Crypto & VC Structures
/ Chris Collins / 4.8.2019 /
Last week, Forbes published an article on how a16z is restructuring to better position itself to take advantage of opportunities in today’s markets. It got me thinking about investment structures I’ve seen and how GPs are maneuvering existing regulation in conjunction with the rise of cryptoassets.
In what follows, I’ll explain the different routes under exploration by crypto investors. It should be noted that I am not a lawyer so none of this should be taken as legal advice
The Venture Capital Exemption
The rise of cryptoassets introduced a new asset class that takes elements from the public markets (high liquidity) and private markets (nascent and highly risky business models with minimal/non-existent reporting requirements). At present, the SEC has attempted to fit this asset class under existing securities laws.
This has important implications for VC firms, the vast majority of whom operate under the Venture Capital Exemption (under the Dodd-Frank Act), which limits fund holdings at cost basis in “non-qualifying” investments to 20% of assets under management. In this case, a non-qualifying investment is broadly defined as publicly traded securities, funds, and long-term/high yield credit. In return for complying, VC firms are exempt from registration with the SEC under the Advisers Act, which implies less tedious reporting requirements. However, cryptoassets count against that 20% threshold.
More legalese on the Venture Capital Exemption can be found here.
Crypto Hedge Funds
In order to invest in cryptoassets, many crypto-native firms have chosen to register as hedge funds in order to do away with the 20% limitation. However, a hedge fund’s structure invites short-termism due to the redemption rights that LPs have. This makes hedge funds susceptible to decisions that can sacrifice long-term value creation in order to lock in short-term gains that appease LPs. Also, when bear markets occur, LPs are more or less free to redeem their capital precisely at the time investors should be entering positions.
Traditional VC Funds
Conversely, funds that choose to operate under the 20% limitation can invest with a much stabler capital base and focus heavily on long-term value creation. In order to stay within the 20% boundary, these firms will make a significant amount of investments in equity (with the option to convert to tokens if a company issues them at a future date). However, they don’t have the liberty to load up on bitcoin, for example, if they see massive potential gains to be made through direct cryptocurrency investments. As a workaround to gain this type of exposure, some firms have decided to invest in crypto funds (like Union Square Ventures).
As the Forbes article mentions, a16z has opted to structure itself as a Registered Investment Advisor (RIA). I believe the main impetus behind this move is a greater ability to invest in the crypto ecosystem. While initially only a16z Crypto Fund was an RIA, it probably became too much of a pain compliance-wise to operate multiple a16z entities with differing registration statuses. The firm was one of the first high profile VCs that started to dabble in cryptoassets and they are now making a bold statement that a massive part of their strategy going forward will involve crypto.
Additionally, the below restrictions associated with the VC exemption may offer clues as to what else a16z is considering.
Limited allowance for portfolio company founder liquidity in connection with investments. To the extent that a venture capital fund wants to provide founders of a portfolio company with some liquidity in connection with an investment (i.e., to acquire their shares directly), it would need to do so within the 20% non-conforming basket. Previously, the SEC had proposed a 20% allowance in this regard, but that was removed when the 20% basket was added.
As companies stay private longer, more founders and early employees are choosing to offload portions of their stake in order to take risk off the table. It’s possible that a16z may see an opportunity to ramp up its positions by buying these stakes from operators.
Secondary Market Transactions must be done under the 20% non-qualifying basket. Previously, the SEC had proposed an allowance for secondary market transactions; however, with the implementation of the 20% non-qualifying basket, the rules require all such transactions to fit within that basket. This could create challenges in valuations when calculating the 20% threshold, as addressed above, particularly if securities acquired on secondary or public markets appreciate significantly.
Sticking with the longer path to liquidity theme, secondaries are increasingly popular among investors that want to take risk off the table or need to return capital to LPs within a certain time frame. a16z could be positioning itself to play a prominent role secondaries market.
The Evolution of Private Market Investing
I respect the bold moves that a16z is making because, after all, venture is a game of outliers that requires bold bets to achieve outperformance. They have a clear investment strategy in mind and are adapting to their structure to make sure they can execute on their strategy within the confines of the law. As more firms restructure it will be fascinating to see how the market reacts and how these theses play out.