The best way to capture alpha as an investor is to create it. Private equity firms have practiced this for decades: groups like TPG acquire businesses and devote significant management resources to improving the business prior to selling. Venture capital firms like USV, a16z, and Craft Ventures create alpha by helping early-stage companies overcome challenges to scaling their businesses.
Crypto is a fundamentally new asset class that combines attributes of existing assets (early stage equity, commodities, public equity, currencies). Most notably, this charge has been led by tech VCs, who typically invest in startup equity. While VCs can create alpha by providing value in traditional company building, there are many new ways to create alpha in this unique asset class.
VCs typically add value to portfolio companies through a combination of the following:
- Recruiting (primarily engineering & executive talent) and other introductions
- Advising founders/management on strategy and scaling
- Providing services which benefit from economies of scale to portfolio companies (eg: office space in incubators, PR, etc.)
- Emotional support
These services are invaluable and the venture capital industry has played a huge part in the emergence of new technologies and business models we are seeing in the economy today. While cryptofunds like Multicoin provide many of these types of services, we seek to really differentiate by providing value in a number of crypto-native ways.
Many, if not all, crypto investments are based on the assumption that a crypto network will benefit from strong network effects that act as a competitive moat. However, network effects, by definition, do not act as a competitive moat until the network is sufficiently large. It’s widely recognized that bootstrapping network effects is among the largest challenges facing all network-effect bound businesses (e.g. why buy a telephone if no-one else owns a telephone?)
There are several ways that crypto-native funds are uniquely positioned to help teams who build crypto networks bootstrap network effects.
For example, let’s consider Livepeer, in which we are investors. Livepeer is a decentralized video transcoding network. Suppliers to the network stake their LPT tokens for the right to provide video transcoding and content delivery services to Livepeer customers. The suppliers are paid in ETH or a stablecoin (e.g. DAI, GUSD, USDC) for providing this service, turning LPT into a yield-generating asset that can be valued using a traditional discounted cash flow model. However, before video-streamers begin broadcasting content on the Livepeer network, it is not economically rational for people who are interested in providing transcoding services to buy and stake LPT tokens to participate in the network. Without suppliers on the network, customers won’t be able to have their needs met. Chicken, meet egg.
Multicoin is operating transcoders on the Livepeer network today to help provide the supply side of the Livepeer network until there is enough demand for other suppliers to see an attractive yield from LPT. By acting as a supplier in the Livepeer network, we are able to assist the founders in their sales efforts and get the flywheel spinning.
We can take this even further in a couple of ways. First, we can operate transcoders in multiple geographies, making the network more distributed, less expensive, and more performant (Livepeer is a latency bound application, so the service actually gets better when nodes are closer to the source of the stream). Second, in the early days we can run transcoders at an operating loss so the founders can advertise even lower prices to potential customers, generating marginal demand and strengthening the network effect. Given the size of our investment and our conviction in Livepeer, just about anything we can do to accelerate the growth of the network is in our best interest.
Let’s consider another example: MakerDAO. The single biggest problem in the MakerDAO system is that the supply and demand curves for DAI do not intersect. Or in other words, as demand for DAI increases, there is no organic reason why CDP-creators will create more DAI.
Again, there’s an opportunity for long-term investors to create alpha through crypto-native operations. An investor in MakerDAO can generate DAI by creating CDPs, and then sell the DAI for USD. By doing this, the investor increases the supply of DAI without taking on the market risk an organic CDP creator would take, and creates additional liquidity on DAI trading pairs, encouraging exchanges to list DAI pairs and liquidity providers to make markets.
A MakerDAO investor can also serve as a ‘Keeper’ – an entity which helps maintain the Dai peg by bidding on collateral being liquidated from insolvent CDPs. This requires significant work which a disinterested 3rd party would not want to do in the early days of the network when the arbitrage opportunities are too small in an absolute dollars basis to justify the investment of not just capital, but effort. The net effect of this is that there’s more DAI available for DAI-based apps and there is more trust in the DAI peg, which further accelerates DAI’s network effect and increases the value of MakerDAO.
Some other examples: an investor in ZRX may choose to bridge liquidity pools between centralized and decentralized exchanges, thereby increasing liquidity for all 0x-based relayers. An investor in Filecoin can help provide storage to the network in the early days to help the network get off the ground. Moreover, she can generate demand on the network by choosing to store files on the Filecoin network, incentivizing other suppliers to join the network.
Each of these actions may not be economically rational in a vacuum. Running a Livepeer transcoder requires investment of time, IT resources, and capital. In the early stages of the network Multicoin does not expect operating a Livepeer transcoder to be operationally profitable. However, this is a rational long-term investment decision because it increases the probability that Livepeer becomes the standard protocol for video transcoding.
Beyond running operating nodes, crypto investors can also help secure the underlying network consensus. By participating in a network’s consensus in the early days, a long-term investor can increase security of the network when it is most vulnerable. For example, let’s consider Skale. In order for any layer 2 network to function, the network must sample validators from a large pool. While this provides an array of benefits, it increases the probability that any given sample of validators is > ⅓ byzantine. When developers (the customers in the Skale network) instantiate Skale chains, a pool of validators (suppliers) are randomly assigned to secure the developers’ Skale chains. Validators must stake Skale tokens for the right to provide security services to the Skale network’s client layer-2 chains. Just as in the Livepeer example above, suppliers are paid in ETH or a stablecoin (DAI, USDC) for providing this service, turning Skale tokens into a yield generating asset. However, the same chicken or egg problem described in the Livepeer example exists here.
Multicoin recently announced an investment in Skale and will be running validators on the Skale network when it launches in Q1 2019. By operating validators on the Skale network, we are able to help bootstrap both the network’s security and network effects. The larger the validator pool available for Skale’s client layer-2 chains, the more secure and higher quality the Skale product is. The more layer-2 chains that use Skale, the more revenue the Skale network earns which then attracts new suppliers. This is a powerful network effect which a long term investor can catalyze.
Just as in the Livepeer example above, we don’t expect providing security to the Skale network to necessarily be profitable in the early days. However, this is a rational long-term investment decision because it increases the probability that Skale becomes the standard protocol for layer-2 chains on Ethereum.
Another area where crypto investors can add significant value is in governance of the network. Governing in open crypto networks is an entirely new field. We are committed to devoting the time and effort to participate actively and help these networks grow. For example:
We recently announced that Myles Snider, our first employee, was spinning out of Multicoin to launch an EOS Block Producer called Aurora EOS. Block Producers are the elected governors of the EOS network. Aurora EOS is building on Multicoin’s strategy of engagement and education with the community to help provide network level governance. As my partner Kyle noted, “crypto-native managers bear the responsibility of ushering nascent markets to stability—by way of investment, governance, and active participation.”
Multicoin is committed to supporting our portfolio networks in their early days by providing marketplace liquidity, governance, and other services where a crypto-native investor can add value. This requires the confluence of capital, technical ability, and understanding of how these networks function. Just as a traditional VC firm would set aside capital for follow on rounds, we believe that crypto investors who typically invest in protocols will find it’s a best practice to also set aside capital for supporting the network. As the crypto markets evolve, we expect to see more opportunities for investors to work with founders to bootstrap networks, and ultimately as a way for GPs to create alpha.
Disclosure: Unless otherwise indicated, the views expressed in this post are solely those of the author(s) in their individual capacity and are not the views of Multicoin Capital Management, LLC or its affiliates (together with its affiliates, “Multicoin”). Certain information contained herein may have been obtained from third-party sources, including from portfolio companies of funds managed by Multicoin. Multicoin believes that the information provided is reliable but has not independently verified the non-material information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. This post may contain links to third-party websites (“External Websites”). The existence of any such link does not constitute an endorsement of such websites, the content of the websites, or the operators of the websites. These links are provided solely as a convenience to you and not as an endorsement by us of the content on such External Websites. The content of such External Websites is developed and provided by others and Multicoin takes no responsibility for any content therein. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in this blog are subject to change without notice and may differ or be contrary to opinions expressed by others.
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