In my previous post I wrote 99% of Blockchain Startups Are Bullshit. This was in part based on the belief innovation in protocols should be owned and financed by the community by way of an Ethereum like ICO (‘initial coin or token offering”), or through consortia like Hyperledger, not as conventional VC funded ventures. With a recent flurry of related news I wanted to look pragmatically at the pros and cons of ICOs in their current form, how they could / should evolve and where we, as a new VC dedicated to this emergent paradigm can play a role if any.
It’s this thought process I wanted to open up here to the community. It’s rough, imperfect and happily open to criticism and feedback. Like most, we are still very much trying to figure out our exact position on this fast moving environment but this forms the basis of our current thinking.
Before I kick off I need to assume you already know what an ICO is. If not please start here.
Much of the reasoning for why ICOs make sense is because of what Union Square Ventures calls ‘Fat Protocols’: the idea that most of the value in blockchains are at the protocol layer, unlike Web 2.0 which saw billion dollar companies emerge at the Application Layer e.g. Facebook or AirBnB.
The idea is in Web 3.0 that the commons infrastructure’s value, realised in the form of the tokens that underpin it, is in and of itself the ‘unicorn’ and always greater than the sum of all applications. In Bitcoin this represents a market cap of just under $20bn (as of 12-April-17)
Whilst I think this argument in principle holds one of the key aspects of my previous post was that if you combine machine learning with the Application Layer you could see private companies hoover up the data, to build monopolistic positions through genuinely smart contracts which might not be so dissimilar to many Web 2.0 monopolies we see today. These very likely could be VC funded because they are looking to create proprietary positions. However for machine learning to be able to deliver any value at all it first needs lots of data and that requires major adoption of the infrastructure first. They key incentive for this network effect in most instances is the token that underpins it.
Below I’ve listed the regularly championed benefits of ICOs by it’s enthusiasts. At this stage I am not saying I do or don’t agree with them, because many have counter-arguments I later address in the Cons section.
‘Liquidity enhanced venture capital’, is how Brock Pierce described his recent ICO. This is basically because investors can trade tokens in secondary markets rather than have value locked up in the equity of a company. As most will know liquidity is the bane of VCs and their LPs who can see capital locked away for up to 10 years.
That’s also a big problem with increasingly shorter technology cycles. Without ICOs Web 3.0 will likely be relatively cash starved until VCs can exit out of their Web 2.0 investments, many of which will likely be disrupted. I think this is especially true if you follow the “Convergence Thesis” we champion which holds that major technology trends will begin to accelerate one another as they benefit from a shared distributed Web 3.0 architecture.
A vibrant secondary market also means investors can get real-time pricing based on the progress of a company, as understood by the crowd. This potentially brings greater transparency to an otherwise typically secretive private market with very little disclosure.
The argument goes: Average Joe is locked out of the very early value available in startups because unless you are lucky enough to be friends-and-family with the right people you are locked out by regulators by not qualifying as an ‘accredited / sophisticated investor’. As a consequence you are forced to pay a premium at the point of IPO, when most of the value has already been extracted by VCs. It benefits VCs to keep retail investors locked out so capital is scarce, inflating their value. This compounds the wealth gap between the haves and the have nots.
This idea is stronger in the US than say Europe, which has a richer and more accessible angel market. In Europe you only need to tick a box to declare you are indeed a ‘sophisticated investor’ unlike the US where you must provide documentary evidence of your wealth. So here ICOs promise to break the monopoly on money in the US and democratise fundraising.
There is also an argument to be made for making capital more widely available beyond traditional geographic hubs of VC activity like Silicon Valley, NYC and London, both for smaller investors that want to participate and startups that hope to receive their backing. At a certain scale of fundraising money is often tied to you physically moving closer to the money itself which compounds the problem. This promises to better distribute capital to where it’s needed and arguably deserved most.
More Social Enterprise,
Simply put, this will mean many projects currently unattractive to VCs because they lack an aggressive profit motive, can now get funded. I’ve seen a lot of interest coming from the ‘platform coop’ movement in ICOs which, typically as a non-profit industry, can finally see a way to aggregate enough financial firepower to compete technically with the centralised rentier ‘sharing economy’.
Crowd Backed Day 1,
An ICO-funded startup, like a standard crowdfunded company, has the benefit of an army of supporters only this time with the added network effect of not just seeing the product delivered but holding tokens that appreciate based on usage. This should dramatically increase virality gained from word-of-mouth, in turn reducing the need for costly marketing and user acquisition. It is this later activity that drives the most demand for billions in investment from VCs.
Unlocking Sleeping Value,
A combined $23 billion of value is held in Bitcoin and Ether, which is largely dormant yet accumulating value but which people are reluctant to bring offline where they may have to pay capital gains taxes. ICOs offer an outlet to invest profits from Bitcoin or Ether, converted into a newly launched crypto token, which in turn adds to their scarcity pushing the price up and in turn creating a self-reinforcing loop.
The degree of liquidity to me is actually a challenge as much as it is a pro. I understand why early pre-ICO investors and founders want liquidity but after issuance, tokens are traded on decentralised exchanges in what are effectively dark pools with zero to little transparency. That means the people you are backing can exit at the point of ICO before any real value has been delivered or gradually dump their holdings over time ahead of the market if they feel things aren’t working out. Currently you just have to trust they won’t.
Incentive Misalignment & Capital Inefficiency
This point on liquidity actually leads to a broader problem around misalignment of incentives. Professional investors want to know the people they are backing are locked in 100% to achieving success. It’s a common belief the more financially comfortable a founding team is the less hungry and more complacent they are. ICOs potentially make entrepreneurs too comfortable too soon. Furthermore it is not uncommon that ICOs are oversubscribed, providing a surplus of capital, which will inevitably be spent anyway creating a major market inefficiency.
In addition typically investors that come in at later rounds want to see signals the early investors remain confident and are following their money to the best of their ability. However ICOs offer no way of really knowing if those early investors are still confident in the team and its progress so you must rely on general market sentiment.
Timing & Pressure of Going Public
Firstly, many very successful companies choose never to IPO and ‘go public’ because it can be a real pain in the ass often forcing companies to become short-termist and reactionary which is the number one killer of innovation and why many public companies get disrupted. I think most startups that will ICO are naive to the implications of crowdfunding which demands having a permanent investor relations team communicating effectively with the community, and even when done well can still be very distracting from just getting the job done.
Unlike normal crowdfunding your investors are largely speculators who can and will actively short you in the markets. Some ICOs like Augur made sure their tokens weren’t tradeable immediately to reduce the effects of early speculation but the market dynamic is still there and can only be postponed. This is something I think will be the main cause of death for the large majority of ICOs.
Furthermore investing in startups before they have achieved ‘product market fit’ means pivots are very likely which requires supportive and experienced investors. To me going public pre-fit makes no sense at all, which is where I see a big role for early stage VCs prepared to assume the risk and ready startups for launch.
Quality Control / Scams
Putting aside VC funding being limited to a few small regions in the world, most startups can’t get funding because they aren’t viable or the team have failed to get traction because it isn’t there to be had or they aren’t the people to achieve it. A lot of due diligence is carried out by professionals, or even just experienced angel investors, into the team and their stories. By losing a lot of money in the process they get good at reading signals and asking the right questions.
Now whilst I am sure the space will professionalise currently any man and his dog can ICO. There is no filter at all. This means a lot of people will get funding that shouldn’t. Worse still, very likely from people that can least afford it to lose their money. It then becomes an ethical debate if everyone, including those less informed, should have equal rights to lose their money.
Whilst many of the PROs listed above are very valid I think most of the community are in denial about the real motivations of those championing ICOs. Sophisticated investors love retail investors because they are basically less informed. And guess what those same sophisticated investors, like in the established capital markets, have accumulated significant positions to be able to move markets. The Winklevoss Twins declared they controlled 1% of all Bitcoins in 2013 which should make 99%’rs very concerned about history repeating. In a lightly regulated wild west there are huge profits to be made from insider trading. So I am very concerned for naive utopists who think these markets will develop any differently to those we have today. It is no coincidence USV recently referred to Coinbase as the Goldman Sachs of Crypto.
So when we see new hedge funds like Polychain emerge it is ridiculous to expect they won’t day trade but instead hold long positions, which will likely bring huge volatility to startups. This is something I mentioned would happen in my predictions for 2017 at the beginning of the year. As previously mentioned this will either kill them off as they pivot to find market fit or force short-termism and stifle game changing innovation.
This is already the one area that has seen much debate. Argon Capital, the entity behind the Blockchain Capital ICO, recently stated:
‘‘There are only two jurisdictions in the world where digital tokens have been determined to be assets and not securities: Switzerland and Singapore. However, while Singapore has the benefit of broad decision from the Monetary Authority and principles of Singapore law that all digital tokens are contracts/assets; the Swiss Financial Market Supervisory Authority’s (FINMA) only decision on digital tokens related specifically to Ethereum and thus arguably only applies to usage tokens. FINMA’s decision can be overturned by FINMA at any time and many Swiss ICOs appear to stretch to breaking its meaning.’’
In any investment offering, the question to ask is whether the offering is an “investment contract” under the Howey Test, which is defined as follows:
- An investment of money due to
- An expectation of profits arising from
- a common enterprise which
- depends solely on the efforts of a promoter or third party.
This test states that whenever you’re trying to raise money, if the investor is relying on your efforts to make their profits, you are considered to be selling a security. Whether or not a certain investment opportunity — in this case, an ICO — is considered a security is important because the issuer, or seller of the security, must either register the offering in any country it wishes to raise money from or comply with the rules around exemptions from registration.
Stephen Palley, a lawyer who has been tracking the emerging ICO space and regularly, offers a slightly different perspective:
‘’Here’s the thing — once you bake in the cost of proper compliance, I am not sure it’s actually any cheaper to do an ICO than doing a traditional capital raise. Often what people are proposing is clearly a securities offering where raising capital using a token is no less expensive than raising capital without. The real reason most people do these things is to try and skirt around securities laws. Once you comply with securities laws, is there any benefit for 99 percent of the ICOs to actually ICO? That’s a rhetorical question, with an obvious answer’’.
‘’For me the really interesting part about tokenized ownership is in governance automation and the use of a shared ledger to record ownership so you avoid problems like in the Dole case in Delaware. But you don’t need an ICO as a capital raising tool to do this. Perversely, perhaps, someone who wants to do a JOBS Act compliant ICO will probably pay more than a person who does a non-tokenized JOBS Act crowdfunding raise, because the token piece adds technical overhead that you wouldn’t have otherwise’’.
In summary, we are entering into a new emergent paradigm with many unknowns. The Bitcoin and Ethereum community have set a precedent which for the first time in history allows an open source community to not just self-finance but directly profit from increased usage. It has introduced the concept of decentralised ownership in an entirely new kind of asset class however I believe at best most people looking to ICO do so not really understanding why and at worst are looking to make a quick buck.
That said I believe ICOs done properly represent a huge opportunity to better distribute and allocate capital. No one can argue VCs fail here, they create geographic concentrations and bubbles but I don’t think they will be the silver bullet. If anything they can increase the advent of bubbles.
As you can see in my view the CONS significantly outweigh the PROS in their current form. But I believe most of these things are fixable, that is if you want to fix them. The problem is many simply don’t want this to happen because it ruins their get rich quick scheme or conflicts with a libertarian world view that we should all be free to bet and lose. It is the responsibility of those of us that genuinely want to see the nascent industry grow, to help it self-regulate so it isn’t just switched off. And to anyone who thinks that’s impossible see the recent precedent set with Bitfinex vs Wells Fargo.
For me there are a handful of key issues we need to collectively address:
- Transparency, who owns what. I appreciate for many bitcoin maximalists privacy is a central tenant of their cult but if an ICO advertises a significant backer at launch the market should know who it is and if they continue to hold their position.
- Trusted Corner Stones, professional DD. I think there is a real need for professional investors to perform DD and act as pre-ICO corner-stone backers to ensure there is quality control.
- Post seed, ICO. I think startups should only ICO once they have achieved clear product market fit.
- Controls, hard coded. I would want to see co-founders and early investors locked into their investments which vest over time against measurable success. As an investor I would happily make this commitment to send the right signal to the market.
OPPORTUNITIES FOR VCS:
So for me there are four ways as a VC you can play in this new paradigm:
1.Pre ICO Prep
Providing R&D capital and support to help startups achieve product-market-fit so they can ICO.
2. Post ICO Speculation
At first glance this is more akin to a hedge fund and will likely become increasingly automated through HFT focused on game theory dynamics about how ICOs are configured. However the more savvy, and perhaps more philosophically engaged, will look to invest at both the protocol layer but also in the apps on top that build at the ecosystem simultaneously pushing up tokens value.
3. Fat Apps via AI
You ignore investing at the protocol layer and focus on building ‘fat apps’ leveraging the data and machine learning to build monopolistic positions.
4. VC as ICO
Rather than ICO the startup you ICO the equity backed VC fund. This opens up the market and spreads risk across a portfolio with professional managers and, based on how Blockchain Capital’s round was structured, acts more like an equity swap than an equity security.
At Outlier Ventures we are exploring all four of those options. If you are interested in learning more reach out to me via Linkedin.
I would like to thank Aron van Ammers, Greg Murphy, Michael van der Meer, Stephen Palley for their contributions.