VC firms wading in undaunted to invest in cryptocurrency, blockchain startups

Only those who will risk going too far can possibly find out how far it is possible to go.
Nine decades later and playwright TS Eliot’s words aptly reflect India’s venture capital ecosystem’s tryst with the fireball called cryptocurrency.
The ability of digital money to deliver ginormous gains is driving scores of venture capital funds in India to the drawing board, never mind that regulators, banks and internet giants including Google seem to be shutting the gates on cryptocurrency.
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Marquee funds including Sequoia Capital, Matrix Partners, Lightspeed Venture Partners and Accel India seem to have factored in these risks and have begun talks or recently finalised deals with domestic blockchain and cryptocurrency startups, said people privy to the developments. IDG Ventures India is reviewing blockchain startups while steering clear of cryptocurrency firms until regulations on those become clearer.
These investors are taking cues from a global wave that saw VC firms overseas put in more than $1 billion in cryptocurrency and related startups in 2017 alone, as per data platform Pitchbook.
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Also, while a regulatory question mark hangs over the viability of virtual currencies such as bitcoin, ripple and ethereum in India, the government has welcomed the underlying blockchain technology for the digital economy, giving VC investors hope.
“We are looking at blockchain as one of the next infrastructure shifts in technology,” said Rajat Agarwal, vice president at Matrix Partners, which is in the final stages of closing an early-stage investment in an Indian blockchain startup. “Value can be captured at the core infrastructure, middleware and application layers, like with all such shifts.”
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The past two months, however, have done little to stoke that optimism. Regulatory concerns have cast a pall of gloom over cryptocurrency trading, which has plunged by about 90% since January in India.
Regulatory overhang
The Finance Ministry and the Reserve Bank of India have made it clear that bitcoins and other digital monies cannot be regarded as legal tender.
And banks, including State Bank of India, ICICI Bank, Kotak Bank, HDFC Bank and Citibank, have asked cryptocurrency exchanges to close their corporate accounts. Globally, too, regulators are becoming wary of the exploding growth in the space.
All this, however, has had little impact on how VCs in India are looking at the blockchain and crypto space. Investors say that although it is tough valuing a company whose revenue is linked to such a fluctuating asset, they will factor in a larger window on both the upside and downside.
“Volatility in cryptocurrency prices is a reality and it’s very hard to ascertain where they will settle. In such a scenario, valuing companies such as exchanges whose revenues are linked to market prices becomes complicated,” said Agarwal of Matrix Partners.
Avenues for VCs
Disadvantages
Agarwal, like other investors ET spoke with, however, maintained that such investments would have to include a shot in the dark where some slip-ups on returns is accounted for. For this reason alone, VCs are not looking to bargain hunt when it comes to valuations of cryptocurrency exchanges, given there is no strong way to predict a further downfall.
“The focus here is more on pricing rather than bargaining since these investments are being looked at from a much longerterm point of view,” said an investor declining to be named. Sequoia Capital has finalized an investment of $1.5 million in cryptocurrency exchange CoinSwitch and held discussions with other multi-cryptocurrency exchanges including Koinex and Ahmedabad-registered Zebpay for potential investments, according to people aware of the developments.
“After China’s clampdown on bitcoins, India is the only country where both (the banking regulator) and the government have explicitly stated that cryptocurrency will not be treated as legal tender. This has caused VC firms such as Sequoia to explore investment options in companies registered outside India, such as in Singapore, where regulations are not this tight,” this person said. Sequoia Capital is exploring if Koinex, too, can be registered in Singapore.
CoinSwitch is in the process of registering as a company in Singapore, said another VC investor, declining to be identified. Zebpay, while being registered in India, operates a second entity based out of Singapore. However the company declined to provide any clarity on the operations that fall under this entity and the purpose of establishing such an entity.
To be sure, Sequoia’s India plans in the crypto space mirror its global bets. The firm is leading the charge along with Silicon Valley investors Benchmark and Kleiner Perkins into the initial coin offering (ICO) of encrypted messaging app Telegram, which is looking to raise $1.2 billion.
According to a Financial Times report, Sequoia has made an informal commitment of $20 million to the Russian messaging app’s ICO, which is a type of crowdfunding done typically in exchange for digital tokens issued by blockchain startups. Sequoia Capital, Accel India, CoinSwitch and Zebpay did not reply to queries from ET.
IDG managing director TC Meenakshisundaram confirmed his firm is evaluating blockchain startups. A spokesperson for Lightspeed said the firm was “neither actively scouting for nor averse to investments in cryptocurrencies. That said, we would not invest in a speculative market.” Koinex chief executive Rahul Raj said by phone that the company had raised money in December and was “not in need of any more capital.” As for homegrown VCs, they are still undecided about ICOs.
Investments in ICOs do not give any right to own equity shareholding in the issuing company, making it a big concern for limited partners (LPs), or investors in VC funds.
“In India, I don’t see venture capital funds investing in ICOs for the next 1-2 years at least. The classic venture capital model comes under a bit of threat in the way ICOs are set up. If there are no shareholders, how does governance really get done?” questioned a VC investor who is in the last leg of finalising an investment in a bitcoin exchange firm.
Another issue relates to valuation. “The big mental shift from a VC angle is the equity versus tokens question,” said Nitin Sharma, a former VC at Lightbox and now founder of blockchain community Incrypt. “This is beginning to play out in Silicon Valley. If entrepreneurs focus energies on maximising token value, what does it mean for the value of equity? Is it as relevant? What will it mean for M&A prospects? Should a VC invest in both equity and tokens? It’s a new tug-of-war between founders and funders.”
ICOs
Even so, as many VC funds reach the ends of their 10-year lifecycles, the lack of a strong pipeline of investment exits has forced several of them to seek some leeway from their limited partners on ICOs and other cryptocurrency models. A few small early-stage funds are studying the white papers of different ICOs and exploring possible modifications to their agreements with their limited partners, according to investors ET spoke with.
Some could also look at making some equity investments in companies that are considering an ICO in the future. Some American funds including Andreessen Horowitz have altered agreements with their investors to be able to accommodate investments in coin offerings.
“They have invested in a lot of crypto currencies and wanted to ensure that they at least have provisions that allow investments in digital assets,” said the first person cited above. Andreessen Horowitz has invested heavily in crypto companies including Ripple, Earn and Axoni. Investors believe sizeable investments by VC firms in the crypto market will help create favourable dialogue on regulating cryptocurrency business models.
“If venture capital investors back a lot of such ideas, it may help the regulator see the potential in this space,” reckons Dirk Van Quaquebeke, managing partner at Singapore-based VC firm Beenext, which has invested in Koinex. “In innovation, regulation is rarely the first at the finish line. It is not preventive in nature, it is reactive.”
While investors don’t expect an extreme reaction from the Indian government with a complete clampdown on this asset class, they are definitely gearing up for regulations and tax policies that they may have to face sooner rather than later.The government is looking at the cryptocurrency space closely and use of cryptocurrencies for payments is likely going to be restricted. Given the large number of assets that have moved to cryptocurrencies it’s likely we will see taxation on gains dampening current business models,” said Agarwal of Matrix Partners.
Indeed, the government is in the last leg of finalising a regulatory framework for the sector by the end of this month. A committee headed by the secretary of the department of economic affairs to study the impact of cryptocurrencies and make recommendations to regulate them is expected to submit its report shortly. The Finance Ministry has expressed its intention to regulate transactions involving legitimate crypto assets to make them transparent.
Beyond regulation, the lack of a legal taxation framework on gains from investments in cryptocurrencies has resulted in the Income Tax department issuing more than 100,000 notices to people who didn’t declare profits made on such investments.
Tax officials sent the notices in January after they found transactions worth $3.5 billion conducted over a 17-month period. Despite the risk of regulatory and taxation run-ins, the volatility and potential arbitrage between exchanges make cryptocurrencies such as bitcoin, ripple and ethereum a gold mine for traders, thus tempting venture investors, too, to want a bite of this pie.
The crypto sector’s ability to engage huge volumes of currency while simultaneously being able to withstand shocks such as the abrupt bitcoin trading halt and ICO ban in China without any impact to the network has impressed investors.
“From a self-governing system point of view, the cryptocurrency network’s survival after the big shock from China shows it is a lot healthier than an isolated financial system of any country. It is self-regulatory and cross-border, so a single shock cannot take the market down,” said Quaquebeke, who maintains that has been the reason why Indian investors, too, are lining up to add cryptocurrency bets to their portfolios.
How Crypto Exchanges Work
Cryptocurrency exchanges typically followed a brokerage model where they held the proprietary inventory and customers could buy from them and sell to them. In such cases, the entire transaction becomes a profit in the company’s books and is taxable.
In 2014, when bitcoin trading began in India, there were only brokerage platforms. A company like Zebpay bought bitcoins from other sources and sold it to its customers. They set the rates at which customers would buy in India. Many exchanges followed this high-reward, high-risk model. Companies like Koinex follow the peer-to-peer model, where the only revenue it makes is the trade fee, which is substantially lower than the actual price. Koinex’s trade fee begins at 0.36% and goes as low as 0.1%, depending on the exchange and tax incurred.
Some industry observers expect Zebpay will end this fiscal year with about $8 million in after-tax profit. ET was not able to independently verify this. But several experts say such a profit may be possible considering the high trading volumes on cryptocurrency exchanges until recently. Now almost all Indian exchanges have moved to a peer-to-peer model.