Can VCs Survive In An ICO World?

Evaluating the impact of crypto funds and ICOs on the future of VCs

The past 18 months have seen a massive increase in interest around ICOs, with some going so far as to boldly predict the imminent demise of VCs — a tech institution very close to my heart. ICOs are new, exciting and pose a serious challenge to the traditional VC funding model: founders can reach a wide investor base at lightning speed, all the while retaining control and profiting from near-instant liquidity. As with all things that have such disruptive potential, the hype is huge. But are ICOs and crypto funds really VC killers? Or can the two coexist?

The State of Crypto in 2018

2017 was a hugely exciting year for ICOs, raising $3.8bn compared to $284m in 2016. Building on this momentum, the trend spilled over into 2018 and earlier this year, ICOs raised more than $3 billion within the first two months alone. This is already over half of what was raised in 2017.

The landscape has been rattled by various developments since then. The money raised from ICOs dipped in March before April saw a drop off between 44 to 66%. After a strong start to the year there was a dip that could have been further intensified due to Telegram’s foreseen withdrawal from their ICO. Anecdotally ICOs seem up again more recently, see e.g. the massively oversubscribed Arweave pre-sale. Things are still exciting.

The increasing number of ICOs has led to the emergence of ever more crypto funds. Back in February, a summary of the ICO market listed 226 crypto funds, up from 110 in October 2017. But the emergence of new funds hasn’t insulated them from recent troubles. Last month, Bloomberg reported that 9 funds have closed this year and reported losses of 43 percent across crypto fund portfolios in 2018.

In my opinion, there is a simple reason for the lack of success seen by a number of crypto funds. I have met a number of accomplished crypto traders. They have successfully learnt to navigate social signals, community and fear of missing out (FOMO) — all of which influence crypto prices. However, I have also seen people from the hedge fund world transfer their traditional models 1:1 to crypto. The two worlds are so different this seems futile.

All of this market volatility could be categorised as ‘expected turbulence’ after a meteoric rise in 2017. It certainly quieted some claims that VCs are soon to be usurped by ICOs and crypto funds. With that said, I think these arguments were fundamentally misguided from the beginning; VCs, ICOs and crypto funds currently operate in different ways and serve vastly different functions.

In the same way young startups don’t start their path by listing their equity on an exchange, young crypto projects shouldn’t start off with an ICO. Building a big projects takes years (shameless plug, see also: How To Scale). A VC can play an important role during this time.

In order to better distinguish the role a VC plays and illustrate why VC firms aren’t suddenly in danger, I want to take a step back and clarify what a VC does as well as put into perspective ICOs and crypto funds. To do that, I’ve broken the lifecycle of a VC fund down into six stages:

  1. Fundraising
  2. Discovery
  3. Evaluation
  4. Deal
  5. Value Creation
  6. Exit

1. Fundraising

Before initiating the investment process, a VC needs to raise money from its own investors (also called Limited Partners, or LPs). In the case of HV Holtzbrinck Ventures, this money predominantly comes from institutional investors such as pension funds, endowments and universities. Across the private equity industry ca. 52% of money is estimated to come from pension funds.

In the end, the work we do benefits a wide range of people, including public-sector employees, students, charitable organisations, people’s pension funds etc. We are very mindful of this responsibility.

Venture Capital is also a notoriously tricky asset class. If you compare an average VC fund with public markets the results are disappointing; returns are highly skewed towards top-quartile funds and investing in VC requires the ability (and the access) to pick top funds. This is generally only possible with long-term relationships across multiple fund generations.

It will be some time before large institutional investors feel comfortable funding crypto funds (especially those without a background in the investing space). Institutional investors in the private equity markets are, by nature, relatively conservative and will likely prefer chinos over lambos.

In the meantime, crypto funds will need to raise funds from private (retail) individuals, making large funds difficult to source. This means the community (and syndicates) will continue to be the main source of funds for crypto projects.

2. Discovery

Once you have raised funds, you need to find great companies to invest into. “Dealflow” is the lifeblood of any VC firm. As an example, HV Holtzbrinck Ventures received around 3,800 business plans in 2017.

Generating dealflow can be a tricky beast. Once a firm has been in the industry long enough, there will be inbound interest. As one might guess though, this is not the best method of finding stellar companies. Effective dealflow entails active sourcing; attending events, maintaining a strong network of business angels, smaller funds and multipliers like accelerators etc. In an effort to improve their sourcing, some funds are investing into technology to identify early signals of success. Some examples would be web traffic traction, Github repositories opening, serial entrepreneurs leaving companies etc.

Somewhat random stock photo I liked, shows the top-level view we strive for. By Tim Trad on Unsplash

Ultimately, dealflow is the leading cause of anxiety for VCs who often catch themselves thinking, what am I missing out on? What deal didn’t I see? Good funds will actively monitor missed deals and try to plug holes in the network.

Discovering great deals will be somewhat similar for crypto investors and funds, albeit with a stronger focus on community. Companies that choose to take the ICO/crypto route are concentrating first and foremost on the process of building and engaging a community willing to invest in their idea. With that in mind, I think raising money via an ICO works especially well in cases where:

  • An existing audience is engaged and passionate about the product, and will help with initial community building.
  • The token is an integral part of the system. This helps ensure there is long-term value accrual to the investor.
  • The company is experienced when it comes to handling the logistics and demands of an outside investor base.

The focus on community and audience means the process of raising an ICO is markedly different to that of a startup looking to attract VC funding. An ICO includes AMAs, explainer videos and building a social presence, versus product demos, pitch decks and financial roadmaps (Daniel has more details). For VCs, this makes it harder to evaluate crypto projects (see the 60-page whitepaper). Crypto projects are however changing their approach to become more ‘traditional’ in their external representation, in order to attract funds.

3. Evaluation

VCs are notoriously fallible and, unfortunately, not every investment we make is a success. Yet, there is a very clear and defined process we follow to try and evaluate a company.

In 2017 alone, HV made 13 new investments and took part in 48 finance rounds. This kind of investment rigour imparts some degree of experience that helps to improve the investment process. HV also has a team of over 10 people who spend countless hours evaluating deals and debating the merits of company investment to an almost exhaustive degree.

Is there a reliable way to evaluate crypto? I would say almost certainly not. Ashley Lannquist has compiled a good overview of methods which includes Token Velocity Thesis, INET Valuation, NVT Ratio, DAA etc. It’s a process that’s evolving rapidly and should help improve investment in the space, but there is also a ton of knowledge and experience in evaluating equity and that hasn’t stopped VCs from getting it wrong.

4. Deal

As part of the lifecycle of an investment, at some point a deal has to be done. Documents are drafted, trees are killed, lawyers get involved. In a process which can take anything from a few days to weeks, the interests of the VC, the founders, existing investors etc. need to be aligned and documented. Excellent books exist on the topic (eg. Venture Deals).

However, as a VC, not a huge amount of additional value is created in the deal negotiation. HV uses a standard form, broadly modelled after the NVCA template, which has been refined over the course of hundreds of financing rounds. VCs generate great returns when companies become successful in the long-run, and not by imposing unusual or onerous terms on the founder.

Part of the ICO explosion was also due to strange (or unproven) deal mechanisms. As an example, the Gnosis project employed a reverse Dutch auction. The idea was to avoid the FOMO investors often encounter when contributing to ICOs. However it ended up to be hugely beneficial for the team, as described on Coincodex:

The Gnosis team set up the token sale to distribute greater percentages of tokens the longer the sale took but did not place any cap on the amount of tokens that the team would receive and the sale was scheduled to end once 9M GNO tokens were sold or $12.5M was raised. Despite setting up the auction to slow down sales, the entire process was concluding in less than 15 minutes and resulted in the team owning 95% of the total, worth approximately $280M at the time

Such results hardly incentivize the team to build a great long-term platform. In the last few months we have seen the gradual introduction of governance mechanisms (like e.g. extended lockup periods) which should help to mitigate these risks.

5. Value Creation

After an investment, the average holding time for a VC fund is 5–8 years. During this time different VC firms can provide varied levels of operational support. Some are there to support with the day-to-day operations of business. Others, like HV, take a more strategic role. Within our team we have a wealth of entrepreneurial, operational and financing experience. We are also more than happy to converse with our network and over 150 portfolio companies to help solve problems. This includes supporting the founders, assisting with key hires, making introductions etc.

Looking at the crypto space, it is unclear who or what replaces this kind of assistance. Can a community provide guidance and support to management? I was very interested when The DAO, a decentralized autonomous organization, emerged in 2016. Unfortunately The DAO went under, for somewhat unrelated reasons, before the underlying theories could be tested. Still, as anyone who has spent significant amounts of time on the internet can verify, I’m not a big fan of the wisdom of the (anonymous) crowd. Crowds tend to work best when there is a correct answer to the question being posed, such as a question about geography or mathematics. Reality is harder. An experienced and engaged VC can offer advice in how to sensibly invest capital and deal with the expectations that come from a large investment round.

A function better served by the community is building a network and providing access to key hires who can take a company to the next level. It would be ideal if a crypto project can hire people, from the community, who are enthusiastic about the mission and ideally already knowledgeable. Still, I would argue that we are likely a number of years away from crypto funds or community being able to offer the kind of assistance a good VC provides.

A final note on liquidity. The fast liquidity an ICO provides is often touted as an advantage. Given my operational experience, I don’t agree. Liquidity obviously has many upsides, however it adds complexity. Building a company is hard enough without having to deal with thousands of external investors. Sure, traditional VCs can be a pain to manage (but there are ways to improve). Many founders with a similar experience to ICOs, e.g. from crowdfunding (or public listing), have found large groups of small investors painful to deal with, especially if things go sideways. Also, any early employees in the possession of (liquid) tokens can decide to cash-in and sell on a moment’s notice. Which means the CEO of a crypto firm has to manage the token price, on top of a slew of other demands.

6. Leading the Exit

Which brings me to the final stage of the investment phase, the exit. Deciphering what exactly can be termed an exit with crypto is difficult. If the token has achieved a listing, an exit could exist every day.

More traditional VC funds are at a disadvantage here. We aren’t typically equipped to market-time an exit, at least not on a daily level. After the investment we typically spend years supporting the management to develop the company. At some point the fund sells its stake. This is generally a decision driven by management or interest from external parties. If an IPO happens, VCs tend to sell down their stake relatively quickly, as our focus is on growing young companies.

Sophisticated crypto investors could actually have an advantage here. They are vastly more experienced in handling listed tokens than most VCs.


ICOs and Crypto Funds Are Not VC Replacements

This article may have come across a little more negatively that I intended, or actually feel. I am convinced that by 2025 we will see billions of people investing in 100,000s of tokens. There is huge potential in tokenizing all kinds of assets, be it software & data (utility tokens), license & royalties (revenue tokens) or equity, debt, real estate (security tokens). By reducing the cost of securitising assets, tokens will open new asset classes and broaden the investor base.

Reaching that stage, however, will be no easy feat. In fact, I am getting the sense of an opportunity spurned, with crypto investing slowly becoming less democratic and more like a walled garden. If you are a serious crypto investor it is essential to be heavily engaged in the space. This will allow the investor to invest in pre-sales and become exposed to the best investment opportunities. This involves building relationships, joining a syndicate and working out where your money will best serve you. This is, in theory, not entirely different to how a VC firm operates but contradicts much of the early framing of crypto as democratising investment.

Platforms like Upvest (disclaimer: a HV Holtzbrinck Ventures investment) are springing up to open these previously hidden pre-sales and ICOs to a broad base of sophisticated investors.

Further, and as many others have also said, part of the problem with crypto funds and ICOs is that they lack a robust regulatory framework. They do not confer any of the ownerships rights and legal protections that regulated shares do. Regulation will come and with it increased investor security. This will create more reliable and transparent investor opportunities. Great projects and companies will be created in the next few years, in all parts of the blockchain ecosystem.

Yet, even in this better regulated scenario, it’s hard for me to see a future where crypto funds completely replace the role of a VC. For one, they cannot deliver the value that VCs provide over and above capital, be it in the form of mentorship, business advice, legitimacy, networks, etc. Although well-suited for projects in which the community’s participation outweighs the loyalty of individual influencers, ICOs are still far from offering a one-size-fits-all approach. Besides, VCs will not be spectators. They are already active in the space and evaluating the crypto market for good opportunities. Smart VCs will push the use of blockchain technology to solve problems at portfolio companies. Once regulation is solved, we will see good, fast VCs enter the space, and tokens will be an investment instrument for us, alongside equity and debt.

I, for one, am looking forward to it.


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