Uncertainty has a way of slowing everything down and forcing people to reflect on where they are, where they’ve been, and where they’re going. The investing universe in crypto has been caught off guard from a few years of higher interest rates and global uncertainty around trade and geopolitics. Yet there are other forces that are critically problematic for crypto, independent of exogenous forces. The quiet scourge that continues to drain time, capital, and conviction: shadow investing.

(Shadow investing = backing a rival after missing the category leader, often to maintain exposure rather than based on differentiated conviction.)

The Brilliance Problem

Finding exceptional talent is the pursuit of every firm in the world but the universe of brilliance is not infinite. Brilliance is a very tough find and even more difficult to force and in some ways, completely sporadic. Companies that come up with “Eureka!” like moments are not able to forward project unexpected outcomes but instead focus their energy and time on creating as many opportunities for brilliance to strike.

In a similar vein, venture capital firms run into this problem as venture is not a linear game. More money in does not equal more brilliance out. This was well understood at the advent of modern venture capital in the early 80s / 90s and well into the 2000s but as expectations and appetite from investors grew, so too did the budget for venture and the search for brilliance. But this is at fundamental odds with venture investing — “How does one find more opportunity when it doesn’t exist?”.

Enter: Shadow Investing

Every few years, we come across a new protocol, project, or business in crypto that truly changes the game and creates meaningful value. These are the delights of every investor and the working goal for each team. Yet the pace and size of these investments make them scarce (by nature) and the lack of original thinking causes investors to start localizing on the existing meta by choosing the zeitgeist option for their next investment. Simply said, investors look to the new meta that exists in the space and choose to back weak “competitors” of projects that they’ve missed out on.

Why it Happens

It’s no secret that I have many critiques of the venture landscape in crypto. You can find my rants across old podcasts, tweets, or writeups but all of these commentaries touch on the same starting point of the Crypto VC Supernova thesis (the idea that there are too many dollars, and in turn too many VCs, in Crypto). There are many net externalities from this type of perverse condition in the space but the perpetual funding of cheap copies of exceptional companies is one of the worst.

The current flow for capital allocation in crypto (or any market for that matter) is simple:

• LPs (limited partners) invest capital into venture firms
• Venture firms take said dollars and deploy into startups across multiple stages
• Startups use that cash to grow and build companies

This model is simple but breaks when there are too many dollars in LP’s hands and thus they over-fund crypto venture firms by giving a lot of money to a lot of investors. In crypto today, there are more than 20 firms that have 9-figures in capital at the venture level, from seed to later series. If every firm (even if we only consider 20 VCs), did 1 deal per quarter, that would still equal 80 investments in a calendar year. In reality the deal count is substantially higher, in the multi-hundreds, annually. There are not hundreds of valuable crypto companies to invest in annually. Even more so, there are not dozens of metas or narratives in crypto to invest in annually.

Instead, we’re left with two truths:

• There are too many dollars in Crypto Venture Capital
• There are too few quality companies to invest in

But still, these dollars have to make their way to market in some way because they are dollars that are designated for companies. As a result, these dollars make their way to the market in companies that fit the same zeitgeist that was most recently invested in: shadow investing.

Much of the market between layer 1, layer 2, wallet, perpetual dex, lending protocol, and bridge, are poor imitations of each other as their original counterpart’s value drives demand that cannot be funded. Take the example of Uniswap as the category first and leader of the decentralized exchange landscape. Hundreds of millions if not billions of dollars in funding have pushed cheap knock-off versions of Uniswap but have failed to deliver meaningful value or iteration in vision. Instead we’re left with a decimated landscape of token inflation that has killed much of the space. There are obviously many companies that build quality iterative products and not every derivative company is exactly a cheap immitation but these tend to be the exception not the rule.

“The imitator can only go where the leader has been. He cannot go beyond.”

— Peter Thiel (Zero to One)

A big problem that extends from the cheap imitation gambit in crypto venture is also upgrading and maintaining a product. Much of crypto’s best projects start as promising builds but always promise a bigger picture of growth and a lot of maintenance. This pushes a myriad of problems from security of a protocol to building out a cogent product vision. How many times have forks of projects resulted in millions of dollars of hacked or exploited funds?

The problem’s end point reaches the root venture firms that are funding these deals. Inevitably the space at large, when the space and its best investors cannot differentiate between quality investments and weak imitation, has its reputation stained from shadow investing. How many funds can we look at and how many teams can we see that are funded directly as the end result of a genuine product that came to market. Imitation is flattery but not when the imitation market is massively overpaying for the “good” that dies out. If crypto is to become a serious industry, committed to even a semblance of capital preservation, then the space and its investors must grow up from their funding antics and seriously remain stringent on investing in teams that are genuinely committed to innovation…or so I hope.

Fin.

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