were launched, rendering risk/return meaningless. So many startups were raising funds that VCs felt pressured to deploy capital. Additionally, startups were raising follow-on funding in a short time, forcing early investors to proportionally exercise their equity to maintain their ownership before seeing meaningful product traction. This led to a faster-than-expected deployment of venture capital and a quicker return to LPs to raise the next fund.

4. It’s either small seed funds or large index funds; the middle ground is a no-man's land.

This is a great example of dialectics (opposing truths in extreme cases). Seed funds are "snipers," becoming the first capital in startups at extremely attractive valuations, where risk/return means that only one successful seed investment can return the fund. Large funds are "aircraft carriers," managing the market in an indexed manner and having meaningful ownership in most companies after their products launch.

Fund size is often a legitimate signal of competition among venture capital firms. New fund managers feel the pressure from peers who want to raise assets in the billions, but the fund size game often favors established brands. Those seed funds that raised larger funds without restraint during the bull market are now caught in the middle, too large to find upside in seed fund investments; too small to become a household name. They cannot raise such large funds again in the short term, and reducing fund size would lower management fees.

Just because you can raise a larger fund doesn’t mean you should.

5. Unfortunately, in bear markets, it is becoming increasingly common for VCs to retract term sheets and ask portfolio companies for refunds.

Retracting a term sheet means that the venture capital firm had agreed to invest under specific terms, but during the wait for legal documents to be completed, the cryptocurrency market crashed, leading the venture capitalists to back out of the deal. This does not mean that venture capitalists must actually sign documents; see YC's handshake agreement for what is considered industry standard. In any case, this sets founders back months as they have to waste time raising funds again in a worse environment.

Asking portfolio companies for refunds means that venture capitalists provided funding to companies during the bull market but now regret it and want their money back. This is not as bad as retracting a term sheet since founders are clearly not obligated to agree to a refund, but it still tarnishes the venture capitalist's reputation of being "founder-friendly."

So far, I have heard from founders and other investors that five well-known crypto venture capital funds have done this. The worst offenders have done this to at least five different companies. I have also noticed that the more public image a venture capital firm invests in, the more they feel they can get away with such bad behavior behind the scenes.