I recently wrote a piece for Coin Center, the leading policy group for Bitcoin and cryptocurrencies. The original article is here. I wrote this for policy makers and the general public, not tech folks.
One Investor’s Take on Bitcoin
Today Bitcoin is a mixed bag when it comes to investors. On one hand, from 2012 until today, there has been fast growing interest in Bitcoin companies. But that interest may have waned recently. At a recent conference where top tier investors were in attendance, a total of zero venture capitalists (VC) said they would invest in a bitcoin startup today. My interest in bitcoin startups has remained constant since I first started investing in Bitcoin companies.
I’m not an expert in cryptography or financial systems. I didn’t read Satoshi Nakamoto’s white paper when it first came out. And when I did read it, I can’t say that I understood every technical detail. There are many VCs who understand these nuances better than I do. Their strategy for investing in bitcoin startups is probably more grounded in the fundamentals of Bitcoin and the blockchain.
I took a more impressionistic approach. I spoke to many computer scientists and entrepreneurs. I made a couple of conclusions that I still believe today. First, Bitcoin is an indisputable computer science breakthrough. One can debate the merits of bitcoin as a currency but I haven’t met anyone serious who can debate its technical merits. Second, Bitcoin has the following qualities I describe below that many of the ‘black swan’ or outliers in technology have. Nassim Taleb defined a ‘black swan’ event as one that was impossible to predict, enormous in impact and seemingly obvious in hindsight. If you look back at the black swan events or companies in technology — the Internet, Google, Facebook, Uber — they have the following qualities. This isn’t a framework to predict black swans since they are by nature impossible to predict. There are technologies and companies that had these qualities and didn’t have any impact whatsoever.
1. Highly Polarizing Among Early Adopters
Even when a black swan first emerges, there’s not early consensus among the innovators and early adopters whether it will have huge impact. Things seem obvious in hindsight. Google seems obvious now but people forget that in its early years, there was no clear path to make money. The same is true for Facebook. David Sze, an early Facebook investor who made a seemingly outrageous investment at the time in 2006, said in 2013 conference that his firm’s best returns were “the ones in the middle, where there’s a lot of debate and it’s not completely clear.” Reid Hoffman, his partner at Greylock, went on to say at the same conference that the great VC investments happen when “a lot of people will think that’s a bad investment but you will think that’s a good investment.”
While VC investment in bitcoin has grown recently, it’s grown off a very small base. The sheer dollars invested in bitcoin startups is a minuscule fraction of other areas like photo-sharing, on-demand economy and mobile commerce. VCs are the funders of innovation and early adopters. Consensus among this crowd is far from unanimous.
2. “What’s the Business Model? How Do You Make Money?”
Related to the first point above, you hear this refrain repeatedly once something starts to break out. Google had no obvious business model. Facebook’s obvious business model (display advertising on social networks) was not durable. The obvious takeaway is that if the business model were obvious, somebody else would be capturing that opportunity already.
Many ‘experts’ debate the commercial potential of bitcoin and the blockchain. And perhaps it’s a technology where a lot of value is created but not a lot is captured by commercial actors. And probably the most valid critique in my view is that it’s still very early with Bitcoin and the infrastructure is still being built.
3. The Sleaze Factor
Most of the breakouts have a bad rap at first. The conventional wisdom is that these services are used primarily for sleazy, unsavory or illegal activity: Google — porn; Internet — porn; Facebook — hooking up; Snapchat — sexting. And while there may be early adopters who use the service for these unsavory purposes, this isn’t the sole or even dominant use case. In fact, they’re usually the minority use cases. But because it makes for a better mainstream narrative, people focus on the unsavory. When it comes to bitcoin, my intuition is that it falls squarely within this category. While some people use it for illegal or unsavory activity, I’d venture to say that most of the usage is legitimate and those are the primary use cases.
4. Legal Troubles
Many of the outliers run into legal troubles, whether civil, criminal or regulatory. Bitcoin is no exception. If you look back, many of the black swan companies or technologies run into nasty lawsuits, regulatory clashes or even criminal problems. Napster falls into this bucket — where record labels were actually suing and in some cases arresting their own customers! A hindsight view is that the law moves more slowly than the rate of technology change. But that doesn’t explain the civil lawsuits that companies like Facebook and Google faced. This might be a factor that’s definitely more coincidence than correlation but nevertheless, there is some overlap.
5. “Strong” Network Effects
Network effects happen when a product or service gets better as more people join. The strongest form of network effects are those technologies that cannot exist without one or more people — and the product gets exponentially stronger as more people join. Some examples include the telephone, fax machine, the Internet, payment networks, social networks, and marketplace businesses. These types of companies and technologies are rare. And it’s very easy to confuse them with businesses that utilize viral marketing techniques or economies of scale that also grow more valuable as size increases. But they usually aren’t as durable or valuable as companies or technologies that display these strong network effects. The latter grow exponentially in the early days and can grow even faster over time.
Bitcoin is a strong network effect technology. On one dimension, it’s a payment network that can’t exist without more than one participant. On a deeper dimension, its decentralized, distributed ledger technology present strong network effects that can power non-financial businesses and technologies that have the potential to grow exponentially.
“Steer into the Skid.”
“Where winters are hard, many drivers have memories of their car skidding out of control on the ice and of the struggle to follow well-rehearsed instructions that negate what they would naturally do: “Steer into the skid, and whatever you do, do not touch the brakes! And every human being has had the experience of not telling someone to go to hell. ”
-Daniel Kahneman, “Thinking, Fast and Slow”
Startup investing is hard. But if there were two simple rules, I’d offer these: first, most of a great investor’s returns are driven by very few (sometimes, only one or two) companies — the so-called “outliers”. Second, these extreme outliers are impossible to predict — they are great ideas that look really bad at first, as investor Peter Thiel points out. As someone who has invested in hundreds of companies, I’ve found that the hardest thing to do is to invest even when it doesn’t feel natural — to invest in ideas that seem bad. Sometimes you need to ignore all your human intuition and judgment, and do what doesn’t feel natural. And many of the “bad ideas” that break out had the qualities I describe above.
There are fundamental and foundational reasons why I’m interested in Bitcoin, but it’s mainly looking at the factors above and concluding that this *could be* an enormous opportunity. It shares many of the qualities that the outlier technologies and companies had. It’s still early days in Bitcoin. But for me, investing in bitcoin startups and founders is about ignoring my intuition and steering into the skid. And the part that makes it even harder is that literally you still have a 1% chance of success when you do this! But if one thinks in terms of expected value (“If this does work, how big can it get?”) instead of probabilities (“Will it work?”), I’d argue that it’s the greatest venture capital opportunity of my lifetime.
David Lee was most recently a General Partner at SV Angel. While at SV Angel, he led investments in Coinbase, LedgerX and TinkerCoin. SV Angel is a seed-stage firm with investments in Twitter, Pinterest, Dropbox, Github and Snapchat, among others. David is also a personal investor in 21, Bitaccess and Changetip. He was named to the Forbes Midas List of Top Venture Capitalists in 2014 and 2015.
