Investing in digital assets: what venture capitalists need to know

Digital assets include cryptocurrencies, stablecoins, tokenized assets, non‑fungible tokens (NFTs) and other digital representations of value. Unlike traditional “paper” shares, which are static and limited in their capabilities, a token is represented digitally on the blockchain as software that can be programmed with additional functionality. This makes tokens a more versatile and powerful tool for investment and value creation.

Investors are drawn to the benefits of tokenization that include access to new asset types, increased transparency, fractionalization, faster trading and reduced fees. But unlike traditional assets, ownership of digital assets requires specific technical capabilities, including secure storage and management.

During a recent webinar hosted by the National Venture Capital Association, EY Global Assurance leaders Rebecca Carvatt, Digital Assets Consulting Leader, and David Byrd, Blockchain Strategy Leader, discussed the future of digital investing and what venture capitalists need to know. They were joined by Matthew Le Merle, Managing Partner & CEO of Blockchain Coinvestors, and Josh Rivera, Operating Partner and General Counsel of Blockchain Capital.

The speakers acknowledged that there are still many unknowns that will play out for decades, but that shouldn’t stop venture capitalists from exploring the space.

Three things venture capitalists need to know about digital assets

1. Understanding asset custody and ownership is key

Owning digital assets requires an understanding of each relevant blockchain and private key management. Each blockchain or contract has unique features and functionality that can enable additional ROI but can also result in unique security risks. The private key is part of a key pair and associated with a particular public key.

While “proof-of-work” (PoW) blockchains (e.g., bitcoin, litecoin) require hardware to generate computing power and “mine” on the network to earn rewards for transaction validation, “proof-of-stake” (PoS) blockchains do not. PoS chains allow holders of the associated digital asset to garner additional returns via staking. This could occur simply by holding the asset (liquid staking) or by designating or delegating a number of assets as staked. No additional hardware and computing power are required. Many funds participate in staking through their custodian’s staking-as-a-service product. We can think of staking rewards as loosely analogous to dividends.

Private key management is the most important process related to owning digital assets. If the private key is ever exposed to an individual actor, that actor can unilaterally access and move the digital assets to other public addresses not in the entity’s control. Proper segregation of duties and other controls around private key management are the crux of all digital asset investments. The two common types of custody are self-custody (owning the private key management process) and third-party custody (owning an access process while a third-party maintains private key management).

2. Digital asset regulations are evolving; investors must be comfortable with navigating uncertainty

The regulatory landscape for digital assets is complex and constantly evolving. While some countries have made progress in establishing frameworks, others, including the United States, are still catching up.

For venture capitalists, this means operating in a space where the rules are not always clear. The speakers urged investors not to let uncertainty hold them back.

“We are seeing what we believe to be the best entrepreneurs, the greatest innovative minds, join this space — irrespective of regulatory lack of clarity,” Rivera said. “I’m a firm believer that regulation must follow innovation. It’s not the other way around.”

Successful investors are willing to embrace new technologies and navigate the uncertainties, confident in the knowledge that regulatory clarity will eventually emerge, Le Merle said. “There’s an opportunity for more VCs to embrace digital assets despite the regulatory issues. There are many other industries attracting early stage tech investors where there’s just as much lack of clarity.”

3. Investing time in learning about digital assets positions venture capitalists for capitalizing on growth opportunities

Dedicating time to learning about digital assets is wise, given the transformative potential of the industry.

As digital asset investment continues to mature, venture capitalists who are willing to invest the time to understand the nuances and stay abreast of regulatory changes will be well positioned to capitalize on the growth and innovation. The speakers urged investors to read white papers and speak with those already in the industry and continue tracking global regulatory developments.

“For those people who are not in the space, please put in if not 10,000 hours, then 1,000 hours and educate yourself because this is one of the maybe three most important innovation changes of the rest of our lives,” Le Merle said.

Venture capital firms should also be asking questions, said Byrd. “If your [portfolio companies] are not already invested in or have exposure to digital assets in one form or another, they will. … It really behooves you to invest time and understand this space.”

Questions to consider before investing:

• How does the digital asset manage and mitigate security risks to prevent unauthorized access?
• What strategies does the digital asset employ to navigate and comply with the evolving regulatory landscape?
• What are the underlying technology and security measures of the digital asset, and how do they compare to industry standards?