Shadow Investment = Supporting competitors after missing industry leaders, usually to maintain exposure rather than based on a belief in differentiation.

Written by: Zaheer

Translated by: Block unicorn

Preface

This is yet another article about capital allocation—but this time it’s different.

Uncertainty always slows things down, forcing people to reflect on their circumstances, the past, and the future. The interest rate hikes in recent years, along with global trade and geopolitical uncertainties, have caught the cryptocurrency investment community off guard. However, beyond external factors, there are other elements that pose a critical threat to cryptocurrency. This silent disaster continues to consume people's time, funds, and beliefs: shadow investment.

(Shadow Investment = Supporting competitors after missing industry leaders, usually to maintain exposure rather than based on a belief in differentiation.)

The Genius Problem

Finding exceptional talent is the pursuit of every company worldwide, but the resources of genius are not infinite. Genius is incredibly hard to find and even harder to demand; to some extent, it is entirely serendipitous. Companies that suddenly have a breakthrough cannot predict unexpected outcomes but instead focus their energy and time on creating as many opportunities as possible for talented individuals to shine.

Similarly, venture capital firms face the same issue, as venture capital is not a linear game. The more capital invested does not necessarily mean more genius output. This was well known in the early 80s/90s and the rise of modern venture capital in the early 21st century, but as investor expectations and appetites grew, so did the budgets for venture capital and the pursuit of genius. However, this fundamentally conflicts with the philosophy of venture capital—"If opportunities do not exist, how can more opportunities be found?"

Enter Shadow Investment

Every few years, we encounter a new cryptocurrency protocol, project, or business that truly changes the game and creates meaningful value. This is the joy of every investor and the goal of every team. However, the speed and scale of these investments make them (in essence) scarce, and the lack of original thinking leads investors to focus on existing trends, choosing the current hottest options as their next investment. Simply put, investors see new trends in the industry and choose to support the weaker "competitors" of the projects they missed.

Why This Happens

As is well known, I have many criticisms of the cryptocurrency venture capital space. You can find my complaints in old podcasts, tweets, or articles, but all these comments touch on the same starting point—the supernova theory of cryptocurrency venture capital (i.e., there is too much funding in the cryptocurrency space, which in turn leads to too much venture capital). This abnormal state has produced many negative external effects in the industry, but the continuous funding of cheap copies of excellent companies is one of the worst.

The current capital allocation process in cryptocurrency (or any market) is simple:

1. Limited Partners (LPs) invest capital in venture capital firms

2. Venture capital firms use this capital to invest in startups at different stages

3. Startups use this capital to grow and build their companies

This model is straightforward, but it fails when LPs have too much capital on hand, as they over-fund cryptocurrency venture capital firms by providing large amounts of capital to numerous investors. Today, in the cryptocurrency space, there are over 20 firms with nine-figure capital, covering everything from seed rounds to later stages. If each investment firm (even considering just 20 venture capital firms) makes only one deal per quarter, there would still be 80 investments in a year. In reality, the number of deals is much higher, with hundreds each year. There are not hundreds of valuable cryptocurrency companies worth investing in each year. Moreover, there are not dozens of investable meta-narratives or stories in the cryptocurrency space each year.

Instead, we face two truths:

1. There is too much capital in cryptocurrency venture capital

2. There are too few quality companies to invest in

But this capital still needs to enter the market in some way, as it is designated for companies. Therefore, this capital flows to companies that align with recent investment hotspots: shadow investment.

In markets such as layer one, layer two, wallets, perpetual decentralized exchanges, lending protocols, and cross-chain bridges, many projects are poorly imitating each other, as the value of original projects drives demand that cannot be funded. Take Uniswap as an example; it is the pioneer and leader in the decentralized exchange space. Hundreds of millions or even billions of dollars have fueled cheap imitations of Uniswap, but failed to deliver meaningful value or vision iterations. Instead, we are left with an industry landscape destroyed by token inflation. Of course, some companies have built high-quality iterative products; not every derivative company is a cheap imitation, but these are often exceptions rather than the rule.

"Imitators can only follow in the footsteps of leaders. They cannot surpass them." — Peter Thiel (Zero to One)

A significant issue brought about by the cheap imitation strategy in cryptocurrency venture capital is the upgrading and maintenance of products. Many of the best projects in cryptocurrency start with great promise but always promise greater growth visions and a lot of maintenance work. This brings numerous issues, from protocol security to building a clear product vision. How many project forks have led to millions of dollars being hacked or exploited?

The endpoint of the problem points to the venture capital firms funding these transactions. Inevitably, when the entire industry and its best investors cannot distinguish between quality investments and poor imitations, shadow investment tarnishes the reputation of the industry.

How many funds can we see, and how many teams ultimately received funding support because of a real product launch? Imitation is flattery, but when the imitation market pays too high a price for the soon-to-be-extinct "good stuff," it is not. If cryptocurrency is to become a serious industry, committed to even superficial capital preservation, then this field and its investors must grow from their financing behaviors and strictly invest in teams truly dedicated to innovation… at least, that is my hope.

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