While some VC firms have embraced ICOs (USV, Sequoia, DJF, and Seedcamp are some prime examples), the broader VC community has shown signs of fear and resentment towards ICOs.
I have been following blockchain and distributed ledger technologies since 2013. The rise of cryptocurrencies since then has been meteoric. Only a year ago, I wasn’t sure what to say when asked on stage about the prospects for ICOs. Now, with seven ICOs raising $ 100 million or more during 2017 and messaging app Telegram having already raised $ 850 million of the $ 1.2 billion it is targeting in the first so-called mega-ICO, I know exactly what to say.
The cryptocurrency market is a bubble.
I can see why some VCs are enthusiastic: It’s hard to stand on the sidelines. Who wants to be the investor that missed the boat on the company that lasts the course, goes supernova, and turns into the Amazon of crypto? They had better hope they pick well (or get lucky), though. Very few winners came out of the dot-com era, and just like when that bubble burst, a lot of money invested in crypto will turn out to have been wasted.
It is important to distinguish the current crypto-mania from distributed ledger technology (DLT) more generally and the potential benefits it may bring.
The implications of DLT and tokenization will be far-reaching and will most likely have a revolutionary impact on quite a few industries. People looking to get involved in the space need to realize that, while good ideas are emerging, the underlying infrastructure required to make them happen doesn’t yet exist, a bit like in 1999 when many great ideas weren’t viable because high-speed internet access and other underlying technologies simply weren’t there. I have yet to see the real killer application that will gain mass adoption, but I believe it will emerge soon enough. There are companies creating ground-breaking DLT solutions with the potential for real, viable business models. But this small minority isn’t the focus of this post.
The current crypto-mania, much like the dot-com boom that preceded it, is largely driven by the promise that the average Joe can make huge financial profits. We all have a friend – I have quite a few! — who put $ 20,000 into Bitcoin or Ethereum a few years ago and is now busy reading the FT’s “How to Spend It.” Just like in 1999, most of the companies raising money have no real business model, revenues, or prospects of ever being viable; the main difference is that regulatory loopholes are making it easier for companies to sidestep or break securities law and market securities, or security-like instruments, to the public.
ICOs do offer certain benefits to companies and investors beyond an easy way to raise money. Having a tradable token or coin means investors can enjoy immediate liquidity and don’t have to wait years for an IPO. But if a company underperforms, its token may trade down, making it hard to raise further capital. ICOs could also be a neat way to fund the development of open-source projects by creating an incentive for early developers and participants in a specific network.
So, why should VCs hate crypto investments?
1. The fundamentals don’t add up. Most tokens are either a security or provide some sort of utility. Utility tokens, by virtue of providing the bearer a certain service, should theoretically have a cap on their value based on the utility they provide. There is, for example, only so much people will pay to store a file on a distributed file system, or to register their sneakers. But these tokens are trading well above their expected utility value, indicating they are over-valued. A lot of money can be made in momentum trades, but VCs don’t usually play that game well. When it comes to security tokens, the SEC has ruled that, roughly speaking, “if it smells like a security, it is a security,” rendering most quasi-security offerings either illegal or impractical. Early developers and adopters of utility coins could see significant returns as the underlying protocol they develop expands, but investors must analyze and form a view of the underlying value of each token and how it might appreciate if usage of the network or protocol expands.
2. P2P and decentralization are utopian myths. Many of the early participants in the crypto ecosystem hold strong libertarian views. Decentralization is seen as a good thing, freeing “the people” from government and regulation. A lot of ICOs I see start from a premise of creating a decentralized system of sorts. But as we have seen over and over again, if a P2P or consumer-to-consumer business model is really that good, businesses will step in and the market will start consolidating and become B2C, giving a number of large players more control over a network. Just note the consolidation in Bitcoin mining for a hint of things to come.
3. The investment mechanics aren’t there. Traditional VC fund documents make it hard for VCs to invest in cryptocurrencies and ICOs. While I expect fund documents to start including provisions to allow investment in cryptocurrencies, this process will take time. Cryptocurrencies also present new types of challenges for institutional investors, such as volatility in the price of Bitcoin, which is a completely exogenous variable that could make or break an investment. Additionally, there are logistical issues around depositary services for cryptocurrencies – investors will expect a fund to hold whatever security it holds in a secure form. If a share certificate is lost, the company can issue a new one. If the key to a crypto wallet is lost, the contents are most likely lost forever.
4. Investors don’t get any control. When a VC invests in a company, it comes with strings attached, mainly in the shape of controls over the business. This is primarily so the VC can ensure its funds are used in the way it expects, to enhance the growth and success of the business. ICOs, however, are usually structured so that the investor has no control over the use of their investment. While this may be acceptable to a small investor holding a tiny fractional percentage of a company, it simply doesn’t fly with a VC that invests millions. These VCs expect a certain level of control in order to deliver an expected return over a given timeframe, and they are accountable to investors of their own.
A classic bubble
Crypto enthusiasts see ICOs as a way to break the hegemony of venture capitalists over funding and supporting startups. Why spend six months pounding up and down Sand Hill Road, give up 30 percent of your business, and cede control of major decisions when you can raise millions in seconds? However, the ability to raise money from the public (at least in the US and the UK) in the form of crowdfunding already exists, and while some companies choose the crowdfunding route, the VC community continues to thrive. I find that many founders want to have a VC invest in their company, be it for advice, experience, network, or the credibility that comes with having an experienced VC on your board.
Ultimately, crypto just has all the hallmarks of a classic bubble. Even if Bitcoin does turn out to have sticking power, that’s no reason to believe there’s a market for all the other fledgling cryptocurrencies springing up on a near-daily basis. Companies aren’t selling coins because they have to but because they can. If the CEO of Kodak has to issue a statement denying that his company’s crypto offering is a cynical ploy to pump its stock price the morning after its announcement had exactly that effect, we have a problem. VCs still have to identify and invest in businesses with real, long-term prospects. When my Uber driver whips out a laptop and tries to convince me to back his ICO on the basis of a white paper that’s barely five percent ready (true story!), we have an even bigger problem.