In a forthcoming book chapter, we analyze the regulatory challenges facing venture capital (VC) firms as they navigate engagement with decentralized cryptocurrency markets, particularly through decentralized autonomous organizations (DAOs).[1] These challenges have grown urgent, as the crypto industry emerges from a period of near existential turmoil to one with the potential for expansive structural growth, wide mainstream adoption, and deep integration with traditional markets. With the Trump administration promising a major legal reset for the cryptocurrency industry, venture capital firms are cautiously reengaging with the digital asset sector in a bid to recover from the failure of FTX and other crypto exchanges.[2]
Crypto markets remained relatively quiet in 2024, totaling around $11.5 billion across 2153 crypto and blockchain-focused deals, but it is reasonable to expect much more activity in coming years.[3] A big question is whether the legal and governance tools traditionally deployed by venture capital firms are up to the task of engaging with this increased activity. Some of the usual approaches to managing the risks and opportunities of funding start-ups probably won’t work well in more decentralized contexts. Venture capital is nonetheless well-positioned to take advantage of crypto’s resurgence.
Traditional VC Protections Meet Decentralized Reality
VC firms typically deploy a range of hard (contractual) and soft (influence) tools to protect against risk and help make new businesses successful. VC funders can typically look forward to lucrative returns when a company goes public or otherwise engages in a liquidity event. Contractual levers include conversion rights, rights of first refusal, pro rata participation rights, anti-dilution provisions. and liquidation preferences. Soft-power levers include nominating representatives to a start-up’s board and monitoring, negotiation, and engagement to encourage companies to progress and to safeguard the funder’s investment.
Conceptual and Regulatory Challenges Posed by Decentralized Ventures
These mechanisms, however, may not work in the context of decentralized ventures like decentralized autonomous organizations (DAOs). DAOs are a form of code-based automated decentralized governance for running a particular application (e.g., for lending or gaming). DAOs automate governance across a broad, often open-access group of users, where governance and participation rights might reflect not just someone’s funding contributions, but also how much a stakeholder contributes to conversation, provides feedback on proposed updates, or adds information to the application.[4]
DAOs present several challenges for VCs. First, tools of hard contractual power are hard to apply where ventures seek to negotiate and enforce contractual protections across a diffuse set of actors. As part of its overall design, a DAO’s governance structure typically seeks to distribute power across its network of community members. Importantly, a DAO can recognize non-financial contributions when allocating power to its members. In other words, rather than necessarily concentrating influence in the hands of major providers of capital, a DAO’s code can reward those that foster creative engagement or offer advice, feedback ,or ideas for an application’s development (e.g., design updates). This more community-orientated approach can dilute VCs’ influence even when they provide substantial funding.
Second, from a logistical standpoint, VCs looking to exert influence within a DAO must often engage with a swath of pseudonymous stakeholders rather than a small group of identifiable founders. This can increase the complexity and difficulty of engagement, as well as shift the dynamics of negotiations and governance, requiring VCs to appeal to many, diverse community interests. The VCs may have to use novel skills in speaking to an application’s online community (e.g., on forums such as Discord, Telegram or Reddit) and understanding its core technology (e.g., the capacity of the automated code to deliver a particular service such as lending in a safe and scalable way) and may also have to contribute more than capital to develop the project that is tailored to an application’s risks (e.g., coding updates to address the price volatility for collateralized assets subject in a decentralized lending application).
Third, traditional VC exit strategy through IPOs becomes largely irrelevant in the DAO context, forcing firms to reconsider how they might realize ultimate returns.
The Regulatory Puzzle
Underlying these challenges, the regulatory environment has added legal uncertainty that increases the difficulty of both pricing VC involvement with crypto as well as guiding it through longer-term advisory engagement. The lack of a federal regulatory framework for cryptocurrency in the United has underscored the costs involved. Several federal enforcement actions, such as the Commodity and Futures Trading Association case involving Ooki DAO, leave unanswered questions like how to establish liability in the context of decentralized ventures, which actors might be implicated (e.g., code developers), and whether digital tokens attaching to decentralized projects constitute securities or commodities or fall into some other asset class.[5] Even as the Trump administration promises to de-emphasize enforcement in its regulatory approach to crypto markets, thereby potentially reducing the liability risks for crypto VCs, a lack of clear laws still affect crypto-VCs in various ways. For example, patchy access to reliable, standardized disclosures or vulnerability to technological failures, hacks, or fraud can amplify risk without recourse for VCs.
Opportunities Amid Challenges
Despite these challenges, VCs’ capacity for bearing novel risk and their expertise in navigating uncertain technological landscapes put them in a good position to engage with crypto markets. Decentralized environments also come with some important advantages. Transparency inherent in blockchain systems can make it easier for VCs to monitor projects and market trends and build on innovative open-source codebases. It can also enhance the reputations of crypto-VCs that show themselves capable of helping to grow new technologies and decentralized structures, allowing their contributions to be recognized more openly than in traditional corporate contexts. Our chapter highlights the need for regulatory clarity in decentralized networks to allow VCs to provide funding more efficiently and safely to their decentralized projects.
ENDNOTES
[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5030890.
[2] https://www.galaxy.com/insights/research/crypto-blockchain-venture-capital-q4-2024/.
[3] Id.
[4] Dimitris Pechlivanidis, The Case of Venture DAOs and the Future of Decentralized Venture Capital (Jan. 15, 2022), https://ssrn.com/abstract=4708467; Lucas Matney, VC-Backed DAO Startups are Racing to Define What DAOs Actually Are, TechCrunch, (Feb. 1, 2022), https://techcrunch.com/2022/02/01/vc-backed-dao-startups-are-racing-to-define-what-daos-actually-are/.
[5] Commodity Future Trading Commission, Statement of CFTC Division of Enforcement Director Ian McGinley on the Ooki DAO Litigation Victor, Press Release, http://www.cftc.gov/PressRoom/PressReleases/8715-23 (June 9, 2023); From Code to Consequence: CFTC Obtains Default Judgment against Ooki DAO for Commodity Exchange Act Violations, Proskauer Rose LLP (July 20, 2023), http://www.proskauer.com/blog/from-code-to-consequence-cftc-obtains-default-judgment-against-ooki-dao-for-commodity-exchange-act-violations.
This post comes to us from Yesha Yadav at Vanderbilt University Law School and Khalil Bryant at the law firm of Haynes and Boone, LLP. It is based on their chapter, “The Challenges Facing Venture Capital In Digital Asset Markets,” in the Research Handbook on Private Equity and Venture Capital (eds, Brian Broughman & Elizabeth de Fontenay) and available here.