Uncovering the secrets of VC profitability: How to identify and invest in potential projects to achieve capital apprecia

Original author: Route 2 FI

Original translation: TechFlow

How can you become a venture capitalist? How can you start your own venture capital firm? How can you become a successful venture capitalist?

What does it take to have the opportunity to invest in the protocol and be at the forefront of the market?

This is what I want to explore today.

Venture Capital: Do you also want to invest in startups, my friend?

introduction

Sometimes you find yourself unhappy with the returns you receive in the market and the market declines causing your investments to suffer.

Other times, you see that everyone in the market is making money, but your personal performance is still not satisfactory compared to those big teams. So, who are these big teams?

There are many participants in the market, such as market makers, hedge funds, liquidity funds, and venture capital funds (VCs). The first three operate in a similar way: they mainly buy and sell tokens that already exist in the market. Venture capital funds are different, they will invest in tokens before they are listed.

Venture capital funds support your favorite teams from the early stages of the project, even when the team is still developing an MVP (minimum viable product). These investors firmly believe that a team can succeed and are willing to invest a large amount of money before the product is launched.

If the project is successful, the investment can achieve significant growth, but if the project fails, it can also face significant losses.

Venture capital has a high risk/reward ratio, but it is not just about investing money, it also includes supporting and working directly with the team to ensure the long-term success of the project.

So how do you become a VC? How do you start a VC firm? What does it take to be a successful VC? What does it take to have the opportunity to invest in protocols and be at the forefront of the market?

To start a venture capital firm, you first need to understand its basic structure, especially the key roles within it.

Each venture capital fund is typically made up of three main roles: limited partners (LPs), general partners (GPs), and founders:

• Limited partners are those who have a lot of money and want to increase their capital through venture capital.

• General partners are those with extensive experience who aim to increase LPs’ investments through successful transactions and earn fees from them.

• Founders are people who develop innovative products or services and want to bring them to market. They need investment to get their projects off the ground. If I were to describe the structure of venture capital in a diagram, I would probably choose something like this:

The mandate of LPs to GPs is quite clear: they only need to invest money and wait for the returns. The main task of LPs is to select the right people to manage these funds, with the goal of achieving significant returns.

Typically, LPs do not directly participate in the investment process of startups, as due diligence is handled by GPs. However, LPs can use their networks to provide GPs with potential investment opportunities and have GPs evaluate their investment value.

GPs typically report to LPs on a monthly, quarterly, or annual basis on the status of their venture capital funds, including changes in investment strategy, market sentiment, completed investments, and unrealized or realized returns.

GPs strive for transparency because venture capital is known to be a risky business; typically only 1 in 100 startups becomes a unicorn, a company valued at $1 billion.

Typical venture capital funds operate under the 2/20 model. This means that GPs will charge 2% of the total investment capital of LPs each year as operating expenses (mainly used to pay salaries, establish partnerships, sign agreements, legal affairs, etc.).

In addition, GPs receive a 20% fee for each successful investment, which is also called “carry.” This means that if the total investment return is $1 million, $800,000 goes to the LPs and $200,000 goes to the GPs as a success fee.

It is worth noting that most VCs are not good and their returns are not high. So why are LPs still willing to invest?

Venture capital usually invests in illiquid assets that are uncorrelated with other assets, thus hedging a small portion of the total assets under management (AUM). Large institutions and high net worth individuals usually allocate 5-10% of their funds to such investments.

However, the right GP can bring impressive returns. In 3-5 years, LPs may get 3-10 times the return, which is difficult to achieve in other asset classes.

So, how can you stand out and make LPs choose you instead of other fund managers?

Selling is an art that improves with every practice.

Even if you want to invest in other startups, you also need to raise funds at the beginning, otherwise you will not be able to invest.

Raising money for your fund is a unique process that gives you the experience of pitching to others because ultimately others will pitch to you, too.

The process is similar to traditional fundraising, but there are some differences. First, if you are a crypto-focused fund, you will only invest in crypto companies (otherwise the fund loses its meaning).

The backgrounds of LPs can be very diverse. If you are raising money for a crypto fund, you don’t necessarily need to look for LPs who are also from the crypto field.

The key is that you need to prove that you have the ability to bring them a substantial return. For example, I have a friend who is a GP of a crypto fund, and his LPs come from various fields such as e-commerce, real estate, and oil production.

This strategy is called a fund investment strategy. In fact, it is just a series of optimized parameters to help you invest more targetedly.

Some of these parameters include:

• Investment Stage. There are usually 6 stages: Pre-seed, Seed, Series A, Series B, Series C, and Series D. In addition, startups sometimes raise private rounds to hide the specific stage they are in. Focus on the Pre-seed, Seed, and Private rounds; these stages may bring the highest returns, but also the greater risk. This will be the key to your success.

• Value-added services. This is probably the most important factor. Investors often prefer to get smart money rather than simply invest and forget. Therefore, you need to provide additional value to the investment objects. For example, a16z provides support for almost everything from research and marketing to product development and recruitment. Identify what you (and your team) can provide in addition to funds, and work hard on this aspect.

It is not difficult to understand that most venture capital firms do not bring any other value besides providing funds, which is also the basis for us to distinguish excellent venture capital firms from ordinary ones. This difference is particularly obvious in bull and bear markets.

In a bull market, projects and capital are plentiful. Everyone (especially retail investors) is investing like crazy, and even the worst tokens can bring returns of around 10 times. Venture capital funds even have to fight for quotas for projects of poor quality because the market demand for tokens is very high. In this case, risk and return management becomes difficult because everything seems to be growing.

However, in a bear market, while there are many developers working hard to build (because a bear market provides a peaceful environment that is perfect for building), capital is relatively scarce because almost nothing is growing.

At this time, excellent venture capital shows its value, because they need to rely on multiple indicators, such as project team, sustainable token model, technical solutions, and overall vision and market strategy. This requires more skills, experience, and sometimes even intuition!

Therefore, if you plan to build a venture capital firm from scratch, it is best to start it at the end of a bear market or a bull market when there will be less competition and more options.

Talent matters—who should you hire?

Indeed, the team is the most important, just like in any field. Human capital is the most critical capital, so how do you build a good team? Who should you hire? The answer is actually very simple and a bit cliche: hire people who are smarter than you and build a team that can outperform the market.

Typically, VC teams are small; managing $50 million or more doesn’t require more than 10 people. Because the process is actually very simple: find (or be found) startups → identify the best → invest → help startups grow → sell your shares (Tokens) → get returns.

However, actually getting every step right requires a lot of experience and knowledge. Obviously, you can’t do it alone, so your ideal team should be:

Associates handle most of the communication between venture capital funds and startups. They are usually responsible for initial screening of startups and providing feedback, and they stay in touch with startups at all stages of the investment.

They source projects from every possible source, including Twitter, alpha groups, local meetups, conferences, demo days, hackathons, etc. Associates are also responsible for establishing deal flow partnerships between different VC funds, which share deal information from their respective networks to facilitate collaboration between funds.

Researchers focus on all research-related work, including token economics, business models, technical solutions, and market analysis.

They are also responsible for observing the market from a macro perspective and predicting trends and directions. For example, a researcher might research a project that has the potential to become a company in a portfolio.

This is great, for example, because you can predict where the market is going to go in the next 6 to 12 months and which companies are likely to create value in it. This gives you a more holistic view of the market as a whole, rather than just focusing on one specific protocol.

Advisors provide expertise and strategic guidance to venture capital firms and their portfolio companies, often working in a part-time advisory capacity.

Their responsibilities include sourcing potential investment opportunities, conducting due diligence, and providing strategic advice to portfolio companies. Advisors help startups connect to key resources and potential partners by sharing their network resources.

Investor relations (IR) specialists at venture capital funds are typically responsible for attracting and maintaining investor relationships. They work closely with the firms partners to develop and execute fundraising strategies, create investor materials, and manage communications, among other tasks. They also often handle media inquiries, prepare for investor meetings, and track investor sentiment.

Every component of the team is critical, and the GP’s key task is to ensure the team works together and delivers results, while overseeing the fund’s strategy and overall performance.

Organizing deal flow and strategy

Investing is a difficult task, should we just go with the flow? While we can do so, it would be too simplistic. To achieve better performance, it is better to build a sustainable strategy that can improve over time.

So, how do I achieve the right growth over time?

• Keep a detailed log for each startup. Over time, compile a list of competitors, including their performance and valuations. When you have a database of 300+ startups, having a brief summary of each one will greatly help you extract as much insight as possible from them.

• Work with your assistants to explore the best strategies for finding projects. When you are well-known enough, you usually don’t need to proactively go out and find startups – they will find you. However, as you grow, you need to actively participate in various activities such as hackathons, demo days and early-stage groups to ensure your presence is felt.

• Not only should you be precise, but you should also be flexible. If you can tell that a startup is not worth paying attention to during the first conversation, dont waste your time. If you encounter a very good startup and they are about to complete financing, be as flexible as possible to seize the best investment opportunities.

• Increase your online presence. Publish articles online, especially on topics related to your fund’s focus areas. For example, Paradigm did a lot of research on MEV and eventually invested in Flashbots, a research and development organization established to mitigate the negative impact of MEV.

What should you focus on when investing?

There are many indicators to refer to when making an investment or choosing a suitable project. But when you are faced with a protocol and decide whether to invest, there are several key parameters worth paying attention to.

• Tokenomics. The study of factors such as the token’s inflation rate, issuance, and rewards to stakers. The key is to avoid selling pressure and ensure that the token has a strong mechanism to incentivize people to continue buying.

• Technical/fundamental analysis. This area is probably the most difficult to research. If the project is very complex, you should ask an expert to help you identify the key points to focus on. Analyzing NFT collections is relatively simple, but understanding the workings of an independent L1 blockchain or developer SDK is much more complicated.

• Competitors. Look at the competitors of the protocol you are interested in investing in. How are they performing? What is their market share? How are they different from other projects? Do they have more advantages or disadvantages? By doing a comparative analysis, you can get a deeper understanding of the project you are researching.

• Ecosystem. Typically, most protocols are based on only one ecosystem, such as Ethereum, Solana, some Layer 2, or Cosmos, etc. The key is to evaluate whether a protocol fits in the ecosystem in which it is located. For example, someone developed a farming protocol on Optimism, but since Optimism is not focused on DeFi, there is no good reason to do so. You need to pay attention to these situations to ensure that the protocol can find its product-market fit (PMF).

• Investor research. If a project is in its second or third round of funding, it means that there are investors who have supported it before. You can research these investors, usually they are divided into levels, the higher the level, the better. For example, Multicoin is considered a top tier 1 investor and one of the best VCs in the crypto space, while Outlier Ventures is about tier 4. You can view some fund information in the table.

• Team. Make sure your team members have the experience and vision to build a successful project. Do they know what they are talking about? Are they smart? Do they fully understand the project proposal? Would you feel comfortable working with them?

There are other important parameters to consider, such as sentiment analysis, on-chain data analysis, partner analysis, and the difference between primary and secondary markets. The advice here is to tend to think that an investment is unfavorable unless there is clear evidence that it is a good one. Therefore, look for parameters and indicators that prove the value of the investment. If you cant find them, it may indeed be a bad investment.

in conclusion

Starting your own venture capital fund can be difficult because setting up operations and processes is always challenging. It’s like moving from one city to another, it’s hard in the beginning but it gets better in the end.

The goal is to achieve a return on the fund. For example, if you have $100 million in total investment capital and invest an average of $1 million per deal for 10% of the protocol, it only takes one unicorn project for your stake to be worth $100 million, so you can return the money to investors.

Remember, investing is an art, marketing is an art, communication is an art, and research is an art. Practice until you and your fund become one of the best artists in the industry.

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