Throughout 2022, venture funds seeking to capitalize on the growing embrace of Web3 products and services helped the space shatter all previous fundraising records, even in the face of bearish market conditions.
However, investing in early-stage blockchain startups isn’t the same as traditional investing. The Web3 space is relatively new and still evolving, requiring a different approach. Moreover, because the crypto industry isn’t heavily regulated, it becomes vital for venture capital companies and investors to understand the legal and regulatory implications of investing in crypto projects.
Between evaluating the team behind a project, the technology use case, market demand, and sustainability, investors must go through many checkpoints before making any investment decisions. To better understand how the crypto investment industry works, we sat down with Deng Chao, the Managing Director of Hong Kong-based HashKey Capital, which invests exclusively in blockchain technology and digital assets.
With new investors entering the market and the Web3 ecosystem flourishing, we invited Deng to share his thoughts and perspectives on the current investment landscape. Chao commands over a decade’s experience in the asset management and fintech sectors and holds a master’s degree from the University of Hong Kong. He is also an early founding member of Wanxiang Blockchain Labs.
Investments across crypto projects are at an all-time high. What do you think is the driving force of appetite for the industry at this stage?
Deng: In every new industry, there is an early bubble, not just in crypto. Crypto is still in its infancy, and when it comes to development, it has a lot in common with the early Internet industry. People are interested in finding more opportunities in crypto because there are more opportunities than traditional industries, even more than the Internet industry now.
In addition, crypto and blockchain can be seen as disruptive innovations that solve real-world problems. These technologies have the potential to bring big efficiency leaps across different industries, such as the financial industry, internet, and gaming, and create massive network effects. These network effects are achieved through decentralized networks and, most times, without relying on centralized parties. This is incredibly unique if we look at how historically technologies have evolved since the 1st industrial revolution over the last 250 years. This is what creates asymmetric opportunities and drives so much investment appetite in the crypto space.
Is investing in crypto initiatives the same as traditional investing? Are there any additional parameters or due diligence areas that crypto venture capital funds should evaluate before investing?
Deng: In general, the investment framework remains the same. The difference is there are two types of investment structures in the crypto field, one of which is the traditional equity structure, which follows the traditional investment method. Companies using this structure generally provide centralized service for crypto users. Another aspect is token structure, which requires consideration of token economics, token utility within products, managing token issuance and liquidity, and stakeholder interests alignment.
On top of that, the blockchain space is an extremely fast-paced industry. The product development cycles are accelerated by the fact that almost everything in the crypto space is open-source and transparent. This often translates into something called composability. Composability refers to the ability to build on top of existing components to create new functionalities and new products.
While this is a great thing to accelerate the development of new products on the blockchain, it often makes them technically very complex. This is why crypto VCs like HashKey Capital have a team specializing in tech research and due diligence, which is a great part of our decision analysis and differentiates us from traditional venture capital.
Could you provide a brief overview of how crypto funds evaluate crypto projects they are considering? What are the steps or processes they undertake?
Deng: There are several things to consider, and there’s no strict rule for evaluation. However, it is best to consider four key aspects: the sector, the team behind the project, the product’s feasibility, as well as its token economics and valuation.
To start, we need to understand whether it’s promising enough or if the upside is big enough. Importantly, investors must update their sector focus every quarter or occasionally based on market trends. Next, what we want to see is a good track record. It is important to evaluate the mindset and insights about what the team behind the project is doing. Strong technology? Strong operation? Strong resources and network? Is the team well dedicated to what they are building?
Then there’s testing out the product market fit and its long-term sustainability. For instance, if it’s a technology-oriented project, it is a good idea to evaluate if the tech design is feasible. Other considerations include analyzing if the project is sustainable and if it is really necessary for the project to issue a token. If a token is required, investors should also check and ensure that the token is fairly priced.
Talking about return on investment (ROI), many people believe that crypto investments can deliver outsized returns. How true is this assumption? How do you think the returns differ from traditional investments, and what are the potential upsides and drawbacks that crypto VCs must navigate?
Deng: As an early-stage investment, it does deliver higher returns. Public data shows that BTC, ETH, and the early top 30 token returns are thousands of times. But it’s also riskier, with 95% of projects struggling to survive the winter. Successful crypto projects have larger returns and shorter payback periods because the tokens give these projects early access to liquidity. Therefore, while seizing opportunities, it is more important for VCs to manage risks well. These risks are different from traditional risks, not only in asset prices but also in products, strategies, and crypto-specific risks, such as the impact of FTX events.
Play-to-Earn gaming and Web3 projects have collected the largest share of venture funding this year. With all the new segments emerging across the blockchain universe, which crypto-based niches do you believe exhibit the greatest potential to attract capital in the near future?
Deng: Both P2E and Web3 projects belong to the application layer, and relatively few projects are doing outstandingly well in the application layer. Now, we are more concerned about the underlying infrastructure and some middleware, which is the premise that the future application layer can explode, such as ZK, AA, Rollup, data, communication, storage layer, etc.
According to our research, the NFT/gaming category received around $7 billion dollars in venture funding last year. However, the infrastructure sector mentioned above also fundraised around $7 billion. Infrastructure and middleware are at the core of the ecosystem’s development and represent a foundational layer. Investing in this infrastructure layer is like being able to invest in the internet layer 30 years ago rather than investing in individual applications.
Your fund, HashKey Capital, is a leading investment firm in the crypto space. Could you tell us more about how your firm overcomes the crypto market’s volatility? More importantly, how are you, as a venture capital fund handling the current crypto winter?
Deng: We must zoom out and look at the macroeconomic cycles that include all asset classes, including crypto. Understanding the big picture and these market cycles can really help investors to adapt their investment strategy and better time their investments.
We have tried to fit our last fundraising to these market cycles, and the timing for our current VC fund couldn’t be better. We have fundraised $500 million in 2022, which means that we are now deploying the fund in a market where the startup valuations are way more realistic. We see this as a great time to build and invest, away from the hype and FOMO.
Can you weigh in on emerging crypto projects seeking capital? Is there a specific way they need to approach venture funds? From your point of view, what’s the most optimal approach an early-stage crypto startup can take?
Deng: Well, there’s no one-size-fits-all answer to this question. HashKey Capital invests in projects at any stage. However, from the get-go, it’s important that the founders can communicate their vision, determination, and why they are building “XYZ.” A clear and concise deck can be the entry point.
Studying the VC space is important. The first step is to create a spreadsheet with all the VCs that invest in the crypto space. Then try to understand the relationships between these VCs. Many of them can co-invest in projects and share deal flow between them. Step two is to create a private Twitter list with all the VCs and respective partners. Try to engage with them on Twitter to start building basic social currency.
The next step is to start emailing the key VCs. When meeting with VCs, the goal is to pass your passion to the VC and share what value your project brings to the world. Finally, it is extremely important to leave the ego at the door when talking with a VC. Remember, a “no” in your seed round may turn into a “yes” in the series A round. Keeping good relationships with every VC, even after being turned down, can later pay off tenfold in your next round.