The crypto industry has not had a great run over the past year. Along with increasing regulatory scrutiny and skeptical investors, capital deployment has pulled back significantly from the highs of 2021, which has left many young startups struggling to raise funds.

This capital crunch is affecting the Bitcoin ecosystem as well. According to Erik Svenson, co-founder and CFO of blockchain infrastructure firm, Blockstream, Bitcoin-focused companies are falling behind as fewer checks are being written.

“I think investment into crypto kind of peaked early last year,” Svenson said on TechCrunch’s Chain Reaction podcast this week. “But Bitcoin itself has always been an area that has been undercapitalized.”

Founded in 2014, Blockstream focuses on its own sidechain technology, dubbed Liquid Network, and it has bitcoin mining operations and provides hardware wallets for bitcoin and other assets. Notably, it doesn’t have a token of its own, unlike many other crypto companies that launched their own during the initial coin offering (ICO) boom in 2017.

“We decided early on not to issue our own token,” Svenson said. “We didn’t raise an ICO like many projects did, so we’ve been relying on more traditional VC investment,” he added.

Blockstream raised $125 million in late January, bringing its total funding to about $400 million. The company had a post-money valuation of $2.49 billion as of August 2022, according to PitchBook data.

However, it’s not been all smooth sailing for the company, especially as the crypto waters have grown choppier amid the broader funding crunch. Svenson pointed out that while Blockstream has some “really bullish Bitcoin investors” on its cap table, it also has LPs, and the turbulence in the crypto market has made things more challenging. “The LPs are trying to parse both the macroeconomic factors and then also the industry-specific direction that everybody’s experienced in the last year.”

A factor in the slowdown of funding to Bitcoin startups could be the fact that web3 developers are increasingly building projects on other blockchains such as Ethereum and Polygon. About 75.9 million smart contracts were created in the second quarter on the Ethereum blockchain and on layer-2 blockchains like Arbitrum, Optimism and Polygon, according to Alchemy’s Web3 Developer Report for Q2 2023. The report didn’t mention any data on Bitcoin development activity.

Understandably, that has people worried about Bitcoin innovation falling behind, despite new trends like Bitcoin-based NFTs, or Ordinals, gaining traction earlier this year and breathing new life into the blockchain.

Bitcoin NFTs are growing quickly as community sees long-term potential

There are still Bitcoin startups launching in the space and getting seed funding, though. Earlier this year, asset management firm Stone Ridge launched In Wolf’s Clothing, a startup accelerator that aimed to bolster, mentor and fund Bitcoin-focused applications and use cases. The program is currently gearing up for its second cohort, but its flagship group of eight teams had a major focus on real-world use cases that were about improving not only the Bitcoin ecosystem, but also “normal” products and services that people could use.

Svenson thinks it’s more to do with funding than anything else. “I don’t think there’s a lack of innovation,” Svenson said. “As I said before, I think there’s just a lack of capitalization. There are dozens of really interesting companies that are building on our technology, and their ideas are stellar. If we could get more funding in the space, I think that would really unlock the potential of what they’re building.”

Early-stage Bitcoin companies may find it easier to raise capital, Svenson said, as there’s a significant focus on the Lightning Network, which is a layer-2 protocol on top of the blockchain that is “accelerating rapidly.” Those projects usually focus on improving payment applications with the protocol, because it allows for instant settlements with micropayments.

“There are many investors who are really bullish on Bitcoin and Lightning, and so early-stage funding isn’t as challenging,” Svenson said. “I think a lot of companies in the Bitcoin space were successfully raising rounds before the bottom fell out. So the opportunity cost of not being able to grow during this bear market is pretty big.”

Developers continue to dive into the crypto space as market remains lackluster

Of course, companies that raised capital during the bull market would still prefer to raise more now, but things aren’t as easy anymore, especially for late-stage companies, Svenson said.

“I actually think a lot of companies working on really cool ideas will either be consolidated or will make it,” Svenson added. “So I think a much higher percentage of Lightning companies than your average tech startup will make it, especially when the market turns and suddenly investing in Bitcoin is cool again.”

But until that tipping point arrives, Bitcoin and Lightning-focused startups should take advantage of the current market, even if it seems unfavorable.

“When the market is more bearish, [companies should] position themselves for the future, not just continue to go with it,” Svenson said. “Pick out the things you think are going to take off when the market turns and lean into those. Line up potential investors, partners and other folk who believe in what you’re doing and can help you continue to accelerate once the market turns.”

This story was inspired by an episode of TechCrunch’s podcast Chain Reaction. Subscribe to Chain Reaction on Apple Podcasts, Spotify or your favorite pod platform to hear more stories and tips from the entrepreneurs building today’s most innovative companies.

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