Three Reasons Venture Capital and Decentralized Finance Don't Mix
Nearly every day brings news that a venture capital firm is investing in a decentralized finance ("DeFi") project. This is not surprising given that there is massive opportunity in this space, and DeFi projects, by their nature, have the theoretical capacity to grow at the relentless pace VC investors demand, even at the expense of profitability (the gap is filled with VC dollars, of course). Unlike most VC-funded startups, though, DeFi projects might be capable of growing at a parabolic pace and remaining profitable, which would make it the pinnacle of VC investments. A unicorn's unicorn.🦄🦄 If two-man DeFi protocols can gain $1B in TVL (total value locked) and have a governance token reach three or four figures all in a month, then what could a VC-funded DeFi project accomplish? It will not take long for more VC firms to notice DeFi, and I predict we will see a massive in-flow of VC dollars into this space. Effective deal sourcing is one of the keys of a successful VC firm, and there is untapped deal sourcing potential in DeFi relative to other industries.
It is not hard to see why VC wants in on DeFi, but does - or, rather, should - DeFi welcome VC?
DeFi might be the unicorn of all VC unicorns, which would cause a mass stampede (no pun intended) of VC dollars into DeFi.
I acknowledge that there are benefits to VC involvement in DeFi. Founders have more financial security and can leave their job to focus on the DeFi project. There is money to pay for expenses of starting the project - employees (if needed), requisite products and services, etc. VCs have helpful connections - potential partnerships, media connections, etc. VCs have knowledge about the best practices for a DeFi project as a result of their investing experience. But, in spite of those benefits, overall, I think DeFi should be very wary of venture capital in DeFi, particularly if we see the massive inflow of venture dollars that I predict, for the following three reasons. (As a side note, founders who of course want the benefits I mentioned in this paragraph could look into alternatives to venture capital, including DeFi-based ones.) Before I dive in, I want to explain my perspective on this topic. I am a self-funded entrepreneur who did not seek VC funding but who is familiar with the VC industry and the finance industry more generally as a result of, among other things, working in the industry. Without further ado, the three reasons I believe we should be hesitant about VC in DeFi:
🔸Venture capital in DeFi conflicts with the ethos of DeFi to disrupt traditional finance. Instead it perpetuates and enriches it.
The real potential and promise of DeFi is to revolutionize and replace (at least to an extent) our current centralized financial system, thereby eliminating some predatory and unfair practices endemic to our financial system. Venture capital is part of our existing problematic financial system, and the VC industry itself has certain predatory practices and is (without intention, I believe) racist and sexist. (I will expand on the predatory practices and racism and sexism further below.) Thus, venture capital in, and profiting from, DeFi is a direct conflict with the original vision of DeFi - it only serves to further entrench and enrich that existing financial system and the people who benefit from it. In fact, it links the fate of the existing financial system and existing power structures with the force that's trying to change it - if and as DeFi explodes, so does the wealth and power of the VC firms who funded the projects, which only serves to increase income and wealth inequality, ensure the continuation of predatory practices, and reinforce the existing hegemonic power imbalances. Essentially, it subsumes DeFi into the current financial system.
I'm not naive. I know that not everyone is in DeFi to change the world. (Really, is anyone these days?🤣) But it remains true that the more that the traditional finance system becomes intertwined with DeFi, the more DeFi becomes merely a convenience (i.e., the ability to perform a financial transaction trustlessly, permissionlessly, and quickly without providing a boatload of information about yourself) and not a potentially revolutionizing force. One solution to this problem is, of course, for DeFi participants who want to limit the influence of VC over DeFi to avoid venture-funded projects. But it can be difficult to determine which projects are venture-funded.
DeFi may be subsumed into the very system it initially sought to change.
🔸Venture capital fundamentally conflicts with the concept of decentralization.
In a typical startup, the VC investor has preferred equity putting them ahead of the founders and employees in an exit event and granting them other sometimes predatory rights. This post is not meant to cover the expanse of ways in which VC investments can be predatory, but I will give some quick examples (among many others):
- Full veto rights over future investments
- Pro rata rights - i.e., anti-dilution rights - based on percentage ownership from the round in which the VC invested rather than their fully-diluted cap table, giving the VC the right to a larger percentage of future investments than they initially realized
- Liquidation overhangs where the VC investor ends up, following conversion of their notes to equity during the Series A round, with substantially more liquidation preference than they actually paid for, at the effective expense of the common stockholders (i.e., the founders and the employees)
- The so-called "customary" terms of the typical early stage VC investment are quite lopsided in favor of the VC. (That's not even to mention the terms of the investment in the VC firm itself - 20% fee on the principal (over ten years), 30% to 40% of any actual profits, little or no ability to withdraw your money for ten years.) I am not concerned with whether the terms of venture capital investments are fair in light of the risk that the VC is taking - I only mention all this to point out that VCs take many steps to ensure that they exact their pound of flesh, which is a relevant point when it comes to DeFi - venture capitalists are very aggressive in seeking a return on investment and control.
A true DeFi project is meant to be controlled by the governance tokenholders with each token conveying equal control and rights. The holders of governance tokens are generally intended to be the actual users of the protocol such that when decentralization is complete, the users of the protocol control the protocol they use. This isn't a perfect system (yet) because sometimes whales use their large number of governance tokens to force decisions that hurt small tokenholders, but it is certainly closer to fair as compared to our traditional financial institutions in which most of us have zero say (imagine if you could vote to reduce overdraw fees or low balance fees at your bank) nor do we share in any profits from them.
Similar to the special preferred position VCs demand in typical startups, VCs will demand special control and rights vis a vis DeFi projects (they will have the same aggressive orientation I described above). I'm honestly not sure how this would be structured. It could be premined tokens (although this is out of favor), tokens sold from the treasury at a below market price (approved by multi-sig founders), maybe even the VC being one or more of the multisigs. Depending on the round of funding, VCs will often demand a seat on the board and being a multisig is a bit like being on the board (but with even more control since the board of a company only manages big decisions whereas the multisig controls everything until governance tokenholders take over). Even if all the VC has is a big block of tokens, that gives them outsize control. It makes them the whale I described above, capable of making decisions for the protocol that hurt smaller tokenholders. The investment will probably be made into a corporate entity but that doesn't change this analysis. In short, I am not sure how VCs structure their investments into DeFi protocols (it presents an interesting problem, actually), but what I am sure of is that VCs will ensure that the investment is structured in a manner that protects their rights and returns, and that is antithetical to the idea of true decentralization, especially if they have direct outsize control over the protocol, either as a multisig or by holding a substantial number of tokens.
🔸 Venture capital as an industry is racist and sexist (unintentionally, I believe), and increasing venture capital involvement will diminish DeFi's potential as a democratizing force.
Although not its primary purpose, crypto and DeFi have the potential to be democratizing forces to limit racism, sexism, homophobia, etc. A smart contract does not care about your race, color, or creed. You can launch a DeFi project anonymously if you wish. Venture capital is a racist and sexist industry - that is not to say that every person in VC is racist and sexist but rather that the industry as a whole has issues with racism and sexism. I am certainly not the first person to suggest this. (See here and here and here. Here is even a VC insider admitting it. That's not even to mention Ellen Pao, who alleged racism and sexism at a very high profile VC firm.) It is imbued in the very concept that a VC firm of, in most cases, 100% white male partners has the Midas touch to pluck the perfect "charismatic" founders from the bunch (like Adam Neumann & Masa, I guess - Masa believed in Adam because of his charisma). If you ask a VC partner what they're looking for in founders, charisma is usually one of the first words you'll hear. Charisma, by its nature, is extremely subjective and, in my opinion, is one element that introduces racism and sexism into the process. I believe that white men are much more like to find white men charismatic. (Not out of malice, simply out of comfort with and confidence in people like them.) Because VC partners are very disproportionately white men, they tend to fund startups run by white men. One more issue that I have with the concept of charisma is that women tend to mainly be deemed charismatic if they're attractive.
Don't get me wrong. I'm an entrepreneur and I believe founders are critical. I just don't think VCs are as good at selecting founders as they think they are - I think they are biased and don't realize it. (Not biased in a bigoted way, just biased the way we all are.) My big concern around this point is that I've raised it with multiple VC partners and every single one of them told me they are not biased and are able to objectively select the best founders. Some of them further pointed to various external excuses for why so many VC-funded startups are founded by mainly white men. If the industry does not even acknowledge that a problem exists, then it will never get fixed and will probably continue to worsen. Again, I'm not asserting malice, just a lack of self awareness. Some efforts are being made to work on this but this industry has very far to go. I actually think it is one of the worst that I have encountered on issues of race and sex.
Frankly, DeFi is super male and white as well. I'd love to see more women and POC in it. But we needn't make that worse by allowing DeFi to be swallowed up and controlled by an industry that has deep issues with racism and sexism. I don't want to see the influence of VC dampen the potential for DeFi to mitigate injustices like racism and sexism.
I am not faulting founders for taking venture dollars. But I do want to suggest that founders be thoughtful about whether they need VC investment and also at least consider alternatives, given that increasing VC involvement in DeFi may have a negative impact on the promises of DeFi, not to mention the question of whether you can even make a truly decentralized protocol that involves a VC. If the VC has more than a moderate amount of control (and even that...), I would call it centralized wolf in decentralized's sheep's clothing. There is nothing wrong with making a centralized crypto protocol, either. But masquerading as decentralized when you're really centralized is not cool. There's actually a risk that people will stop using the protocol when they find out. I don't think there is any question that the involvement of a VC in a DeFi project most definitely impacts the decisions and direction of the protocol. Consider VC-funded Unswap v. un-VC-funded Sushiswap. Consider Uniswap's requirement of $1,000,000 to even present a protocol proposal for a vote. Basically the entire development of Uniswap is skewed by the involvement of their VC investor, USV. I am just asking founders to be thoughtful about taking VC investments and to consider the impact on both DeFi and their own projects.
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About the Author: Emily Stork is co-founder of Worth The Fight Boxing & Fitness in Denver (Worth The Fight's website) and is forming DeFi-based crypto hedge fund, QuoinVault. She is passionate about cryptocurrency, especially DeFi and smart contracts.
