The venture capital industry has been around since 1946, and over seven decades, we have collectively learned a lot and established mental models for success as investors. But the arrival of blockchain technology, the emergence of new business models, and — more disruptively to investors — new capital raising and governance models has rendered much of our knowledge base and best practices irrelevant or in need of revision.
As a new venture capital investment platform focused on the blockchain, my team has had to dismantle some of our mental models and develop new ones which are worthy of broader debate and discussion.
The Halcyon Days of Venture Capital
If you were to ask seasoned venture capitalists (or fairly newly minted ones) about what guides their search for investments and informs portfolio management decisions, they are likely to rattle off a familiar list starting with this:
- Teams: the largest determinant of success
- Markets: the larger the better
- Products: need to fit market needs or on rare occasion create new markets
- Business models: need active and early experimentation, fail fast, intermediate/dis-intermediate/disrupt/expand well understood ecosystems
- Deal terms: preferences are sacrosanct, valuations and protective rights matter, governance and viable board supervision are non-negotiable
- Financial engineering: rounds of funding, convertibles, leverage, secondaries, trade-sales, IPOs all set up to maximize return to preferred equity holders
- Returns: early stage is about picking winners; growth stage is more about consistency; multiples and IRRs are very different beasts
However, the arrival of blockchain and distributed ledger technology has forced us to revisit this list. While teams, products, and markets will always matter, every other rule is either being revised, thrown out, or seeking a new definition.
A New Investment Paradigm
Good teams with compelling products can go directly to the public markets via Initial Coin Offerings (now called “crowd sales”). This dynamic has created some fundamental changes in the the opportunity for “venture risk” capital.
Successive rounds of equity/debt funding have been replaced by a rapid sequence of one or more seed rounds in equity (usually less than $1M), pre-sales of tokens ($5M to $30M), and a crowd sale of tokens ($30M to $200M+). The process of getting to $200M+ in capital can take less than 18 months. Market caps of startups have exceeded $10B within months of funding.
Their marketcap hit $10B in six months (chart via Coinmarketcap.com).
A quick peek into their Github repository indicates that the project did not exist in its current form till March 2017 (via Github).
So we have essentially gone from a company that did not materially exist in March 2017 to a company valued in tokens at over $10B in about 10 months.
Implications for Venture Capital Investors
The rapid and easy fundraising for blockchain investments from “retail” investors has made existing VC playbooks largely irrelevant. Business models, governance, deal terms, holding periods, risks, and returns-expectations are all getting redefined. But investment opportunities in early stage venture capital do exist.
Most blockchain projects are trending towards token sales as a financing alternative instead of equity funding. However, they frequently need $1M to $10M (in fiat currency) to build out the initial team, successfully run a marketing campaign, set up legal structures, and execute on a token sale. These teams are seeking equity investments in the early days or, in some cases, going directly to pre-sales of their tokens.
As a venture capital investor, the options to invest in a blockchain business are either or both
- Equity: participate in a seed/angel round to get a project jump started.
- Tokens: purchase tokens early in the life-cycle of a project at a significant discount to crowd sale price. The discounts are to compensate investors for the early stage risk and/or for longer lockup periods post-crowd sale.
Equity ain’t what it used to be
The issuance of tokens is usually treated as a prepaid product sale, which creates a deferred revenue liability. On day zero, that is matched by a corresponding infusion of cash as an asset. But as token prices fluctuate, so does the liability on the balance sheet — and that’s not healthy for the value of your equity.
Token allocations have unintended consequences
Most blockchain projects reserve a significant portion of their tokens for founders, key employees, and some investors. Many white papers offer little transparency on the allocation policies, which brings governance questions and increases liabilities on the balance sheet at the expense of equity holders.
Gregory Simon does a great job of explaining both these phenomena, so I will not get into details here.
Some New Rules
As VC investors developing new playbooks, we at AVG Blockchain Fund have had some early realizations.
1 If buying equity, seek perfect alignment: Buying equity in a company is still a viable option if investors’ equity is treated exactly the same as a founders — i.e., all token reservations and allocations are also available to investors on a pro-rata basis. This is especially important if equity value is constantly getting depressed and the long-term value of the project appears primarily in the token network.
2 If buying equity, maintain convertibility: Some projects will thrive as traditional software/SaaS businesses even if built on the blockchain. Others may find building out a token network more optimal. As equity investors, we may find that new investing structures like the Token Equity Convertible proposed by my friends at Pillar.vc work best.
3 If buying tokens, seek the best deal possible: This includes doing usual venture investing diligence, but also forming a view on token econometrics and velocity, pre-sale discounts, lock-in periods, etc., that are unique to token sales.
4 When in doubt, step away. This is probably the biggest of our recent learnings. In a recent equity deal, we saw some well respected investors sign up for terms that broke rules 1 and 2 above. But at AVG Blockchain Fund, we chose not to; rigor and self-discipline are not always easy to develop, but I am proud of our nascent team for demonstrating it early.
The playbooks for blockchain investing are still being developed, and I welcome your thoughts but minimally please clap so I know you find this interesting.
Originally published on Medium; all views are personal.
My long form posts on Blockchain investing:
- A Framework for Blockchain Investing
- Guardrails for blockchain investors
- My latest adventure: a Blockchain VC Fund for qualified individual investors
- Yet another primer on Blockchain
Other analyses from me on Medium: