This article is produced by CMS Holborn Asia, a Formal Law Alliance between CMS Singapore and Holborn Law LLC.
What is Web3?
Those familiar with the advent and development of decentralised ledger technology generally regard the internet as having gone through two iterations and being on the cusp of a third: Web 3.0, or Web3 as it is commonly referred to.
There is no universally accepted definition of each phase of the internet, nor is not clear where Web 1.0 ends and Web 2.0 begins, but Web3 is markedly different from its predecessors. While Web 1.0 generally describes the early days of computer networks, browsers and websites and Web 2.0 the applications built on top of that (such as social media platforms, search engines, etc.), Web3 envisages an ecosystem of decentralised applications run on public blockchains, in which the use of digital assets (security or utility tokens, NFTs etc.) features strongly.
A new asset class
Digital assets have become an increasingly hot asset class, and the increase in prices of major cryptocurrencies over the past 2 years and the fact of NFTs being sold at Christie’s and Sotheby’s bear testament to that. VCs have also invested $20.7bn in cryptocurrency start-ups as of October 2021, an increase of more than 160% from the previous record in 2018.
Notwithstanding its popularity, the challenges of investing in digital assets are widely known. For one, China’s ban on cryptocurrency activity in June 2021 underscores the regulatory risk of the nascent asset class, although this risk is of course country-specific. In addition, there is also the key issue of navigating global tax rules, which when it comes to digital assets, vary significantly country-to-country. Even in Singapore, which is considered to be a more favourable environment for digital assets, gains from a Web3 fund’s investments in most digital assets would not currently qualify for Singapore’s range of fund management tax incentives.
Yet it seems that these issues have not dampened interest in this burgeoning industry amongst private investors. In June 2021, Andreessen Horowitz announced the launch of its third crypto fund that raised $2.2 billion, which was at the time the “largest crypto fund ever raised”. Just months later, VC firm Paradigm announced the launch of a new $2.5 billion crypto venture fund. In both instances, the funds raised twice as much as they had hoped for. Closer to home, Singapore’s sovereign wealth funds have also been at the forefront of investing in crypto, with Temasek leading a funding round in crypto start-up FTX trading, and GIC investing around $70 million in BC Technology Group, the parent company of the crypto exchange OSL.
As the universe of investable digital assets has expanded with such speed in the past few years, most tech-focused VCs will be unable (and unwilling) to ignore this asset class. However, there are certain aspects of a digital asset or Web3 fund that differ from traditional ‘equity’ VC funds and which both investors and GPs alike should note.
VC funds: Equity vs digital assets
Firstly, most Web3 funds will likely seek to invest in a mix of equities and digital assets, and possibly derivatives of each (such as SAFEs or SAFTs). Regulators may take different approaches as to whether the various types of digital assets (and their derivatives) constitute ‘permitted investments’ for certain types of funds or for funds managers that are subject to distinctly ‘analogue’ regulations. In Singapore, regulations applicable to VC funds currently do not contemplate digital assets, and fund managers licensed under the ‘light touch’ VCFM regime may consequently find themselves restricted from holding certain types of digital assets unless they ‘upgrade’ their fund management licence.
Secondly, managers who raise Web3 funds are undoubtedly bullish on the future of crypto and the use cases of its underlying technology. Investors, on the other hand, may not necessarily have the same confidence to stomach a largely untested investment class or prolonged periods of underperformance, such as the crypto bear market of 2018, and may understandably wish to withdraw from the fund, or perhaps even terminate the fund if the prices become particularly volatile. Issues relating to the fund’s investment period, term, and termination, will need to be carefully considered and negotiated more so than ever. This also fuels the debate as to whether Web3 funds are best structured as traditional closed end PE/VC style funds or as open ended, liquid funds, more akin to hedge funds.
Thirdly, issues relating to the storage and custody of digital assets should be front of mind. If a custodian is used, it should be clear how the fund’s digital assets are secured. In our experience, investor due diligence for Web3 funds can focus as much on the fund manager’s digital security infrastructure and policies as on the investment thesis of the fund.
Fourth, there is always the question of whether to incorporate digital assets into existing funds or to set-up standalone Web3 funds? Funds taking the former approach may find that their fund documents and perhaps even their fund structure do not cater for Web3; more conservative LPs in ‘traditional’ VC funds may also not support the change. However, setting up a standalone Web3 fund is not straightforward either. The tax and regulatory considerations are shifting and Web3 funds may need to be structured and operated differently than existing funds. There is also the question of how the investment objectives of existing “conventional” funds and a new Web3 VC fund may overlap and how deals will be allocated between them.
Technical considerations aside, the extent to which Web3 investments are consistent with the increasing focus on sustainable investing remains to be seen. The environmental impact of digital assets, in particular Bitcoin and the ‘mining’ associated with its proof-of-work consensus protocol, has long been an object of criticism. An oft-cited statistic in the public debate on the sustainability of cryptocurrencies is how the electricity consumption of Bitcoin is comparable to that of Sweden, and in its recent Financial Stability Review report the European Central Bank described Bitcoin’s carbon footprint as ‘exorbitant’, although the argument is of course more nuanced when considering digital assets generally, as the type of energy sources consumed have to be taken into account. However, it has been suggested that decentralised networks that use alternative consensus protocols (such as the proof-of-stake protocol) may be significantly more energy efficient, which may give ESG-minded investors more comfort in holding Web3 investments in their portfolio.
An important footnote to the many legal, regulatory and technical considerations is a human one – will VCs be able to find the talent to successfully manage a new breed of fund? In Singapore, for example, the MAS requires licensed fund managers to have at least five years’ relevant experience. How many VCs can claim that in an industry that to most people barely existed two years ago?
In conclusion, it should be obvious to all that digital assets will increasingly form part of the VC ecosystem and cannot be ignored by anyone focused on tech investing. However, Web3 investments will not always sit comfortably within conventional VC strategies, structures and regulation and so VCs looking to launch Web3 funds need to tread carefully. Over the past decades the key developments in the funds space have focused on control, tax and regulatory matters – normally to combat the perceived risks and excesses of the investment management industry. It is incredibly refreshing and genuinely exciting that today’s developments are driven primarily by technological ingenuity and entrepreneurship that promises to reshape the world as we know it. Tech-focused investors and GPs alike get ready – your next LP meeting may well be in the metaverse.