The following is a summary of “The Challenges Facing Venture Capital In Digital Asset Markets,” a Vanderbilt Law Research Paper and forthcoming chapter in “The Research Handbook on the Structure of Private Equity and Venture Capital.” The authors are Yesha Yadav, Milton R. Underwood Chair of Law, and Khalil Bryant, Associate at Haynes & Boone in Houston, Texas.
The struggling fortunes of the cryptocurrency industry, culminating in the collapse in November 2022 of the crypto-exchange FTX, has left prominent venture capital firms facing an uncomfortable bind. On the one hand, high-profile loss-events are par for the course in a funding model premised on seeding experimental, high-velocity ventures with an endemic risk of burn-out. On the other, investing in the digital asset ecosystem, often through Decentralized Autonomous Organizations (DAOs), has shown itself as a uniquely challenging regulatory proposition – even for those typically fluent in navigating dangerous waters.
Crypto markets pose a deeper, more fundamental challenge to traditional venture capital that cannot simply be addressed by instituting more searching due diligence. Critically, venture firms are traversing an investment arena often characterized by legally novel and complex categories of assets, an atypical trading and market structure, and emerging governance paradigms designed for more decentralized, disintermediated transactional environments.
Under a cloud of regulatory uncertainty in the U.S., venture firms confront thorny questions when seeking to price risk, or calibrate the likelihood of enforcement actions, where threat to reputation, legal costs and the need for payouts or outright business closure could result in perilous outcomes for those investing in crypto-firms.
The digital asset ecosystem also holds out the possibility of putting growth capital directly into ventures that aspire to operate in a more automated and decentralized manner. Capital providers may be rewarded through the issue of digital tokens that bear governance rights, alongside access to services delivered by the venture. For example, automated processes for deliberating may entail participation by any number of (everyday) token-holders – a practice contrasting sharply with the focused access and governance generally enjoyed by venture firms. Further, the usual pathway for successful venture exit – via an initial public offering – does not map into the digital asset ecosystem, where rewards tend not to include a right to a project’s future cash flows at all.
However, venture participation in DAOs also comes with the promise of novel kinds of benefits. The digital asset ecosystem also holds out the possibility of putting growth capital directly into ventures that aspire to operate in a more automated and decentralized manner. Capital providers may be rewarded through the issue of digital tokens that bear governance rights, alongside access to services delivered by the venture. Venture firms are often ideally placed to guide novel blockchain-based technologies from inception to launch.
In the research paper “The Challenges Facing Venture Capital In Digital Asset Markets,” Yesha Yadav, Milton R. Underwood Chair of Law, and Khalil Bryant, Associate at Haynes and Boone, provide a brief introduction to some challenges confronting the venture capital industry as they look to engage with the digital assets market. It includes a primer on crypto-assets, which highlights some of their novel attributes and costs of a limited federal regulatory framework for their oversight; some key practices and legal paradigms traditionally relied on by venture capital firms when funding start-ups outside of the crypto ecosystem; the challenges posed by digital assets for venture capital, exemplified by attempts by venture funds to capitalize decentralized autonomous organizations (DAOs); as well as regulatory gaps, their impact, and some conclusions.
