The FTX crash spooked venture capital firms into tightening their purse strings. Now, US market watchdogs’ latest crypto crackdown is rattling them even more.
”The SEC crackdowns on Kraken and Paxos have impacted how we do due diligence,” Hugo Lee, CEO of Haru Invest, told DL News. “We take a premeditative look at how deep the business is, considering the recent crypto regulations, and how they prepare for it.”
The US Securities and Exchange Commission rocked the crypto industry over the past week by firing off two enforcement actions against major exchange Kraken and stablecoin issuer Paxos. The moves angered crypto watchers, with one lawyer claiming that regulators aim “to choke off and reverse the growth of digital assets.”
It’s a one-two punch. After the collapse of FTX and other crypto companies last year sent Bitcoin and other tokens lower, jittery VCs have held back. VC investment into crypto projects plunged. Backers injected $569.9 million into startups in January 2023, a 77% drop from the same month last year, according to DefiLlama data. So far in February, the industry has secured $429.6 million.
“Doing your homework [is] incredibly important going forward,” Sean Stein Smith, an assistant professor at City University of New York who serves on the Wall Street Blockchain Alliance’s advisory board, told DL News. He argued that while the collapse of FTX cemented the need for VCs to improve their due diligence, the latest regulatory crackdown has added an extra urgency.
Smith argued that any VC considering making an investment into a crypto firm would be well-advised to look at “the operational guts” of the company and compare it to offerings slammed by regulators. Another box to tick.
Others worry that the crackdown would risk US startups to lose out on funding as investors bet their money on ventures based in more regulatory lenient or transparent regions of the world.
“Aggressive movement from the US regulators has made us look at businesses if they are already under impact by the SEC regulations,” Lee said. “We also consider their growth potential in countries outside of the US. If they are a US-based business, it is highly likely that they will be directly impacted by the authorities, so as an investor, it is difficult to make decisions for investing in those companies.”
VCs already pressed
“The issues around crypto due diligence were really brought to the front burner in 2022,” Smith said.
The case has prompted VCs to overhaul how they investigate new businesses, especially during crypto bull markets like 2021.
“Due diligence processes were broken through the sheer madness in the [market,]” Oliver Kicks, principal and crypto lead at investment firm Concept Ventures, told DL News, adding that he hoped VCs’ vetting process “will now return to where they should [be.]”
Smith recognised that investing in startups is a high pressure business. In a bull market, VCs compete against other firms and face tight deadlines. However, he said it’s no excuse for failing to properly vet companies and avoid investing in poorly managed firms – even Ponzi schemes.
“It can be difficult, but frankly that’s the responsibility of the VCs – to balance the risk and any time pressures they’re facing versus their fiduciary duty on how to allocate capital,” Smith said.
Confidence in the industry
Some VCs are bullish about the outlook for the industry. Sayantan Mitra, partner at Cogitent Ventures, told DL News that investors with dry powder to inject into the industry endure “less noise” preventing them from ensuring that prospective investment targets are sound and “have done proper audits.”
Cogitent Ventures backed DeFi lender Archimedes’ $4 million seed round, announced in February, and also invested in several projects in January, rounds which have not yet been made public.
“Now that the froth has settled, company valuations have dropped to realistic prices,” Graham Friedman, head of venture at investor Republic Crypto, told DL News. “For an investor, this is the best time to come in and back the serious folk at a price that has major upside potential.”
He said that Republic Crypto has deployed about 50% of its capital in the 2022 and 2023 period.
Not everyone shared that optimism. “It is going to be a volatile area for the next six to 12 months,” Smith said. “But then overall, having more comparability and transparency into how these products and projects are going to be treated will ultimately make it more comfortable for investors to allocate funds going forward.”