“My confidence in encryption comes from experiencing many encryption cycles and also experiencing the world’s skepticism about encryption early on, but ultimately I saw the victory of technology.”
Original author: Edgy, DeFi researcher
Translated by Leo
Electric Capital is a relatively active venture capital firm in the industry. In March 2022, they raised $1 billion for two funds. Some of Electric Capital’s more well-known investments include Frax, dYdX, Near Protocol, Eigenlayer, etc. DeFi researcher Edgy recently interviewed Ken Deeter, a partner at Electric Capital. Ken Deeter is a partner in the investment team of Electric Capital, focusing on DeFi, crypto games, and crypto collectibles. With 15 years of experience leading teams and developing products as a software engineer and product manager at VMware and Facebook, the two had a fascinating conversation about “how VCs consider betting on investment, Electric’s investment views, how VCs make money, recent trends in the crypto world, L1 and L2, crypto beliefs and adoption, and how to become a crypto institutional researcher,” among other topics. The following is a compilation and translation by BlockBeats:
- Vitalik answers everything: personal interests, AI technology and RWA, encryption narratives such as Layer2
- Reversing the technology? Aptos and Sui are actually consortium chains, their survival depends on the patience of capital.
- Bug Finance – Another Attempt at the ve(3,3) Model on Polygon
Note: This interview does not constitute any investment advice. It is entirely Ken’s personal thoughts.
The VC’s Wide Net
Edgy: Venture capital firms have large portfolios and many investments. Some people joke that this is a way of casting a wide net and praying that investment projects will succeed. Why is this the case?
Ken: Many venture capitalists have their own theories and professional standards. You should know that 90% of early investments will ultimately go to zero, which is an inherent risk of investing in early-stage projects. Indeed, many projects have excellent founders, ideas, or other excellent things, but the ending is not good. There are always some negative factors, perhaps Covid-19, or perhaps Powell’s wrong decision. For casting a wide net, I think that all investments have risks. Maybe you invest in 40 projects, but as long as one project succeeds, the loss you incur in other projects is far less than the benefits you get from discovering a successful project. So investing more is just a way to diversify risk, which is a mathematical way of thinking. As for how to choose investment projects, each VC has its own ideology, and then makes decisions based on some aspect.
Actually, most founders will chat with each other to get to know each other well, and some companies will do it well. For example, some startup founders who are thinking about starting a company or raising funds usually contact other founders and say, “Hey, who is the most valuable person in your company?” They usually say, “You’d better go talk to Ken or someone else because they are the ones who are really valuable and capable.”
This is also the best “transaction flow” I understand. Once you get on track and bring a brand into its normal development stage, people start paying attention to you and say, “I know Electric Capital, they’re really good.” Investing in a project is actually easy, but I want to say that we still stick to some more interesting things, get early access to projects from project founders, so we can know if we are ready to participate.
Many founders I have worked with together will constantly pass on some information to me, “hey, I just talked to him, he wants to talk to Electric Capital, can you arrange a meeting?” These are the conversations that happen around me all the time. All of the above can provide value and guide you to become an effective investor.
L1 and L2
Edgy: How do you look at various Layer 1 and Layer 2 in 2023? Has Ethereum won Layer 2?
Ken: Remember in 2021 and 2022, especially in 2022, Gas on Ethereum was very high, which also brought opportunities for other L1s because their transaction speed would be faster under high Gas. Of course, they suffered a lot during this bear market, so we started to focus on all the L2 technologies. I don’t think we can write the story of “L2 correct architecture” smoothly at present. Ethereum still seems to be mainstream, and L2 is just there. To surpass Ethereum and add one more zero in terms of transaction data, if Ethereum is a complete entity, ZK technology may take us further.
But at present, these L2s do not have the performance of Solana in terms of delay and throughput, the sharding performance of Near, or the parallel execution performance of Sui and Aptos. I think it is difficult to say who the final winner is at this point in time. We don’t know the answer yet, but Ethereum is indeed in a leading position. For example, there may be some regional or critical reasons, or perhaps the Democratic Party uses one chain ecosystem while the Republican Party uses another. No one knows how to end these preferences, just as people prefer something for various reasons.
Evaluating Founders
Edgy: One fundamental element of a protocol is the quality of its founders. VCs have more opportunities to meet founders than retail investors. What do you think makes a successful founder? Also, is there a difference between Web 2 and Web 3 founders?
Ken: Evaluating founders requires consideration from many angles. The first thing is that you must know the reason why they are doing what they are doing. If you can easily feel that founders are just trying to make a quick buck, for example, “The crypto bull market is here, I have to take advantage of it to make quick money” projects, then they really have no faith, right? Most successful projects in crypto have been quietly built and preparing for financing for a long time before anyone pays attention to them. Finally, they will achieve success after adapting to market conditions. Therefore, if you want to find truly firm believers, they must have strong crypto faith, be able to observe what is happening in the crypto world, and experience many dark moments to achieve success. You may see many second-time and third-time startup founders who know what they are doing and will continue to do so. This is also why they will be more likely to receive investment because they are experienced.
Other than that, there are really many considerations in different fields. Founders need to solve many different problems. Some people are interested in token economics and protocol design, but some people are interested in who you are recruiting and where the company is going to be built. You have to face too many different problems. The best founders, such as a partner at Mico-Electric, have explained many interesting comparative cases to me. If you want to create a company, you must have 50 threads that include reasonable plans. If a founder advances his thread without careful consideration, this thread will mostly fail during the implementation process. If you have 10 different threads, you will exit multiple “carefully considered” solutions when the company faces various problems, and you will gain greater influence.
Profit
Edgy: Investors are always afraid when token unlocks come, and they are afraid that VCs will dump on us. How do you balance supporting the long-term vision of the protocol with getting some profit? Do you have any standards for this?
Ken: Generally, we know that most major successes don’t happen in just a couple of years. For example, they happen once every decade. If you look at IPOs of traditional companies, all the recent ones have happened in patterns like SBlockingC (special purpose acquisition company), and it still takes 6-9 years for an IPO to actually happen. We think it’s rare for something like this to happen within those timeframes, unless the team leaves the project, or there are other reasons, like we’re no longer interested in that project. Generally, we hold onto these tokens. There are a lot of use cases for tokens. In most cases, if there’s some kind of voting escrow model in the project, we actually re-stake some of our unlocked tokens and lock them up again for different time periods if we want to get governance rewards or governance yields.
Generally, we take a long-term view. When you work at a venture capital firm, you’re ultimately hired by the investors to create returns for them. From a risk management perspective, sometimes we have conversations with investors and they’ll say, “Hey, we think this is a long-term thing,” but like the market is right now, you have some views on taking profits or having long-term risk exposure, like some investments that have multiplied by 100x or more in the short term, that’s very rare. Most of the time it’s a multiple of returns, and for any given investment, going back to how venture capital works, if your investment is 2x, 3x, 4x in the short term, it’s not actually the result that you want from a venture capital strategy. You have to wait for 50x or 100x.
But at least in the long term, if we make a profit on some investments very early on, we’ll still be bullish on them, but it doesn’t actually give us a sense of accomplishment in the investment, mathematically it doesn’t work out that way, and we don’t really think about it in that situation too much. As the project enters its sixth or eighth year, we start thinking, okay, there’s a lot of liquidity in the market, it’s developed well, or there have been some amazing successes, and the ultimate valuation may be judged by us as the initial investors. That’s the question we should start thinking about, does it still make sense to exit?
Risk portfolio construction
Edgy: Portfolio construction is crucial for retail investors. How do venture capital firms determine the size of their bets and portfolio construction? Do you have any rules you always follow?
Ken: I think there are two aspects to this question. First, generally speaking, venture capital firms have their own check size and deployment scale. Many times, this boils down to “how much money do we have to do how much.” If there is no organization or fund to do this, or no capable people to help founders work with them, they will find it difficult to succeed. But what outsiders don’t know is that this needs to be determined based on the size of the fund, the investment stage, and the look of a diversified investment portfolio. But generally, in a given fund, there may be about 20 or so main funds, depending on how many employees you have, how large your investment team is, and other such things. There may be special cases where one or two of your funds are very large, but generally the size of these 20 funds is often similar. Of course, some of them have succeeded and others have not, and you will double down on the successful investments and choose to give up on those that have not succeeded. Then, venture capital is a category of assets in a broader investment portfolio, at least that’s how most of our investors think.
What we offer to investors is a portfolio of investments in what we consider to be early-stage products, which will have a high return if successful. But this is just our expectation, not all methods are effective, in fact, most methods fail, and that’s the reality of early-stage product investment, so I think it’s difficult to compare it to how retail investors build their investment portfolios, because venture capital itself is an implicit investment portfolio structure that requires mathematical calculation.
Real-world adoption
Edgy: What kind of products do we need to drive more real-world adoption of crypto at scale?
Ken: I often think about something, no matter when the technological shift happens, the original intention of the products we build is towards solving existing human problems, the people who use these products will not change over time, and their needs will not change over time, it’s just the way technology solves these needs that has changed. So, if you think about what DeFi is, it’s a demand for financial services, as a financial demand, it has actually existed for a long time. And then you look at NFTs, PFPs, or things like that, they are symbols of status, digital identities or community membership, wanting to stand out among peers, or wanting to be part of a community. These ideas have existed in human history from the very beginning.
I often think that it is always difficult to know exactly what future products will be like and in what form they will appear. To some extent, I have given up trying to predict future products, even those that I personally created in previous companies. You don’t know how they will develop, even if you think you are the most knowledgeable expert in this area. Speaking of which, humans are always too complex, especially these network products. It is difficult to predict the dynamic behavior of millions of people on the network. Their behavior is based on the desire to meet any of their needs. So now I have deviated a little from that kind of thinking, and I am trying more to think about what problems these products can solve and what will happen in the end. When I think about it this way, I suspect it may be the next stage of things like NFT. NFT-type products have identified many social use cases, not just pure on-chain financial products for adoption.
I think our most urgent need now is to make people get used to operating wallets at lower risk and get used to using these on-chain products, because I think these products will eventually become the pinnacle of DeFi-type finance. There must be many people in the world who are pursuing DeFi because they are interested in this type of finance, but most of the people, such as Venmo users and PayPal users, are not very interested in DeFi. But they know how to operate their phones because they use their phones to do many things. Therefore, when this new financial application appears in a familiar form to them, it will be easy to increase adoption.
However, currently I think that if you are not interested in encrypted finance, you have to cross multiple barriers to become an encrypted adopter. So I guess we need more application categories where people enter not to participate in DeFi, but to install their own wallets, such as buying PFP or other things, social, games and other low-risk use cases. If billions of people are brought to online wallets, it is the first step for people to enter the “cryptographic space”. At that time, they will realize that there is actually more to do in this space, which is the product that I think can ultimately bring about mass adoption.
Cryptographic Belief
Edgy: We are currently in a bear market. After lawsuits by Terra, FTX, and the SEC, some people are losing faith. What makes you confident that there will be more adoption, use, and innovation? Please give us some hope!
Ken: I think the belief in crypto comes from your belief in the world. Personally, I’ve been through many cycles of crypto adoption. When I was young, no one had a PC, and we’ve gone from that era to everyone having a computer, to everyone being on the internet, from AOL in the US to the internet, to everyone having a phone, to everyone being able to send their own photos to social media and put them online, I’ve seen all of these changes.
Another thing is that in retrospect, I think you should also notice that there were a lot of problems in the early adoption stages of these applications. You may have a mundane experience at the time, but during your experience, you will think, “This is the future.” I still remember when I was in high school, my friend and I used dial-up modems to order something, like a music CD. At the time, you would get a paper music catalog, then tear off the back page, write down all the CD numbers you wanted, and then send it back with that piece of paper. Then you might get a box with your favorite music CD in it a few weeks later, which was popular at the time compared to filling out forms in web browsers like netscape 1.0 and other browsers.
Just like filling out forms in web browsers at that time, there was no security or confidentiality, but they appeared like that. Although it’s not a prosperous period yet, if you experience it, you will feel that “this is the best way we can use so far.” In a sense, everyone will do it. So I think crypto is the same, you can only hope if you have experienced it. What’s more interesting is that many people are saying that crypto will be adopted, perhaps currently smaller than emerging economies. But now the traditional financial infrastructure is really not that good, and many US financial infrastructures are actually very inconvenient. But now, you will find that “as long as you know someone’s address, I can buy 5000 stablecoins for $5000.” I can buy and sell crypto 24/7, and it’s easy to confirm transactions. It can be settled immediately or relatively immediately. If you have experienced all these things, it feels like the first time you buy something on the Internet, it takes time to do these things, but the current crypto is obviously a better way of handling it, and then you experience DeFi and other crypto services.
My confidence in encryption comes from experiencing many of these cycles and the early skepticism of the world about encryption, but there are always conflicts in my mind, but there is always a sentence: “Oh, this is obviously a better way of doing things.” In the end, I still saw the victory of technology, although many people don’t know what encryption is. Encryption is going through this cycle, and these large-scale adoptions may take decades, and eventually reach their peak.
SEC
Edgy: SEC is suing everywhere. A few weeks ago, they sued Binance and Coinbase. Should we be more concerned about this kind of thing as people in the encryption industry?
Ken: In fact, strategically, I think SEC’s crackdown on Coinbase may be wrong. SEC is very good at hitting the “bad guys” in most people’s hearts. When SEC does this, most people will say: “Maybe they are expanding their regulatory scope or other things”, but do we really want to defend SEC? There are many projects in the industry that people think are very rubbish, but most people are not willing to take the risk of ruining their reputation in this way. But as you said: “I think Coinbase may be a very popular and respected company in the encryption industry. They have been insisting on doing things the right way, trying to communicate with SEC, to do what they should do, and trying to promote the conversation between them.” So I think if there is a company (including Binance) that can provide support for people in the United States who are interested in encryption, it should be Coinbase. But it seems that Coinbase is also going to join this war of US regulation and will not give up. If you want the entire community to unite against you, continue to crack down on Coinbase. I think it is strategically unreasonable for SEC to crack down on crypto by regulating Coinbase in this way.
I think this may end in a very high appeal court type case, not the Supreme Court, or it will stimulate legislative action, because in the political field, you can do something to benefit encryption, even if Coinbase is closed or hit very hard, it will still exist in other areas of encryption.
Becoming a full-time analyst
Edgy: Many people are interested in becoming full-time researchers or analysts. If someone wants to become an analyst at a venture capital firm like Electric Capital, what should they do?
Ken: The qualifications for a full-time analyst may differ from company to company. At least in my view, we tend to prefer people with technical backgrounds. Crypto is a field that involves multiple disciplines. Fundamentally, we need to analyze various stages of the analysis process. If we were in a more mature industry, there might be things like Bloomberg data sources or every protocol would already be fully compliant. You need to have the skills of numerical computation and modeling to understand some project and industry changes. Perhaps some people have traditional analytical skills, such as quantitative analysis, and they can also work, but this is not what we need in crypto.
You need to be able to do analysis in Dune, solve problems on your own, or run a node alone, extract and analyze data to find problems. You also need to understand things like the differences between ve contracts on Curve and Balancer and why they differ. You need to read project Docs, but if there are no Docs, you need to read its code. So, if you don’t have the ability to explain things in detail technically in this industry, you are an unqualified analyst. You need a technical background – that’s also our recruitment criterion.
Book recommendations
Edgy: Do you have any book recommendations for those who want to have critical thinking? What books should I read to become a better investor?
Ken: What was helpful for me were books on the evolution of finance, especially those that could give me some inspiration in the DeFi field. I remember a book called “The Ascent of Money: A Financial History of the World,” and another book about hedge funds, which may be called “More Money Than God: Hedge Funds and the Making of a New Elite.” The title may be a bit exaggerated, but the content tells stories about large hedge funds, understanding how they succeeded or failed completely, and hedge funds have a long history. Understanding these contents can also help me better understand the development and evolution of such financial structures. For example, currently, there are some vulnerabilities and ways that could lead to the failure of the financial system, which should be regulated properly.
There is another book that I want to recommend called “One Nation Under Gold”, which is about the history of gold in the United States. I think all the books I like are historical books. You can see some incredible similarities between the past financial development history and the current crypto development trajectory in these books. This is really great. Going back to what I said before, humans have not changed, only technology is changing. Many historical stories can give you some hints about how people should deal with changes in the world in a specific environment. What you need is insight to help you understand or at least have a mental model to face the changing world.
Yes, I prefer historical books. This kind of book can connect the past with the present. I also like authoritative books on the dilemma of innovators and the business cycle pattern, just to better understand what changes are happening in the world under technological change.
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