ICOs are Cancer

I have been involved in a few venture-capital funded startups, so I’m used to getting introduced to entrepreneurs building software companies. It’s fun to see how people are building the future and a good way to give back. Over the past year many of the introductions I get are involved in ICOs, and I struggle with how to politely decline the intro and explain my disdain for what they’re doing (without it coming off as contempt for them).

New tokens are now available from snake-oil salesman to “cure” all ailments (source)

The first part of this blog post will explain what problems ICOs are trying to solve, and the second part will explain how they’re creating far more problems than they’re mitigating.


The Problem

ICOs misguidedly attempt to solve four perceived problems in the market:

  1. Government regulations designed to protect poor people from making risky investments have ended up allowing only the rich to participate in some of the most lucrative investments. The way the government views things, if you have less than $1MM you are not an “accredited investor” and can’t be trusted to make important financial decisions on your own behalf.
  2. Access to liquidity for early investors. When you invest in a startup, even in the best case scenario it takes many years before you’ll ever see a penny of your investment returned. VC funds typically have 8+ year time horizons.
  3. More investment for startups. Starting a company is hard. Isn’t a tool that allows more connections between investors and startups only a good thing?
  4. Platform profit-sharing (utility tokens). If you were an early user who helped contribute to the success of a social network like Facebook/Twitter/Instagram/WhatsApp/Reddit/etc, then you receive no extra compensation for helping that company achieve success.

#1 is a real problem that blockchains don’t solve, #2 exists for good reasons (that are naturally mitigated by market forces without ICOs), and #3 and #4 are edge cases that create more problems than they solve.

#1 Government Regulation

US investment regulations have run amok. It’s strange that the government runs ads on TV encouraging you to buy their lottery tickets but also (mostly) bans you from investing in high risk/reward activities like venture capital. There is a legitimate fear of your grandparents being swindled by a slick salesman out of their retirement, but the current regulations are blunt, arbitrary, and ineffective. They also make it hard for foreigners to invest in American startups, which only hurts Americans. That said, the solution here is for the US government to get out of the way. One thing I’m thankful to ICOs for is that they’ve given a counterpoint to regulators’ “control everything” mindset, now that we can see the damage caused by pushing some legitimate companies towards ICOs.

Regardless of whether you think these government regulations are making the world better or worse, ICOs don’t actually avoid these regulations at all! The whole reason Satoshi Nakamoto invented the blockchain (and hid behind a pseudonym) was to create something that was censorship resistant against third parties and state actors. What’s unique about bitcoin (vs other tokens) is the highly decentralized nature. Unless the project whose token you bought is 100% anonymous (no known principals) and doesn’t have a bank account, then there is a single point of failure where the government can easily exert pressure if they disagree with what that project is doing (for example, not following securities laws). Once they go after a project, the value of that token will plummet. Just ask the founders of Liberty Reserve how that worked out for them and their investors.

In case you think the government’s stance on these is ambiguous, check out what current and former SEC regulators have to say:

The highly centralized companies are in for a painful lesson about decentralization.
Not understanding technology and having staff shortages can only protect you for so long.

Using a blockchain without a need for censorship resistance is like using a rube goldberg machine to turn the page on your newspaper:

This technically works, but do you think it’s a future you want to invest in?

#2 Access to Liquidity

Venture capital investments are unusual in that even the most successful investments often return little-to-no capital to their early investors for many years.

There is good reason for this: building a billion dollar company is a massive undertaking, and investors (and employees) should have a very long-term time horizon to accomplish such audacious goals. Would you buy stock in a company if the senior management was dumping that stock? Investment structures that require incentive alignment are essential to discourage bad behavior. Typically, insiders (including early investors) are restricted from selling equity immediate before or after an IPO so that outsiders are treated fairly.

That said, there are still ways to get some liquidity. Here is famous Venture Capitalist Fred Wilson of Union Square Ventures describing how their firm sold stock in Twitter and a host of other companies well before their IPO (source):

We have done similar things in many other situations including Zynga, Lending Club, MongoDB, and a number of other investments. We typically seek to liquidate somewhere between 10% and 30% of our position in these pre-IPO liquidity transactions. Doing so allows us to hold onto the balance while de-risking the entire investment.

#3 More Investment for Startups

It is certainly amazing that teams are able to raise tens of millions of dollars from investors all over the world, but is this a problem without ICOs?

It turns out, that more money has been pouring into the space (and at more favorable prices for founders) for a long time:

That doesn’t strike me as a tough funding environment (source)

During this same time, the cost of starting a company has plummeted.

While some will complain that it’s hard to raise money, given how easy it is for so many it’s difficult to take claims from these “wantrapreneurs” seriously.

It’s no surprise the ICO process gives us a perfect market for lemons

Before you argue that tokens will bypass the VC industry and allow individuals to back other individuals, keep in mind that actual ICO investors are often just a small group of wealthy VCs.

There is perhaps room for a notable exception for non-US startups, which have historically done quite poorly as the US has by far the most investors and startup infrastructure. The most relentless founders have traditionally been able to move across the world to increase their chances at success. That will probably not hold forever, but even then you’d be better off to make an investment directly on a foreign company’s cap table than in their token.

#4 Platform Profit-Sharing (aka “Utility Tokens”)

In a business with strong network-effects, utility tokens could incentivize a group of users to evangelize a platform and help it reach critical mass. That part actually makes sense. There is a reason why nearly all publicly traded companies have Employee Stock Purchase Plans (ESPPs); utility tokens have extended that model to customers (with different interests).

When you look at these utility tokens more closely, there’s no logical reason for them to achieve monetary status in the long run:

  1. Most companies are not actually platforms with powerful network effects, so the value added by the early users doesn’t justify granting them ownership in the company. Remember that the users are signing up voluntarily (and sometimes paying money for the privilege), meaning they already believe in the benefits of the service.
  2. It becomes very hard to pivot or make adjustments if the model you built your utility token around doesn’t work. You have too many stakeholders and it wouldn’t be fair to change the economics that they had agreed to if you decided for example to launch another product that didn’t have use for the token. It would also crash your utility token’s price, similar to the way managers of publicly traded companies optimize for quarterly results over the long-term health of the company.
  3. Designing a cryptocurrency protocol is enormously complex and outside the scope of building a company. There are probably only 1,000 people in the world qualified to do it. You now have to think about security, node communication, scalability, proof of work/stake/burn/space, regulatory compliance, stability, bitrot, etc.
  4. There are already lots of effective ways to reward and incentivize early adopters. For example, having a short twitter handle is a great benefit of being an early twitter user. For paid services you can offer lock-ins where you get a cheaper plan for many years. Many services have waitlists and reward the most beneficial users (perhaps those that share on social media) with earlier access. Kickstarter has also raised billions of dollars for unproven ideas.
  5. The whole point of money is that it solves the double-coincidence of wants problem that makes barter massively ineffective. Requiring customers purchase your tokens in order to use your services is a huge barrier to mainstream adoption.
  6. It confuses where the value is. Are customers using your product because they like it (and thus are willing to pay) or because they hope that everyone else will use it and their tokens will become valuable? The former is the foundation for a lasting enterprise, and the latter is how you create a house of cards. Tokens can encourage founders to go after the wrong customers.

The “Solution”

Even if ICOs could deliver on solving these real problems, they have fundamental issues that would make the cure worse than the disease:

  1. Lack of Basic Investor Protections
  2. Misaligned Company Incentives
  3. Not Actually an Investment
  4. Massively Complex Regulations and Other Distractions
  5. Fundamentally Incompatible with the Legal System
  6. Private Key Management is Really Hard

#1 Lack of Basic Investor Protections

ICOs don’t have the standard investor protections that professional venture capitalist investors have required for decades. Things like a minimum 1x liquidation preference, meaningful 4+ year vesting schedules (know of any ICO founders with “vesting” who have been fired and stripped of their equity?), board approval for large salaries/expenses, bans on insider trading, and audited financial statements are practically unheard of in the get-rich-quick world of ICOs.

The idea that a founder could quickly lose their investors’ money and also retire off their failed venture is terrifying to professional investors and has great appeal among con artists. I’m amazed at how many token salesmen I’ve talked to that don’t see this as an obvious issue. Here’s Vitalik Buterin during the Ethereum ICO saying that while they wouldn’t guarantee a liquidation preference upfront, they might consider it later if things went south. It’s the equivalent of saying, “I can’t promise to be responsible with your money, but if things don’t work out I won’t agree to return what I have left of your money. I’ll decide that later.”

That this is even possible tells you what kind of crazy market we’re in.

#2 Misaligned Company Incentives

ICOs are designed to be not only the first major funding but also the last. This all but guarantees you’ll raise too much money while you can, and then be locked out of the market later if you need it. It seems counterintuitive, but raising too much money before finding product-market-fit is actually a huge problem that can kill companies. It’s rare for traditional startups to never need more money in the future and in the case of a utility token, it makes pivoting much harder in the future.

#3 Not Actually an Investment

Stock is effectively a claim on a company’s dividends and the governance ability to hire/fire management in search of better cashflows. Token holders waive all of their rights. I’m amazed at how many people are jumping at the opportunity to invest in tokens even while the issuers of those tokens are publicly proclaiming that it has no value, no expectation of future price appreciation, no claim on the company’s cashflows/assets/IP, etc.

“It’s neat” is rarely a good investment thesis

#4 Massively Complex Regulations and Other Distractions

Even if you like what a company is building, an ICO will be a major distraction. Not only does the startup need to accomplish the herculean task of build a successful business, but they’re also charged with navigating complex securities laws, banking relationships, private key management, partnerships with payment processors, educating their users, auditing crypto software, complex legal opinions, inflation schedules, governance protocols, etc.

#5 Fundamentally Incompatible with the Legal System

While the motto “Code is Law” is popular in the Ethereum community, in the real world of centralized (and thus censorable) assets, it just doesn’t work on ICOs since in their very nature they are inherently centralized around their company/nonprofit and founders. For example, what does the blockchain do when a judge rules that a transaction needs to be rolled back (perhaps one party with the private key didn’t have proper authorization to make that transaction or the proceeds came from stolen funds)?

Unless courts decided to cede their power (don’t hold your breath!), they will always be able to override the blockchain through blunt means like seizure of bank accounts, physical property and/or arrest of principals involved. It’s one thing to bet on Uber or AirBnB rivaling the taxi or hotel lobby, it’s another thing for a company to side against all three branches of government. There’s just no way you can win.

Only bitcoin has a chance to survive against a state actor as it’s a decentralized bearer asset; there’s no person to threaten with arrest and no bank account or physical property to seize.

#6 Private Key Management is Really Hard

An estimated ~1% of all cryptocurrency is lost each year due to imperfect private key management, and the UX for those who don’t lose their keys is awful compared to traditional web services. It makes sense for bitcoin to require end-users to manage their private keys, because it’s the only way users can algorithmically prove ownership of their bitcoins to the network (which is essential to mantaining strong censorship resistance) at scale. In the case of highly centralized and regulatable entities, there’s no reason to incur this cost in the name of decentralization.


What You’re Involved in Reflects on Your Character

Starting a company has never been cheaper/easier, and raising capital via traditional means these days is quite easy for talented entrepreneurs. If you’re thinking of doing an ICO, you should take a hard look in the mirror and ask yourself why that makes the most sense for your stakeholders. In the words of legendary investor Warren Buffet:

It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.

Buyer beware:

If my warning hasn’t convinced you and you must invest in an ICO, I recommend this one for being the most transparent:


Postscript

I’m often asked why I dislike ICOs so much. If these tokens existed in their own vacuum then I wouldn’t care.

The problem is that because these token projects tout the “revolutionary blockchain technology” they’re building on top of, newcomers think they’re legitimately comparable to bitcoin. Ever since the early days of Bitcoin it has attracted snake-oil salesmen and con-artists, but tokens have brought buses full of multi-level-marketing types to nearly every blockchain event.

When these tokens inevitably destroy billions of dollars of value for their investors (while the project founders become wealthy!), angry mobs will be looking for someone to blame and bitcoin may get caught up in that aftermath. Bitcoin is the world’s first (and best!) censorship-resistant digital store of value, and has amazing potential to improve the world by helping individuals regain their financial sovereignty. Bitcoin is nothing like these ICO tokens.


Thank you to Tuur Demeester, Michael Goldstein, Nicolás Arqueros, Parker Lewis, Bennett Hoffman, and Alex Krupp for feedback. Errors and opinions are my own.