VC vs ICO: CAN THE TWO COEXIST AND WORK TOGETHER?
One of the topics that struck my attention the most lately has been whether the infamous Initial Coin Offerings, better known by their acronym ICOs, are somewhat disrupting the venture capital industry. This relatively new funding model offers entrepreneurs a seamless process to do what they were unable to do before: raise virtually limitless capital from masses of individuals worldwide in a time-efficient manner.
Every day the crypto market learns and evolves at an unprecedented pace, and as a consequence the venture funds that were sitting on the fence about this issue are being pushed to decide to either close this door (for now), or make cautious steps forward into embracing what could be deemed as an opportunity. After many travels witnessing what some of the absolute brightest panelists in the US and Europe had to say about this, here’s what I found.
Venture Capital Investments and ICOs in Numbers
Let’s start with some key figures: as highlighted by Svjatoslav Sedov, angel investor and founder of The First International Incubator, almost $7bn went into ~530 ICOs only in the past 14 months (an average of $13m raised per ICO), accounting for a total current market capitalization of $460bn at the time of writing. Despite this being hard to forecast two or three years ago, this value is still a small fraction (3.8%) when compared to $182bn of aggregate global value of the 11,145 venture capital deals completed in 2017 — an all-time high (Preqin, 2018).
Sean Seton-Rogers, General Partner at ProFounders Capital, sustained that, “It’s tough to understand quality deals out of the hundreds of ICO offerings in continuous proliferation, and without a clear EU standard regulatory framework that is audible and that serves as a benchmark for all”. Since his view is representative of a spread skepticism among many other venture capitalists, one key question may be: so, who is behind the $7bn that were poured into ICOs? Mr. Sedov responds by saying that “it is estimated that in the US almost 70% of the entire population have only $700 in their bank account. Being that the stock market is [therefore] closed for many, crypto is the only available solution of a democratic nature that may enable a capital appreciation”, potentially building hopes of social escalation. Could these be the many investing parties compiling the big bucks for ICOs? Most likely, yes.
Fundamental Ontological Differences
Ashmeet Sidana, Managing Partner at Engineering Capital, says that, “Venture Capital is a craft, a response to a specific, narrow market need which was invented in 1948 by Harvard professor Georges Doriot, Founder of American R&D”. VCs have to be capable of understanding complex risk-reward situations, display emotional intelligence when judging new ventures’ founders and leaders, and assess the feasibility and the expected financial returns of investing in markets that don’t yet exist. On behalf of their limited partners (LPs) who entrust them with financial resources, they serve as savvy capital distributors within the high-risk game of startup investing. As registered entities who play in a carefully regulated market, VCs tend to combine scientific discipline and subjective art. Venture Capital by definition is also the asset class with the longest duration, locking capital for 10–15 years offering the highest risk-reward ratio, with the biggest trade-off for investors being illiquidity.
At the other end of the scale, ICOs have a completely distinct nature and dynamic: regulations are ambiguous, accounting and reporting is done differently, and governance is low or non-existent at all. On top of that, the underlying preparation, due diligence, and aptitude to absorb losses of an ICO investor tend to be poles apart from a VC’s. Consequently, the socio-economic motives that drive investments differ too, making liquidation and return expectations for ICOs much higher with respect to venture capital (just remember that it took Facebook and Uber 7 and 5 years respectively to raise $1bn, while block.one (EOS) raised $1.5bn in under 9 months).
Competition or Complementary?
If a company at its earliest stage — usually pre-product and often even pre-team — could raise millions in cryptocurrencies, why would startups need VC investors?
Michael Sofaer, CTO at Brian Kelly Capital Management, sees Bitcoin as a flawed role model which is leading on entrepreneurs globally to raise hundreds of millions of dollars without a compelling and structured business plan, proven business development links, past coding skills or competent CTOs in the team. As a result, financing rounds of not-so-real-companies that would have never been closed (or even raised a dime) under normal market circumstances, get filled by fairly uninformed (but highly motivated) ICO contributors in the hopes of betting on the next Bitcoin. To this end, news.bitcoin.com reports that 46% of companies that launched an ICO in 2017 already failed, and another 13% are failures-in-the-making, adding up to a whopping 59% of failure rate.
To make matters even more tricky, according to Mr. Sofaer, many blockchain companies launching an ICO found loopholes to avoid having their tokens being categorized as securities, and issued utility tokens instead. Security tokens or asset-backed tokens are digitally issued shares that may offer increased liquidity, while still providing investors with the same legal and economic rights of traditional securities. On the other hand, utility tokens merely serve as a future access to a functional product or service and can be best compared to a coupon card or software license; they shouldn’t be considered an investment, thus its investors should not expect any profit to be made from the work of the entrepreneurs (the issuer). In simple words, offering security tokens, as opposed to utility tokens, means companies face many regulations and limitations on who can invest in these tokens and how they can be exchanged. Particularly with secondary trading, security tokens cannot be traded freely and are subject to many restrictions. This can hinder or neutralize the network effects and the use of the tokens to build a widely adopted platform or protocol. Solutions to regulate this problem do exist — Polymath, for example, is helping companies by offering a turnkey security-tokenization service in compliance with their respective regulatory jurisdiction and with KYC/AML requirements –but are not yet mainstream.
Nevertheless, Salil Pradhan, venture partner at Draper Nexus, suggests that “there might be an alignment with venture capital asset class and equity investments in blockchain companies that will run an ICO”. Venture capitalists generally put at the disposal of startups their competences, their domain expertise and network to foster growth and reach economic success in the long-run. Guiding and advising a firm prior to their ICO might fit well with the traditional venture model and their role. Miko Matsumura, founder of EverCoin and an LP at Pantera Capital, defends the potential of the decentralization process stemming from the use of blockchain technology to disrupt current markets and create new ones; thus venture capital investments into companies that are developing blockchain infrastructures should naturally occur, be it through equity or tokens investments. He supports and relates to what he calls “the median case”: reorganizing a marketplace with an externality in it, through the incentive of decentralized factors. (in fact, Mr. Matsumura is an advisor of The Bee Token, a decentralized home-sharing platform that is disrupting Airbnb’s market).
Future trends and conclusions
The outcome is likely not to be that ICOs will replace venture capital, but rather that ICOs will work in conjunction with VCs to make up a more robust funding environment and ecosystem globally.
We have to take into account that not every new startup will make significant use of blockchain (and therefore they won’t have a direct benefit from issuing their own utility token). And even in situations where blockchain can be of crucial use, the two types of financing, VC and ICO, can both bring diverse advantages, especially if combined at different company lifecycle stages. Lisa Cuesta, Principal at NextGen Venture Partners, claims that the transition where VCs will start participating in ICOs is definitely possible, but only with significant investment from VC firms to acquire the internal competences needed to deeply understand the tech infrastructures being built by these startups. Mr. Sidana is also confident that since the crypto space is moving extremely fast, new best practices and clearer regulations will come (watch out for the latest list of subpoenas issued by the SEC with respect to utility tokens), which will ultimately motivate VCs to include in their mandates with LPs the possibility of investing in tokens and participating in ICOs.
It’s worthy to mention the general trend that is gradually shifting the spotlight onto security tokens. The advantages are clear both from a protection point of view for ICO contributors and the issuers, as well as from a regulatory perspective — as Securities and Exchange Commission Chairman, Jay Clayton, stated, he believes all ICOs constitute securities. More and more this is the direction that market is taking, and if it continues to be a win-win for all, VCs will likely be more interested to get familiar with the overall token investment process (as well as its administration mechanisms) in order to keep up with the best opportunities out there.
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