Your Crypto Startup Needs a Recession Strategy

Lex Sokolin, a CoinDesk columnist, is Global Fintech co-head at ConsenSys, a Brooklyn, N.Y.-based blockchain software company. The following is adapted from his Future of Finance newsletter.

Imagine we are venture capitalists and succeed in raising $30 million. Let’s say in this world there are two types of VCs: (1) ones with a network, skillset, and timing, and luck enough to generate real returns, and (2) ones whose attributes are insufficient for beating even the most conservative benchmark. In reality, 10 percent of VCs will be in category (1), and 90 percent will be in category (2).

We won’t know ahead of time which type of investor we are. Only after seven years (the typical investment timeframe), do we start to realize and mark to market our investment bets. Given human bias and nature, of course, we are convinced that we are in the good category (1), and self-confidence is high.

Since there are no market prices, proxies are used. Whenever one of our companies raises a follow on-round (e.g., Series A), the paper valuation from that round trickles down into our valuation models, which then trickles down into performance reporting, and is then presented to limited partners (LPs). Since the entire value chain has an information problem, not knowing what anything is really worth, everything *could* be worth a lot. But on paper, our returns look correct. They are generating 25 percent IRR every year in valuation gains.

The stated investment strategy is to have lots of bets that have some probability of returning a massive order of magnitude return, with nearly all others failing out. So a single Binance among 30 other exchanges is just fine. Also, we will want to leave about half of the cash in the portfolio for follow-on investments, so that if some of our companies start to de-risk and show signs of success, we can add more money into them. 

Since the mark-to-market moment comes after we’ve invested our fund, and we believe that our fund has good underlying performance. We just can’t see yet. So we will raise as many new investment vehicles as the market permits to stack management fees and our personal reward. 

Now let’s apply a shock like coronavirus. All of a sudden our whole portfolio is in distress. If you run a public equities fund and value fell by 30 percent, you experience massive fund outflows immediately. People are turning off risk and going into cash, full stop. 

But with venture capital, our investors (i.e., the limited partners) have a harder time both seeing the price collapse, as well as pulling money out. So the first issue right now is that VCs are trying desperately to sanity check their portfolio. Of those 30 projects, which are most likely to have the cash position to weather the crisis? And which are most likely worth supporting through it?

Entrepreneur POV

If you are an entrepreneur trying to raise money, understand that pretty much every single one of the venture investments the portfolio manager already made is raising again. This means that new deals may be interesting, but they are far less interesting than preserving the valuations of the most promising companies already held. 

Because if you are actually forced to mark-to-market on those venture portfolios, many will lose 20-50 percent immediately. This is not in the self-interest of the VC, who would like to raise a follow-on fund and keep accruing management fees. Thus capital reserves will be used for internal bridges and bail-outs.

To that end, see the watershed moment of SoftBank pulling out of their $3 billion commitment to purchase WeWork shares. Or the general sense that VCs are starting to act “badly” and pull term-sheets from companies. Or the comments that VCs will not be able to raise very much over the next year to continue funding new companies. Well, yeah! All our stuff is on fire and reputations are in tatters!

In this coming period, spoils will go to companies that generate their own cashflow and balance sheets without external funding.

The other important thing to keep in mind: VCs don’t necessarily hold all the assets they raised in a bank account. They have what are called “capital commitments” from other institutional investors, like endowments and pensions (e.g., Harvard). That endowment runs an asset allocation with lots of things in it, and most of those things are down, or being sold into cash. So the endowment just may cancel, or somehow reverse, its capital commitment. LPs may bail on commitments, preferring to litigate rather than give you the money, which will cost them less in the end.

In short, there is a shakeout coming in venture capital. The pandemic shock is causing an economy-wide mark-to-market event in private assets, caused by the need of large institutional managers to rebalance and take risk off. There will be less capital flowing in fintech and crypto VC ecosystems in the next 18-24 months. 

The same deleveraging is happening for entrepreneurs. Tripping from one pot of growth funding to another put of growth funding, with value underpinned by a metric that doesn’t lead to cash flow, is now a suicidal strategy. See the defunding of WeWork. You need a business to say that you have a business. While investors sort out their own houses, the shrewd entrepreneur has a chance to make a killing against less disciplined competitors.

Have a recession strategy

In the crypto markets, I would figure out how to provide services adjacent to industry leaders like Binance and Coinbase and their businesses. Watching Binance try to snap up CoinMarketCap for as much as $400 million and launch a debit card suggests to me two things. 

In this coming period, spoils will go to companies that generate their own cashflow and balance sheets without external funding, and second, companies with large user footprints will flourish, while the rest will be integrated as features or liquidated. Delivering a large audience and a data engine to a large trading value is clearly synergistic. Building risk management, analytics, staking, and other neo-banking and roboadvisor features also makes sense. 

If we look at the parts of the ecosystem that generate cash flow in a downturn, it still largely comes down to trading and mining. These are the core engines of the crypto economy, and will thrive as the traditional monetary system thrashes itself. One step down in total addressable market size are the media businesses, enterprise blockchain, digital assets, and developer tooling. Lots of folks are building things and talking about them, and that will continue under economic pressure as well. Companies that are taking a more niche bet will need to find a way to add value to revenue for the industries mentioned above. It is right to show conviction under pressure, but you have to be nimble and accurate.

There are lessons from wider fintech. From neo-banks to payments to roboadvisors, we will see consolidation and downward valuation pressures. Automation software and digital experiences are likely to become more important than ever. For example, digital wealth managers have seen a surge in account sign-ups as people stay home. The same is likely to happen to companies like Chime and Square as they try to become the vehicle for universal basic income (I mean stimulus) in the US.

The SME and mortgage sectors will need smart digital providers, connected to digital personal and corporate identity. The more transformational projects will be hard to commercialize in the short term, but to me that doesn’t mean they aren’t worth doing in the long run, especially when others are fearful. I hope to see a lot more cross-pollination between these fintech needs – especially in payments and lending – and the Decentralized Finance (DeFi) sector. We have an opportunity to hide the complexity of blockchains behind the use-case that millions of people desperately need, likely supported by government grants and support. 

Let’s step into the moment. You don’t need to raise money. It is time for skunkworks and bootstrapping.