In the world of venture capital (VC) investing, particularly at the early-stages, the power law reigns supreme. It’s a concept that has reshaped investment strategies and expectations across sectors, and now, it's playing a transformative role in the cryptocurrency space. As crypto markets continue to develop, understanding the power law is key to making sense of both the present moment and the long-term potential of this highly volatile market.
While many digital asset projects are struggling, and altcoins are far from their peak, this environment is neither unexpected nor cause for despair. The crypto ecosystem, much like traditional VC-backed sectors, is designed for a world where a handful of projects deliver the majority of returns, with others fading into the background. What matters is not the current mood in Telegram groups or Twitter, but the reality that despite the noise, a handful of successful projects will lead to outsized returns and significant industry shifts.
What is the Power Law?
The power law in venture capital refers to the distribution of returns in a given portfolio. A small number of investments account for a disproportionate share of the profits, while most other financings either break even or result in losses. In venture capital, this often means that 10% to 20% of the investments can generate 80% or more of the total returns.
Crypto VC follows this same principle. Despite the extreme volatility of the crypto market, a select few projects consistently emerge as market leaders, providing substantial returns to early investors. For VCs, the strategy is to allocate capital across sectors with the highest growth potential, aiming to secure stakes in the select few projects that will dominate the market and deliver exponential returns, fully aware that many other investments will likely fall short.
In traditional venture capital, the power law is best understood through the lens of high-risk, high-reward investing. VCs are willing to invest in dozens of companies, knowing full well that most will fail. However, those failures are more than compensated for by the few that succeed, often returning 10x, 50x, or even 100x the initial investment.
In the world of crypto, these dynamics are even more pronounced. A few reasons why power law effects are stronger in the digital asset VC space:
- Faster liquidity cycles: In crypto, the lines between private and public markets are blurred, with tokens becoming tradable much earlier. VCs can realize gains or even increase their stakes after projects go public. Unlike traditional startups, which may take years to go public, crypto projects often launch tokens early. This creates faster liquidity opportunities for investors, allowing them to recycle capital or reinvest into new projects.
- Continuous funding models: Crypto projects can raise funds via token sales at various stages, allowing VCs to continuously participate and increase exposure to promising projects. The sale of liquid tokens to fund new allocations and double-down on winners accelerates the Power Law by pushing down valuations of perceived losers and favoring the winners.
- Network effects: Crypto projects benefit exponentially as their user bases grow. Whether it’s through composability (building on other protocols) or widespread adoption, these network effects can turn small, niche projects into dominant market players.
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Unique Challenges of Crypto VC
While the power law works in both traditional and crypto VCs, the latter presents some unique challenges that make it more dynamic—and more volatile.
Regulatory Uncertainty
The cryptocurrency space is still in its infancy from a regulatory standpoint. Governments around the world are wrestling with how to regulate crypto assets, blockchain technology, and decentralized finance (DeFi). This uncertainty makes it difficult for VCs to evaluate the long-term viability of certain projects, particularly those reliant on controversial token models or operating in regulatory gray areas.
Rapid Innovation and Pivots
Crypto is a space that moves at breakneck speed. Projects are iterating faster than ever, pivoting to new opportunities, and launching new features within months. While this speed of innovation can create massive opportunities for growth, it also presents challenges for investors trying to evaluate projects' long-term potential. A project that looks promising today might be made irrelevant by the success of another tomorrow—or vice versa.
Tokenomics
Unlike traditional startups, which typically operate with equity-based models, crypto projects often rely on tokens to fundraise, incentivize participation, and build communities. The complexity of tokenomics can sometimes lead to inflationary models that dilute early investors, while other circumstances involve heavy selling from early backers just as retail finally gets access to an attractive offering. Having liquid tokens included in compensation packages adds complexity in a cyclical industry because team members may feel disincentivized to continue building during a bear market.
The Power Law in Action
Let's consider the current state of the market. Out of 4,335 protocols listed on DefiLlama, only 161 generate $100,000 or more in monthly fees, which represents a mere 3.71% of the total. Of those, just 17 generate over $10 million in monthly fees, less than 1% of the total market.
This is classic power law at work. While the vast majority of projects fail to generate significant revenue, a select few dominate the market and drive most of the returns for investors.
Market Capitalization of Top 20 Crypto Projects (in billions, USD)
For instance, Ethereum and Bitcoin continue to lead the pack in terms of market capitalization, building off a base of robust developer activity, and strong user engagement, while smaller projects often struggle to break through. However, projects like Stablecoins, Solana, and DeFi have demonstrated that with strong network effects and committed teams, new players can rise quickly and command significant market share.
YTD Fee Generation of Top 20 Crypto Projects (in millions, USD)
At the same time, many other projects fade into obscurity. The sobering reality is that most protocols cannot sustain their operations on fees alone. As VC deployment slows, we can expect many of these projects to scale back or shut down altogether. However, they leave behind code bases and case studies that help inform the next cohort of builders, helping to pave the way for future winners.
Riding the Power Law Wave
Despite the challenges and failures, the power law is what makes early-stage crypto investing so rewarding. A handful of winners will not only survive but thrive, and their success will outweigh (and build off of) the losses incurred from the numerous failed projects.
As Joel John recently commented in the Decentralised.co telegram channel, "Crypto is in a magical era. Developers finally have tooling that balances decentralization and utility. Token prices might go down due to supply and demand imbalances, sentiment, etc., but the entry barrier to build cool things has never been lower."
The Case for Optimism
It’s easy to get caught up in the day-to-day price fluctuations, especially when many altcoins are underperforming and sentiment is overwhelmingly negative. Taking a longer-term perspective reveals a more encouraging outlook, though.
Infrastructure and Innovation
The building blocks for the next wave of crypto applications are already in place. Blockchains are faster and cheaper than ever, stablecoins have reached a level of scale and adoption that makes them viable for everyday use, and user interfaces are becoming more intuitive to non-crypto natives.
Continued Developer Momentum
Despite market downturns, developers continue to innovate, with many promising projects in the pipeline. From decentralized finance (DeFi) to physical infrastructure networks (DePIN) to gaming, the crypto ecosystem is teeming with potential for disruptive applications that could shape the future of consumer, entertainment, and beyond.
Long-Term Value Creation
For investors willing to take a longer-term view, the opportunities are vast. The power law ensures that while many projects will fail, those that succeed will provide the kind of exponential returns that have defined the greatest success stories in the space so far. Given the network effects inherent in blockchain projects, these winners can lead to whole ecosystems of innovation, growth, and of course, returns.
The Future is Bright
While the crypto market might seem bleak to day traders and short-term speculators, the long-term prospects are as promising as ever. The power law dynamics that govern traditional VC are even more pronounced in crypto, providing investors with the opportunity to capture outsized returns by identifying the next wave of market leaders.
Despite the negative sentiment on social media, the projects being developed today are set to drive the next wave of innovation and value creation. Colosseum, an accelerator supporting early-stage crypto projects, shared an insightful observation in their latest investor letter: "An early point of validation, evident in the submission volume, is that over a quarter of all submissions (31.3%) were to the Consumer Apps track. This is encouraging, especially when contrasted with the flow of venture dollars in crypto, which have historically been biased toward infrastructure. It’s promising to see such a significant volume of experimentation occurring at the application layer."
At Aquanow, we continue to facilitate the connection of crypto into the financial service landscape around the world, and the ventures we’ve invested in are still shipping cutting-edge tech, laying the foundation for the future. Risks are ever-present, but from this vantage point, things look really promising.
FAQs
Q: What is the power law?
A: The power law refers to the phenomenon where a small percentage of investments or projects account for the majority of returns, while most others fail to produce significant outcomes.
Q: How does the power law apply to crypto VC?
A: In crypto VC, a handful of projects will generate outsized returns, while many others will fail or deliver mediocre results. This dynamic is amplified by the fast pace of innovation, public market dynamics, and network effects in the crypto space.
Q: Should I be concerned about the current crypto market sentiment?
A: While sentiment is low, especially among altcoins, the long-term outlook remains encouraging. Power law dynamics suggest that even in a tough market, a few successful projects can lead to significant gains.
Q: What are the main risks associated with crypto VC?
A: Crypto VC involves high volatility, regulatory uncertainty, and rapidly changing tokenomics, making it a high-risk, high-reward space. Investors must be prepared for a high failure rate but can reap massive rewards from the few successful projects.
