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After the 2022 cryptocurrency industry cleanup, what will be the future?

Leo

Read this article in 30 Minutes

The purified cryptocurrency industry will steadily advance again.

Original Title: The State of Crypto Funding in 2022

Original Author: Steve L.R. Kamer, Ex-Banker, Blockchain enthusiast

Translated by: Leo, BlockBeats

For crypto, the sprouts that grow back in the ruins may be the towering trees that shelter us from the storm in the future. BlockBeats has compiled an article by Steve L.R. Kamer on "Current M&A and Venture Capital, and How the Current Market Shapes the Future of the Industry" as follows:

Face the reality, the crypto and blockchain industry in 2022 is in a dilemma, partly due to industry characteristics and internal chaos, but also due to external forces such as geopolitical tensions, persistent inflation, and long-term trade interruptions that are cooling the global economy and reducing risk appetite for assets such as cryptocurrencies.

During such a difficult period, we have seen the difference between the strong and the weak, with the winners being crowned and the losers stepping down. The concept is actually quite simple - survival of the fittest.

In this article, I will explore how the current market environment affects blockchain companies, what they need to do to increase their survival chances, and how mergers and acquisitions and venture capital should balance the current situation.

把钱拿出来

translates to

Take out the money

Buy when there's blood in the streets. - Warren Buffett

You don't need to be a market expert to realize that so far, the crypto and blockchain industry has experienced a tumultuous year, from regulatory uncertainty to rampant hacking; the failures of massive crypto empires like FTX and Luna; executive departures and legal issues, which not only caused cryptocurrency prices to plummet to multi-year lows, but also eliminated much of the trust that the blockchain industry has painstakingly built over the years.

You may think I am wrong, but many failed projects have internal manufacturing problems. They are driven by greed and unwillingness to face risks correctly. Many projects often start with an unstable foundation. In other words, the blockchain industry is full of self-proclaimed masters, ruthless harm, and short-sighted investors who only focus on their own actions and never think from the perspective of the industry.

Dot-com bubble and its relationship with Web3

People sometimes have a nostalgic feeling, and history is often the best teacher. I have to compare it with the Dot-com bubble in the early 2000s.

Looking back, the internet was similar to crypto and blockchain at that time, in a similar stage. In the late 1990s, the internet was still an abstract concept, and some tech enthusiasts claimed that it would change the world. Many companies had almost no rules and regulations, resulting in a fragmented industry with no dominant players in the market. Many startups promised too much and delivered too little, and regulatory agencies worked hard to control the situation.

Since the mid-1990s, relatively stable interest rates and "cheap" funds have meant that start-up companies can obtain sufficient funding, with valuations reaching millions of dollars even before the launch of their products or services. Some companies (not to be named) can even go public on the US stock exchange based solely on their business plans!

Then, in the late 1990s, the Federal Reserve began raising interest rates due to concerns about an overheating economy, coupled with soaring company valuations and dwindling funds. With a lack of sustainable sources of income, or simply no products to sell, many companies went bankrupt, leaving behind disillusioned investors, lawsuits, and most importantly - a loss of trust in the industry.

The intensification of risks also means that investors begin to withdraw funds and protect their interests, and start selling technology stocks frantically, which will soon spread to other risky assets, ultimately leading to the "tech winter" and the "mild recession" later referred to by analysts.

"The internet bubble is also related to the NASDAQ. From January 1995 to March 2000, the NASDAQ Composite Index rose from 751.49 to 5132.52, an increase of 582%. From March 2000 to October 2002, the NASDAQ Composite Index fell by 75%, wiping out most of the gains since the initial appearance of the internet bubble." - Corporate Finance Institute

This is a real technology frenzy, which ultimately led to the almost complete collapse of the industry. So, what was the ultimate mastermind behind this bubble?

Company valuation is too high

Abundant Capital

Media frenzy

Does everything sound familiar?

History seems to repeat itself

Despite the despair in the technology industry, not everything is predetermined. The internet bubble has also given rise to a series of new regulations aimed at creating a fair competitive environment, protecting investors, and providing better prospects for solid and stable projects.

Soon people realized that the burst of the Internet bubble was not due to the deficiency of underlying technology, but rather due to the projects and frameworks built on top of the technology.

The internet has always existed in some form or state. If I were to depict it as nature, the internet would be a forest fire. Although destructive, it can have a purifying effect, providing fresh fertile soil and space for regrowth, making it stronger and more diverse than before. This may take several years, but time is a relative concept. In the macro development process of an industry, ten years is just a fleeting moment.

Another interesting fact is that not all trees will disappear in a wildfire. Weak and inferior trees will perish, while strong trees will persist, carrying scars but surviving and bringing new life to the entire forest.

Ironically, startups are often victims of the so-called "burn rate". The burn rate defines the speed at which a company's available funds are consumed. As you may have guessed, relying solely on hope, seed funding, and venture capital is not a sustainable business plan. This may work for a while, but if the industry climate becomes more hostile and funds dry up, ultimate failure is inevitable.

Survival of the fittest

In my opinion, the crypto winter is remarkably similar to the internet bubble. Despite the fact that many people believe that distributed ledger technology has enormous potential, the industry is still in its infancy, experiencing a similar boom and bust period as the internet did twenty years ago.

Despite the increasing cost and difficulty of financing, the "shiny coat" of the blockchain industry has already begun to crack. Before we assess how this will affect companies and their future financing, let's take a look at some of the problems facing the blockchain industry mentioned earlier.

Executive Departure

We have seen reports that many high-profile executives in the crypto industry have left, or at least temporarily left. CoinDesk published an article titled "Why Are So Many Crypto Execs Leaving?" which also revealed some key issues:

Why do captains abandon seemingly intact ships and run away?

What does their departure mean for the remaining companies, employees, and stakeholders?

Are all these projects illegal from the beginning, just to fill the pockets of a few deceitful businessmen behind the scenes?

Especially for emerging industries, the development of a company relies on the management and leadership skills of its executives, rather than the actual success of its basic business. When raising funds, having a strong executive reputation is often the key to success or failure. You may have the best project or idea in the world, but without a well-known leader to drive it and make it a reality, you will find that the fundraising stage is already difficult to navigate.

A leaderless company may also face opposition from new and existing investors, making it difficult to attract new capital and even leading to the worst-case scenario of capital outflow.

缺乏透明度
Lack of transparency

This is controversial, but it is also the most interesting, especially in the blockchain and crypto industries, which boast of providing unparalleled transparency. However, many projects fail precisely because of a lack of transparency.

When both the project and the project gatekeepers are opaque, what are the benefits of transparent underlying technology? TradFi experienced the tragic failure of Lehman Brothers in 2008. Why does it take a bankruptcy the size of FTX to prompt cryptocurrency trading platforms to disclose their security procedures and reserve proof? Haven't lessons been learned from past failures?

On the other hand, we still see "investors" putting their money into any project that promises quick profits. I don't want to discourage you, but if it sounds too good to be true, it probably is.

Opaque business practices, coupled with widespread risk aversion, may impact financing and acquisitions. Looking again at FTX, Binance initially intended to acquire it to maintain market integrity. However, a few days later, Binance withdrew, claiming that the complexity of FTX's issues was insurmountable and could ultimately harm their own business, causing even greater ripple effects.

Lack of regulation

Similarly, there is a great deal of disagreement on this issue among industry practitioners. My view is that although excessive regulation can stifle innovation and make the market exclusive, lack of regulation can lead to anarchy and harm everyone, except for ruthless businessmen.

Yes, I have repeatedly mentioned this topic in many of my articles, because meaningful regulation is crucial for the adoption of blockchain in the future and the survival of crypto.

From the perspective of venture capital, an unregulated market is difficult to manage, as it reduces the quantifiability of risks and hinders the ability to evaluate investments accurately. Regulatory uncertainty may mean that a potentially profitable investment fails without warning.

Capital Cost

If you want to start a company, capital is one of the most basic requirements. In the past decade, this has been an easy task, except for some temporary declines, the global economy has steadily risen under the push of cheap funds. Applying for loans or seeking capital was simple and almost did not require any funds. However, soon the situation of abundant funds changed. Regardless of the risks, people will invest money in anything that has a return.

We can discuss in detail how to value a company and the impact it will have, but this is beyond the scope of this article.

In short, cheap funding (i.e. low interest rates) means a lower discount rate and higher company valuation. When the central bank suddenly starts raising interest rates, for example, to combat inflation, the valuation of companies based on discounted cash flows begins to decline. (If you are not familiar with discount rates and cost of capital, click the link.)

The conclusion is that the rapidly changing company valuations greatly affect their ability to obtain funding, maintain operations, and grow.

So, what does all of this mean for the blockchain industry?

Integration Effect

Recall the history again. Despite the ruthless burst of the dot-com bubble, some companies had enough capital and structure to survive. In the early 21st century, people began to use special funds to frantically search for talent and promising projects that they could afford. Google, Amazon, Priceline, Microsoft, Apple, or others?

The result is the rapid integration of the technology industry, no longer dominated by a few giants. The era of technology unicorns has emerged, with some unicorns becoming so powerful that they continue to dominate our daily lives, leading to a series of new problems.

However, the lessons learned from the bursting of the dot-com bubble also led to the improvement of new rules and regulations. Until now, these rules and regulations have prevented a repeat of the Web 2.0 bubble, although there are still some issues. Finally, Web 2.0 has matured.

History always repeats itself. So far, the development of the blockchain industry has followed a similar path to that of the internet. When looking at the history of mergers and acquisitions (M&A) in the blockchain industry, some interesting theories can be observed.

2013-2022 M&A Activities

Despite the fact that M&A transaction activity in the encryption industry seems to have peaked in 2021, the average value of each transaction remains at a historical high. Between 2016 and 2020, the average transaction size was about $20 million, and in 2021, this data increased by about 100% year-on-year. However, it does not seem to have decreased significantly in 2022. One explanation is that buyers are still willing to pay large sums of money, but what they are buying is more specific. Another explanation is that due to the decline in the encryption industry, more projects are prone to failure, resulting in fewer buying opportunities in the market. Assuming that the demand of buyers exceeds the supply, we can expect higher competition, which will provide higher acquisition prices for high-quality transactions.

M&A Outlook

The trend of rising average prices may or may not continue, and there is currently no consensus. The recent global economic uncertainty and strict regulatory requirements for the crypto and blockchain industry may hinder the completion of transactions in the short term. On the other hand, the pursuit of vertical or horizontal integration of business by well-known enterprises to help cope with new (legal) requirements, further scrutiny, and demands for transparency may accelerate merger and acquisition activities in the medium term.

TokenData's report previously supported this argument, showing clear differences between strategic and financial mergers and acquisitions. Although the markets in 2018 and 2021 were largely driven by financial M&A, the trend has shifted towards more strategic acquisitions. In an era of high financing costs, uncertainty, and low demand for risky assets, this seems logical.

Strategic acquisitions aim to improve operations, reduce supply chain costs, and strengthen existing enterprises. Large companies with strong balance sheets will seek to integrate competitors and potential disruptors to gain an advantage. A good example is the acquisition of TradFi, which attempts to integrate cryptocurrency and blockchain providers to enter the market. From a strategic perspective, there is a greater opportunity to find better deals in demanding environments.

On the other hand, financial acquisitions are more like a bet on the future success of a company, with the buyer's interest typically being purely financial and speculative. Uncertain industry prospects can reduce the potential for future returns, thereby reducing the prospects for financial mergers and acquisitions.

Strategic M&A: Deciding to acquire a company to further strengthen its brand or eliminate competitors through vertical/horizontal integration.

Financial M&A: Acquisitions conducted by financial companies such as private equity firms and SPACs.

Therefore, we may see consolidation in the blockchain industry, with many smaller companies being integrated into larger, more dominant companies. Another driving factor for consolidation is the increase in financing costs, which makes it difficult for small projects to survive on borrowed assets. Some projects will have to obtain life cycle funds at a significant valuation discount, otherwise they will face the risk of bankruptcy.

The question remains whether the integration happening in the Web 3 space will lead to a few controlling the many, as we saw in Web 2. More importantly, what does this mean for the decentralization of blockchain technology?

Before answering these questions, I would like to briefly talk about venture capital, as it is an important source of funding for many projects.

Overview of VC Industry

After the highly active years of 2020 and 2021, this year is undoubtedly different for the venture capital industry. In the past few years, the "good times" of the blockchain industry have attracted investors of all sizes. However, I have seen increasing changes. If your assumptions are correct, venture capital is the most profitable risk game. The fragmented and increasingly complex environment of blockchain and crypto is advantageous for VCs, who have abundant resources to evaluate investment opportunities and quantify related risks.

In order to obtain funding, blockchain companies must improve their quality, fulfill their promises, and provide transparency. Looking ahead, funds will flow towards projects that solve real problems and bring added value to consumers.

Finally, venture capitalists are constantly searching for better deals. The current industry turbulence has a purifying effect and is expected to remove more and more bad actors from the market. As a result, VCs will find it easier to identify suitable opportunities.

If you are the party raising funds, ask yourself how to attract capital. Here are some ideas on how to position yourself:

- Ensure business operations are transparent and easy to understand;

- Taking responsibility means that stakeholders must be able to solve problems and someone needs to be accountable for the project.

-Do not raise too much capital for the project at the beginning, and a high company valuation will also bring higher expectations to investors and stakeholders.

-Provide a solution to a real problem and emphasize the advantages of this solution. Do not make crypto or blockchain the main driving factor of the project, but focus on the value added by the solution and how Web 3 supports it.

-Start small, focus on a specific problem, make it work, then focus on expanding.

- Focusing on user experience, Web 3 is still a niche industry, with the greatest growth potential coming from attracting first-time users by lowering entry barriers.

Decentralized Risks and Opportunities

The definition of decentralization is at the core of the entire blockchain debate. As mentioned earlier, I support the idea of not allowing a single entity to control too many concepts. On the other hand, I am happy to partially delegate some responsibilities in exchange for comfort and usability, but this is a personal preference.

Risk

The original purpose of the Internet was to simplify knowledge transmission and improve global communication, but information is a powerful tool and whoever controls it bears great responsibility. Clearly, after the integration of the early 21st century, the main drawback of Web 2 is the transparency and centralization of data control. Therefore, the idea of introducing blockchain technology seems attractive, but we must be careful not to blindly follow a new messiah just because they promise to do better than before.

Opportunity

Undoubtedly, Web 3 has tremendous potential in improving transparency, efficiency, and control of information. By introducing protective mechanisms and combining meaningful rules and regulations, we can correct the shortcomings of Web 2. Consolidating power through M&A or other means is not necessarily a bad thing, as it can help create efficient, vertically integrated solution providers, reduce development costs, establish industry standards, and create usability. However, we must ensure that those who consolidate power are held accountable for their actions through transparent business practices, reporting requirements, voting rights, or other forms of stakeholder participation in case of misconduct.

Conclusion

Undoubtedly, the current situation of the blockchain industry is very complex, but it also provides huge opportunities. The current encryption industry is moving forward against the wind, but what will ultimately change is the face of this industry today.

As players seek discounted entry, more popular and widely adopted options will continue to attract capital. With vertical and horizontal integration of companies, an increase in strategic M&A may bring further consolidation. The key is that blockchain technology provides the necessary transparency to keep these "big players" under strict control. No matter how much data you control, if anyone can see what you're doing with it and you can be held accountable for improper behavior, the likelihood of abuse of power will be greatly reduced.

Returning to Buffett's words, who wouldn't want to buy a reliable Web 3 project at a significant discount?