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Nine Questions Every VC Should Ask Before Investing in a Web3 Project

9 questions every VC should ask before investing in a Web3 project

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The Web3 space can be challenging, and it's difficult sometimes to distinguish good projects from bad. Here are the questions VCs should be asking.

Blokhaus Marketing Operations Team

So you’re one of the wave of VCs brave enough to try their luck in crypto! Congrats on getting into the space early. You might assume that crypto is similar to the traditional investment landscape, but that’s not entirely true. From anonymous developers, to what kind of wallet the founders use, crypto is unique, and asking some basic questions now might save you a lot of hassle later. This article covers some of the questions you should be asking about both blockchains and applications built on blockchains, before committing any investment.

1: Why does this product need to be built on a blockchain?

When evaluating a new investment opportunity in the crypto space, one of the most basic questions is often overlooked – Why was this product built on a blockchain in the first place? Tech founders are getting wise to the fact that a lot of VCs are speculating on the crypto space without a firm understanding of the technology. Blockchain technology is incredibly powerful, but it doesn’t make sense for every application, and if a founder can’t explain why their product needs to be built on a blockchain, rather than a standard cloud host or software download, that’s a red flag.

Consider longevity – are there convincing reasons to believe that this blockchain will still be around in ten years?

2: Why this particular blockchain?

If they do offer a convincing-sounding explanation, it’s time to dig in: Why did they choose the specific blockchain this product is built on? Or, if the product itself is a new blockchain, why does it need to exist? There are currently over 1,000 blockchains - what makes this new one unique? Additionally, not all blockchains are created equal. Is the transactions per second (TPS) high enough for the product to scale? Is the block time short enough for frictionless use of the product? And consider longevity – are there convincing reasons to believe that this blockchain will still be around in ten years?

3: How might regulation impact this project?

Longevity isn’t just a question of technology. Governments all over the world are starting to take a close look at crypto, with an eye to regulating the segment. Does the product you’re being pitched carry any regulatory baggage or face possible legal battles in the future? If it’s an older product, has it attracted legal or legislative attention already? Because the crypto space is so new, investors and users can spook easily when they hear the word ‘regulation’, so make sure you’re aware of the regulatory landscape of your potential investment and be prepared for any possible outcomes from legislative action. if you’re not familiar with how active the US government is in regulating the space already, check out what's happening with Tornado Cash.

Have the founders you're talking to done their due diligence in creating a secure product?

4: Is this product secure?

One of the most commonly-cited justifications for crypto regulation is the risk of hacks. This is not limited solely to crypto end-users. Billions of dollars were hacked from crypto protocols last year. Have the founders you're talking to done their due diligence in creating a secure product? Have they employed an outside party to audit the code? Is there any language in the contract to protect your investment in the event of an exploit? Many projects offer 'white hat' hacker rewards to encourage outside developers to try to break their updates. It might seem like an unnecessary expense, but setting up a bug bounty program is the easiest way to get regular external code audits – plus it’s free, as long as your team doesn’t release bad code.

5: Who are the competitors, and what is this project’s unique value?

So now we're looking at a safe product that makes sense on a blockchain. What’s next? It’s time to ask about competitors. Is there a product out there already which does the same thing, or serves the same user base as the product that you’re being asked to invest in? If so, this may not be the dealbreaker that it would be in traditional investing. In the crypto world, many users are loyal to a specific blockchain. This means that if the competing product is on a different blockchain, it may not be a true competitor (i.e., not one that you have to worry about). But how difficult is this product to clone? The crypto industry contains some of the best coders in the world right now, so if the entire investment thesis is built around a smart contract, it won’t be long before a competitor emerges.

6: Who is behind this project?

Many developers are drawn to the crypto category by the allure of anonymity. For a VC to invest in a project with anonymous founders is nearly unheard of in the traditional investment world, but it isn’t unusual in crypto. This makes it even more important to do your due diligence before investing. Many communities are more supportive of projects when they know the identities of team members, so you should ask the founders how public their identities are within the space. Also, check their past products – have they built anything in Web3 previously? It’s easy to anonymously inflate numbers in the crypto space via wash trading. Do a deep dive into their previous projects to assess the volume of conversations about them on Twitter, Discord, and media outlets. If the social volume doesn’t seem commensurate with the money invested in the product, it may be worth hiring someone familiar with the space to do some on-chain digging.

Teams known to be 'ruggers' are not welcomed in the crypto community, and investing in their projects is risky

Another common occurrence in crypto is 'rugging' – where founders pump the value of a project early, before selling their investment and abandoning development. You should be able to get a general idea of whether this is the case by examining one of the founders' previous projects and looking at the volume of transactions by date. If the volume of transactions faded significantly after launch, there’s a chance the team quietly pocketed the money and abandoned the project. Teams known to be ruggers are not welcomed in the crypto community, and investing in their projects is risky. If the team hasn’t launched a product before, what crypto experience do they have? There’s a steep learning curve in crypto, and teams without personal or professional experience often treat their product as if it was traditional tech, without understanding crypto markets, hype cycles, or narratives.

7: How does this project intend to keep its funds safe?

One way to assess how serious the team is about the crypto industry is by asking them how they store their funds. In a hot wallet? Very bad. In a hardware wallet? Pretty good, but check if it’s a true cold wallet. In a Gnosis Safe? OK, they know what they’re doing. One of the attractions of crypto to users is self-governance of their assets, but this comes with a lot of responsibility. Even the smartest people in the space are occasionally fooled, and you shouldn’t assume these founders are any better than the average person at avoiding phishing scams. Additionally, with the anonymous nature of crypto, it’s not unheard of for teams to claim their funds were stolen while secretly owning the 'hacking wallet'. This is where having a doxxed team and language in the contract with stipulations around hacks can be life savers.

8: What currency is used to hold the treasury?

Assuming the team has its funds stored in a safe place, you should ask how the funds are held – in fiat currency, stablecoins, or altcoins? Responsible project treasuries should not be entirely reliant on a single cryptocurrency’s performance to ensure runway for the project. Crypto winters and bear markets are notoriously rough, and keeping the treasury entirely invested in crypto can create risk if there’s a significant market downturn. You should audit the project’s treasury and provide guidelines on how the project team is allowed to hold your investment to ensure they’re being responsible.

If the founders don’t give themselves a significant lockup on what they’re allocating themselves, you should be very wary. A short lockup could point towards a 'pump-and-dump' project

9: When can I expect a return on my investment?

Speaking of money, when can you expect a return on your investment? Most reputable projects will have rules for founders and VC investors that govern how quickly they can sell their tokens or shares. If the founders don’t give themselves a significant lockup on what they’re allocating themselves, you should be very wary. A short lockup could point towards a 'pump-and-dump' project. A recent study by Chainalysis revealed that up to 1 in 4 new tokens are scams, so you need to do your due diligence on the team and their intentions. Ideally, you would negotiate a phased lockup period for yourself and the founders. The allocation of the project’s tokens is another important factor. Even with a lockup period, if the team is keeping more than 30% for themselves, that’s a red flag.

Because of the decentralized nature of the crypto space, the larger the portion allocated for the general community, the higher the probability that a project will succeed. Web3 is about community, and before trying to sell something to a community, make sure you genuinely understand their values. That way, they’ll regard you and your project as a value-add instead of a value-extractor.

Blokhaus is a marketing and communications agency with a focus on Web3 and emerging tech. Since we were founded in 2021, Blokhaus has supported numerous high-profile projects and activations around the globe, working in partnership with some of the biggest brands in the world. To learn more about our work, check out our Case Studies. To get in touch, visit our Contact Us page.