Chasing Shadows: The Dilemma of Crypto Assets Capital Allocation

Shadow Investment = Supporting competitors after missing out on industry leaders, usually to maintain exposure rather than based on a belief in differentiation.

Written by: Zaheer

Compiled by: Block unicorn

Preface

This is yet another article about capital allocation - but this time it is different.

Uncertainty always slows everything down, forcing people to reflect on their situation, the past, and the future. The interest rate hikes in recent years and the uncertainty of global trade and geopolitics have caught the cryptocurrency investment community off guard. However, aside from external factors, there are other elements that pose a crucial threat to cryptocurrencies. This silent disaster continues to drain people's time, funds, and faith: shadow investing.

(Shadow investing = supporting competitors after missing out on industry leaders, typically for the sake of maintaining exposure rather than based on a belief in differentiation.)

Genius Questions

Finding outstanding talent is the pursuit of every company worldwide, but the resources of genius are not unlimited. Geniuses are extremely difficult to find, and even harder to force; to some extent, it is entirely a matter of chance. Companies that suddenly have flashes of brilliance cannot predict unexpected results, but instead focus their energy and time on creating as many opportunities as possible for talented individuals to shine.

Similarly, venture capital firms face the same issue, as venture capital is not a linear game. The more money invested does not necessarily mean more genius output. This was widely known during the early 80s / early 90s and the rise of modern venture capital in the early 21st century, but as investors' expectations and appetites continued to grow, the budgets for venture capital and the pursuit of genius also increased. However, this fundamentally conflicts with the philosophy of venture capital—"If opportunities do not exist, how can more opportunities be found?"

Shadow Investment Makes Its Debut

Every few years, we come across a new cryptocurrency protocol, new project, or new business that truly changes the rules of the game and creates meaningful value. This is the joy of every investor and the goal of every team. However, the speed and scale of these investments have made them (inherently) scarce, and the lack of original thinking has led investors to focus on existing trends and choose the hottest options of the moment as their next investment. Put simply, investors see new trends in the industry and choose to support weaker "competitors" for projects they missed.

Why is this happening

As we all know, I have many criticisms of the cryptocurrency venture capital space. You can find my complaints in old podcasts, tweets, or articles, but all of these comments touch on the same starting point—the cryptocurrency venture capital supernova theory (i.e., there is too much money in the cryptocurrency space, which in turn leads to too much venture capital). This abnormal state has produced many negative external effects in the industry, but the ongoing funding of cheap copies of great companies is one of the worst.

The capital allocation process for cryptocurrencies (or any market) is quite simple:

1. Limited partners (LPs) invest capital in venture capital firms.
2. Venture capital firms use these funds to invest in startups at different stages.
3. Startups use this funding to grow and establish their companies.

This model is very simple, but it fails when LPs have too much capital. They overfund cryptocurrency venture capital firms by providing large amounts of capital to numerous investors. Nowadays, there are over 20 companies in the cryptocurrency space with nine-figure capital, covering everything from seed rounds to later stages. If each investment firm (even considering only the 20 venture capital firms) makes just one deal per quarter, there would still be 80 investments in a year. However, the actual number of transactions is much higher, with hundreds each year. There aren’t hundreds of valuable cryptocurrency companies worth investing in every year. Moreover, there aren’t dozens of worthwhile crypto narratives or stories to invest in each year.

On the contrary, we face two truths:

1. Excessive funds in cryptocurrency venture capital
2. There are too few quality companies to invest in.

However, this capital still needs to enter the market in some way, as it is designated for the company. Therefore, this capital flows to companies that align with recent investment hotspots: shadow investments.

In the markets of Layer 1, Layer 2, wallets, perpetual decentralized exchanges, lending protocols, and cross-chain bridges, many projects are poor imitations of each other, as the value of original projects drives a demand that cannot be funded. Taking Uniswap as an example, it is the pioneer and leader in the decentralized exchange space. Hundreds of millions, even billions of dollars have fueled Uniswap's cheap knockoffs, but they fail to deliver meaningful value or vision iterations. Instead, we are left with an industry landscape destroyed by token inflation. Of course, there are some companies that have built high-quality iterative products, and not every derivative company is a cheap imitation, but these are often exceptions rather than the rule.

"Imitators can only follow in the footsteps of leaders. They cannot surpass them." — Peter Thiel (Zero to One)

One major issue brought about by cheap imitation strategies in cryptocurrency venture capital is the upgrade and maintenance of products. Many of the best projects in cryptocurrency start with great potential but always promise larger growth visions and a significant amount of maintenance work. This leads to numerous issues, ranging from protocol security to building a clear product vision. How many times have project forks resulted in millions of dollars being hacked or exploited?

The endpoint of the problem points to the venture capital firms that fund these transactions. Inevitably, when the entire industry and its best investors cannot distinguish between quality investments and poor imitations, shadow investments tarnish the reputation of the industry.

We can see how many funds and how many teams end up being funded because of the actual product launch. Imitation is flattery, but not when the imitation market overpays for the "good stuff" that is about to die. If cryptocurrency is to become a serious industry, committed to even superficial capital preservation, then the space and its investors must grow from their fundraising behavior and invest rigorously in teams that are truly committed to innovation...... At least that's what I hoped.