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Ponzi schemes by crypto VCs become increasingly common during bear markets, with more and more invested companies being asked to refund.

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Original Title: "Thoughts on the Crypto VC Landscape in Bear Market: Increasingly Common Demands for Refunds from Invested Companies Due to False Book Profits"

Original Source: TechFlow Deep Tide

Firstly, we need to define two important indicators.

DPI (Distributed to Paid-In Capital) is the cash distributed to LPs after deducting management fees and performance fees. This is the most important metric for LPs to date, as it cannot be fabricated and is the most accurate measure of fund performance.

TVPI (Total Value to Paid-In Capital) is the value of a fund's assets calculated at market prices, also known as "book gains". Venture capital firms have significant discretion in how they mark their assets (see below), so TVPI is often exaggerated. Excellent LPs can easily dig deep and see through false TVPI during due diligence.

1. Most funds with high TVPI have low DPI.

This is the famous "VC Ponzi scheme" described by Chamath, showing your book profits to LPs in order to raise large amounts of capital and earn hefty management fees.

Especially in the field of cryptocurrency, venture capitalists have a lot of leeway in deciding how to account for their investments. For example, if a venture capital firm invests in a project that launches a token with a lock-up period of several years and low liquidity on exchanges, many people may choose to mark their investment at the current spot price of the token without any discount, even though they cannot sell the token to realize such returns. Therefore, this is why new shiny L1 VC chains continue to receive funding.

Therefore, the prudent approach is to achieve good DPI over time to display that your returns are genuine. While having a high TVPI is certainly desirable, you should let it fluctuate with the market and write down your investments at the appropriate time.

2. Most 2017-18 vintage funds have a DPI lower than that of a16z crypto Fund I.

Obviously, I cannot share exact numbers, but a16z's ability to multiply fund size is very impressive.

a16z is a great brand, and for large institutional LP investment committees that must reach consensus on decisions, investing in a16z is equivalent to "no one being fired for choosing IBM".

For other less well-known funds, if their returns may be worse, LPs also need to bear more reputation risks. So why should LPs choose them instead of a16z? This is especially true for individual GPs who are currently raising their second fund and have poor performance in their first fund.

3. The one-year bull market fund in 2021 is one of the worst performing funds.

One-year term refers to the fund quickly raising and deploying all funds within a year, and then raising the next fund in the second year. By inquiring with institutional LPs who have been investing in the venture capital field for decades, I cannot find a historical case of a one-year term venture capital fund performing well.

Any LP will tell you that the most important factor in fund returns is the number of years, not the ability to obtain good trading flows or select good companies. However, as a venture capitalist, you cannot control the macro environment. Your job is to find the best founders and themes in your field and slowly deploy them over multiple years to diversify macro risks.

For cryptocurrency venture capital, 2021 has been a particularly bad year. Seed funding has been completed at crazy valuations of over $50 million before product launch, with no meaningful risk/reward. So many startups are raising funds that VCs feel pressure to deploy capital. In addition, startups are raising follow-on funding in a short period of time, forcing early investors to exercise their equity proportionally to maintain their ownership percentage before seeing meaningful product traction. This has led to a faster-than-expected deployment of venture capital and a quicker return to LPs for the next round of funding.

4. Either small seed funds or large index funds, there is a no man's land in between.

This is a good example of dialectics (the truth of opposition in extreme cases). Seed funds are "snipers" that provide the first capital for startups with attractive valuations. In this case, risk/reward means that the fund only needs one successful seed investment project to get a return. Large funds, on the other hand, are "aircraft carriers" that manage the market index and have meaningful ownership in companies that go public after most of their products are launched.

The size of a fund is often a legitimate signal of competition among venture capital firms. New fund managers feel the pressure from their peers and hope to raise assets under management in the billions of dollars, but the fund size game often favors existing brands. Seed funds that raised larger funds without constraints on fund size during the bull market are currently in a middle position, with a size that is too large to have upside potential in seed fund investments and too small to become a well-known brand. They cannot raise funds of such size again in the short term, and reducing the fund size would lower management fees.

You can raise a larger fund, but that doesn't mean you should do it.

5. Unfortunately, in bear markets, it is becoming increasingly common for VCs to retract term agreements and demand refunds from invested companies.

Withdrawing a term sheet means that the venture capital firm has agreed to invest under specific terms, but the cryptocurrency market crashed while waiting for legal documents to be completed, causing the venture capitalist to back out of the deal. This does not necessarily mean that the venture capitalist had actually signed the documents; refer to YC's handshake agreement for what is considered industry standard. In any case, this sets the founders back by months as they have to waste time raising funds again in a worse environment.

Requesting a combination company refund means that venture capitalists provided funds to the company during a bull market, but now regret it and want the company to return their money. This is not as bad as a withdrawal clause, as it is clear that the founder is not obligated to agree to a refund, but it still tarnishes the reputation of the venture capitalist as being "founder-friendly".