A Venture Capital Approach to Crypto Investing
A framework that emphasizes outsized potential return to compensate for inherent risk of an uncertain asset class.
Venture Capital is commonly understood as an asset class, or an investment strategy that falls within the alternatives asset class, that seeks to invest in the early stages of companies with massive growth potential. Regardless of how many “bets” a VC firm may make, it is expected that a singular investment made be able to return the total size of the fund. It is not uncommon for the vast majority of a funds return to be primarily from a single stellar investment such as Facebook, Microsoft, Apple etc.
Investments are traditionally evaluated through the lens of a discounted cash flow model (DCF) analysis. A business is worth no more than the total cash it earns over the life of the business discounted at a required rate of return (r) to the present moment. Required rates of return are dictated by quite a few things, but the important things to take into consideration are the risk free rate (essentially the return on a US t-bill of equal expected timeframe of the investment) and the riskiness of the investment in question. The riskier the investment, the greater the required rate of return demanded for bearing that risk.
But JJ, crypto has no inherent cash flows! Why should I care? Because the fundamental principle that applies is that risk demands a certain level of expected return. If the return expected is inadequate to be compensated for the risk assumed, it is a bad investment. Investing in spot crypto in particular is an extraordinarily risky endeavor that demands an outsized amount of expected return. The systemic risk of crypto being regulated away, being hacked and stolen, events like FTX, etc etc paired with idiosyncratic risks of holding any one particular token are vasts.
Simply, when I buy spot crypto, I am looking for any one investment to be able to return the total size of my crypto investment allocation. In my judgement, the risk I assume by buying spot crypto, be it BTC, ETH etc is massive across all coins. In particular, I would contend that the risk adjusted return on capital from the largest market cap crypto currencies from this price point are some of the least attractive investments opportunities, though markedly better than the run of the mill shit coin that pops up. I’m not going to suggest to you a particular coin or required expected return for your investments; that is for you to decide.
In my own investment in this bear market, I am looking for a few characteristics:
A floor that has been established. I don’t want the new hyped shitcoin, I want something that already has a minimum size and history.
I want a narrative. AVAX, SOL, NEAR, and so many other trash coins went on a massive tear because they filled certain narratives: L2, low gas, alt L1, defi etc. Narratives matter. VC is a prime example that even “smart money” can be tricked into giving shit businesses with zero cash flows massive valuations. I don’t care about real life applicability - I don’t have to believe that everyone is going to use XPR. I care that enough people think that a coin has potential.
Maximum current size. ETH and BTC are down roughly 80% from their ATHs accomplished during a period of historically easy monetary conditions. Moving forward, higher rates for longer likely mean that getting back to those levels is not going to be quick or easy, and that the required rate of return on crypto investments is higher as the risk free rate stays elevated. The best risk reward proposition is in coins that are not at already high market caps.
Personally, I will be finding in the ballpark of 10 lower market cap alt coins to build positions in over the next 12-24 months. I think this bear market will last quite awhile until a full fledged bull market returns. But any single one of my investments MUST imo be able to return the total size of my crypto allocation or I will not invest. I hope this framework is educational to you in your own endeavors!