Chasing Shadows: The Dilemma of Cryptocurrency Capital Allocation
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Chasing Shadows: The Dilemma of Cryptocurrency Capital Allocation
Shadow investing = backing a competitor after missing the category leader, often to maintain visibility rather than based on a belief in differentiation.
Navigating Web3 tides with focused insightsAuthor: Zaheer
Translation: Block unicorn
Preface
This is another article about capital allocation—but this time, it's different.
Uncertainty always slows things down, forcing people to reflect on their current situation, past decisions, and future directions. Recent interest rate hikes, along with global trade and geopolitical uncertainties, have caught the cryptocurrency investment community off guard. However, beyond external factors, there are other forces posing critical threats to crypto. This silent disaster continuously drains people’s time, capital, and belief: shadow investing.
(Shadow investing = backing competitors after missing out on industry leaders, often done to maintain visibility rather than based on differentiated conviction.)
The Genius Problem
Finding exceptional talent is the goal of every company worldwide, but genius is not an infinite resource. True brilliance is extremely hard to find—and even harder to force—often emerging entirely by chance. Companies that experience sudden breakthroughs cannot predict such outcomes; instead, they focus their energy and time on creating as many opportunities as possible for talented individuals to flourish.
Likewise, venture capital faces a similar challenge because venture investing is not a linear game. Deploying more capital does not necessarily yield more geniuses. This was widely understood during the rise of modern venture capital in the early 1980s/1990s and again in the early 2000s. Yet as investor expectations and appetites have grown, so too have VC budgets and the pursuit of genius. But this fundamentally contradicts the nature of venture capital—“How do you find more opportunities when opportunities don’t exist?”
Enter shadow investing
Every few years, we encounter a truly game-changing new protocol, project, or business in crypto that creates meaningful value. This is the joy of every investor and the goal of every team. However, the speed and scale at which these investments happen make them inherently scarce. A lack of original thinking leads investors to latch onto existing trends, selecting the hottest available option as their next investment. Simply put, investors observe new trends within the industry and choose to back weaker “competitors” of projects they previously missed.
Why This Happens
I’ve been openly critical of the cryptocurrency venture capital space for some time. You can find my complaints in old podcasts, tweets, or articles, but all of these critiques trace back to one root cause—the crypto VC supernova theory (i.e., excessive capital flooding into crypto, leading to overfunded venture investing). This abnormal state generates numerous negative externalities across the industry, but one of the worst is the continuous funding of cheap copies of excellent companies.
The current capital allocation process in crypto (or any market) is straightforward:
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Limited Partners (LPs) invest capital into venture firms
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VC firms deploy that capital into startups at various stages
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Startups use that capital to grow and build their businesses
This model works well in theory, but breaks down when LPs themselves possess too much capital. They then overfund crypto venture firms by allocating large sums to numerous investors. Today, in the crypto space, there are over 20 firms managing nine-figure capital pools, spanning from seed to late-stage investing. If each firm (even limiting to just 20 VCs) made only one investment per quarter, that would still amount to 80 deals annually. In reality, deal counts are far higher—hundreds each year. Yet there simply aren’t hundreds of valuable crypto companies worth investing in annually. Let alone dozens of compelling meta-narratives or themes worth backing each year.
Instead, we face two truths:
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There is too much capital in crypto venture investing
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There are too few high-quality, investable companies
Yet this capital must enter the market somehow, as it is designated for company investments. As a result, it flows toward companies aligned with recent investment trends: shadow investing.
In markets like Layer 1s, Layer 2s, wallets, perpetual decentralized exchanges, lending protocols, and cross-chain bridges, many projects are poor imitations of one another, because the value created by original projects drives demand that cannot be satisfied through genuine innovation. Take Uniswap, the pioneer and leader in the decentralized exchange space. Hundreds of millions, even billions of dollars, have flowed into cheap clones of Uniswap, yet delivered neither meaningful value nor visionary iteration. Instead, we’re left with an industry landscape ravaged by token inflation. Of course, some companies have built high-quality iterative products—not every spinoff is a cheap copy—but these remain the exception, not the norm.
“The imitator follows in the footsteps of the leader. He cannot surpass him.” — Peter Thiel (*From Zero to One*)
A major consequence of the cheap imitation strategy in crypto venture investing also lies in product development and maintenance. Many of crypto’s best projects start with promise but consistently require greater growth ambitions and extensive maintenance efforts. This creates challenges ranging from protocol security to building a clear product vision. How many project forks have resulted in hacks or exploits draining millions of dollars?
The buck ultimately stops with the venture firms funding these deals. Inevitably, when the entire industry—and its top investors—fail to distinguish between quality investments and inferior imitations, shadow investing tarnishes the sector’s reputation.
We can see how many funds operate and how many teams ultimately receive capital not for launching real products, but simply for mimicking trends. Imitation may be the sincerest form of flattery, but not when the market pays inflated prices for fading “good things.” If crypto is to become a serious industry—even superficially committed to capital preservation—then the space and its investors must mature beyond their current fundraising behaviors and rigorously back only teams genuinely dedicated to innovation... at least, that’s what I hope for.
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