Investors jumping into Web3 find the rules are not so simple

ALL over South-east Asia, private market investors are witnessing a shift in conversation and money flows. Some of the smartest people they know have started discussing Web3 – a next version of the Internet based on decentralised technology.

Engineers and top executives from the likes of Grab, Meta and Amazon are leaving to build Web3 startups. Funding is pouring into the space like never before, and seemingly out of nowhere, a unicorn has emerged from Vietnam after creating the global hit game Axie Infinity.

It's enough for tech investors – some who haven’t even made a definitive mark on the Web2 space – to ask themselves: Just what am I missing?

“The interest is strong,” said Kenneth Bok, managing director of Web3 advisory Blocks.

“Family offices are interested in yields from decentralised finance (DeFi)…Private equity funds are interested in growth equity – (particularly) infrastructure plays,” said Bok. Venture capital (VC) firms, meanwhile, are rushing to understand the opportunities in early-stage growth across all verticals.

But Web3 is also rewriting the rules of investing. Those used to making pure equity investments are finding that token-investing is a large part of Web3 deals. The timeline for returns and the assessment of valuation and risk differ as well.

Law firm Morrison & Foerster has observed that over the past two years, partnership agreements for most new funds now expressly allow a fund to invest into tokens and other digital assets.

“Some limited partners are still unsure of this strategy, so it is common for a general partner to agree to limit these types of investments to under 10 or 20 per cent of the fund’s total portfolio in order to ensure that the fund’s exposure will not be too concentrated in this area,” said Jason Nelms, a partner specialising in fund formation.

For most funds formed more than 3 years ago, partnership agreements do not mention Web3 investments because the term was not popularised then. Fund managers either decide that they are permitted to make these new types of investments as part of the usual VC strategy, or ask their investors for consent, said Nelms.

One of South-east Asia’s pioneer VCs, Openspace Ventures, wants to be an early mover. Late last year, it began working on a fund called Ocular that looks exclusively at early stage Web3 startups.

Ocular has backed 8 companies including STEPN, a non-fungible token (NFT) game based on the play-to-earn concept where crypto rewards are gained through physical activities like walking. About 60 per cent of Ocular investments have been in tokens while the rest were in equity.

For token-investing, the most value is often captured at very early stages, said Amy Zhao, who leads Ocular.

“Our investment in STEPN was in January, it was listed on Binance in March, and now it’s trading at about 500 times our entry cost,” said Zhao.

Once tokens start trading publicly, investors are subjected to volatility, but it also lets them get to an exit much quicker than in equity investments.

Ocular’s fund life is 6 years – shorter than the typical VC fund life of 10 years. Zhao said its small cheque sizes reflect the risk it is taking on, with typical investments ranging from US$100,000 to US$500,000 compared with the core funds’ US$3-5 million.

This mix of token and equity investing creates new challenges. It requires an understanding of what is commonly referred to as tokenomics – how incentive and distribution structures work in a “token economy”.

Deals have to be carefully put together as well. “As the tokens may not always be a fully formed idea yet, how can a buyer do due diligence or precisely define and draft terms that secure the value they expect from the investment?” said Jonathan Olier, the executive partner of law firm White & Case’s Singapore office.

The first principles of drafting deals remain highly relevant, said Olier, including defining what investors believe they are buying – to secure the value they expect – and making sure the right counterparties are involved, which could include subjecting founders to a lock-in so they remain invested.

“As with all transactions, the devil is in the details. Yet, from what we observe, founders and investors tend to overlook a few key aspects when it comes to Web3 deals.”

Web3’s meteoric rise has put some investors on edge, including those who still remember the days of the initial coin offering boom and epic bust. Many issues still loom over the nascent sector, including excessive speculation, cybersecurity risks, and the impact of regulation on business models.

Still, that hasn’t stopped the unprecedented amount of money pouring into the space. Global VC investment in Web3 totaled only US$31.7 million in 2020, according to PitchBook data.

But by the following year, VCs had pumped US$443.5 million annually into Web3 startups – a 13 times increase. Just four months into 2022, investments have already hit 2021 levels.

Much of the activity is happening in the US but South-east Asia is beginning to see more action.

Singapore-based DeFi analytics startup Treehouse in March announced US$18 million in seed money from investors including Binance, Lightspeed and MassMutual Ventures. The Philippines has also become a hotbed for crypto adoption, with Axie Infinity finding a large player base there.

“I think the reason that (Web3 has) caught such attention is that investors are looking for the next platform shift,” said Billy Naveed, chief strategy officer of venture builder and investor Smile Group. He added that the last major platform shift was the proliferation of smartphones.

But unlike the mobile-first revolution in South-east Asia that gave rise to models like “the Uber of Indonesia” or the “Amazon of Philippines”, geography matters less in Web3 investing because startups are by nature global, said Naveed.

It could take newcomers some time to adapt to the Web3 culture, with its distinct characteristics such as founder anonymity and community-driven nature.

Some believe there is exclusivity in Web3 investing as well, with so-called “crypto natives” – such as the investment arms of crypto exchanges – drawing the bulk of deals.

The space is set to heat up even more as Web3 players set up their own funds. Singapore startup Cake DeFi recently launched a US$100 million venture arm to find its own deals.

“Anybody who has a good position in the crypto market is going to become an investor in some way, shape, or form,” said Jon Russell, partner at Crypto.com Capital. “It’s such a liquid space – imagine there are IPOs happening every day. If you’’e in the industry, you’d think, ‘Gosh, I should be taking part in some way.’”

It would take effort for new investors to break into the Web3 world, said Vishal Harnal of 500 Global, which has been investing in Web3 startups for some years.

To kickstart everyone’s understanding of the sector, the VC firm minted NFTs on OpenSea for its nearly 200 employees to claim — but only if they could figure out how to set up a crypto wallet.

In the Web3 space, it’s easy to tell whether someone is genuinely interested, said Harnal. “It’s up to the investors to take those steps and make efforts within those communities to show that value — that you can be of service to the companies and communities in some way, based on whatever your unique talents, skills or abilities are.”

As much as traditional VC and Web3 investing differ, the fundamentals of evaluating early-stage companies and founders remain the same, industry players said.

“Extract everything away, and it’s about assessing people and building relationships. Those things will never change,” said a startup founder who, in true Web3 fashion, only wanted to be known as 0xBob.