Blockchain Disruption’s Next Stop: Initial Coin Offerings and the Venture Capital Industry
With a total of 235 initial coin offerings (ICOs) having taken place in 2017 and many more being launched every day in 2018, it is impossible to ignore this level of disruption in the previously traditional venture capital (VC) industry. This article will discuss the rise of ICOs as a startup funding mechanism, outline the unique features that make them better suited to set blockchain companies up for success, and whether this alternative presents itself as a competitive threat or an investment opportunity in the eyes of VCs.
In 2014, an open source digital trading engine called Buttercoin was launched. The goal was to provide a reliable, fast, and easily accessible bitcoin marketplace to facilitate larger-scale transactions in the US business sector. Hardly a year later, Buttercoin shut its doors, despite having secured $2.1 million in funding from highly reputable investors including Google Ventures, Centralway Ventures, and Y Combinator.
The reason? A lack of interest from VCs meant that the marketplace was unable to generate enough capital to continue funding itself.
Buttercoin is far from being the only startup that has experienced grievances with the traditional venture capital funding model. Startup roadshows can take several months and VCs generally fund less than 3% of the companies they review. Even then, there have been reports of founders being left with negligible stakes in their own companies after multiple rounds of funding and exploitative investors exerting aggressive decision-making pressure. Not to mention more widespread concerns like the legal costs of putting together shareholder agreements and term sheets, limitations on how much capital can be raised, and the long-term nature of the commitment. Generally, VCs are looking to make returns greater than several times their initial investment and if a firm’s business model does not meet this requirement, the likelihood of securing funds is next to none — regardless of the viability of the business model and the societal value of the product. So naturally, the stifling of innovation in the blockchain space would be a valid concern if firms had no options other than VCs. Fortunately, there is a reason why headlines like those of Buttercoin are becoming less prevalent. Decentralized alternative technologies call for decentralized alternative funding mechanisms and lately, these have taken the form of initial coin offerings (ICOs).
An ICO is a means of raising funds where a percentage of a venture’s cryptocurrency is sold to early backers of the project in exchange for legal tender or other cryptocurrencies.
The coin or token in question does not represent an equity stake in a company the way shares do. Instead, it carries the benefits embedded into the smart contract governing its use which are decided upon by the company. Since these can be purchased by anyone, from anywhere, and at any time, an ICO represents a method of crowdfunding capital that bypasses intermediaries such as banks or VC firms. Interestingly enough, this new alternative does not necessarily mean that blockchain startups pose a threat to VCs. The relationship is ultimately a lot more complex than it initially appears.
This trend is even more remarkable when considering the risks companies are choosing to subject themselves to through ICOs. A company could face severe legal penalties if their coin is deemed an ‘investment contract’ subject to US Securities laws, without being compliant with the registration and disclosure requirements of this classification. Many startups choose to operate through regulatory loopholes, bearing the inherent risk of regulatory uncertainty associated with ongoing legislative development in this field. Hackers also present a security risk, as many thefts of crypto-assets have occurred where proper security protocols had not been in place. Now the question remains, what is it about ICOs that makes them worth the risk to the extent that they have now become the norm for raising blockchain startup capital?’
Access To Funds
The most obvious answer to this question is the sheer volume of capital that blockchain startups have been able to raise through this method. ICOs regularly raise upwards of $10 million with little more than a white paper. They are also responsible for 8 out of 10 of the crowdfunding projects that have generated the most funds to date. These funds are acquired by the company as soon as the transaction is completed, allowing some ICOs to raise millions of dollars in just several hours. The coins or tokens are usually paid for with Ethereum tokens on exchanges worldwide, making them open to virtually anyone with internet access.
This also makes them particularly attractive as they are highly liquid and easily tradeable, expanding a company’s investor base from just wealthy limited partners contributing to VC funds, to virtually any retail investor with an interest. Now, investors can contribute to the capital of a blockchain startup for reasons other than simply having faith in the feasibility of their business model, as was the case with VCs. Investors may instead choose to take advantage of the success of the cryptocurrency market as a whole, or even to diversify their investment portfolios since price movements of blockchain tokens have little correlation with price movements of other asset classes. ICOs also present a unique opportunity to invest in private companies by directly offsetting one of the biggest downsides; the difficulty of selling the investment. Overall, crowdfunding capital through ICOs have given blockchain startups access to a multitude of new investors, and as a result, a more expansive pool of funds to potentially benefit from.
Incentivize Community-building
This is where factors unique to blockchain startups really start to make a difference. Investors participating in an ICO get to benefit from more than just the increase in the value of the token over time. Most tokens give holders the privilege of unlocking some kind of value in the company. This could include early access to a company’s platform or application, free or discounted services, or complementary products- all with the goal of facilitating early adoption and establishment of a user base. These benefits are especially critical for blockchain startups whose platform or application’s success depends on the network effect, where having a large number of participants improves the value of a product or service, similar to social media. The tokens can even be later utilized to incentivize deeper involvement of users, as the instant messaging app Kik took advantage of by rewarding active users with its Kin token in proportion to their usage volume.
These tokens can also raise capital indirectly by incentivizing developers to create complementary products and contribute to open-source code, resulting in potential alternative revenue streams and greater value of the core product. Rewarding these third-party developers with a token allows them to capture the value they create for a project, and incentivizes them to contribute in the future. This is a solution of the ‘tragedy of the commons’ problem often occurring in open-source communities whereby many people own a resource and could benefit from its improvement, but the reward for any individual’s contribution is low. ICOs also provide the opportunity to raise resources other than capital that may be just as valuable. For example, quantitative hedge fund Numerai launched their Numeraire token, not to fundraise, but to automatically reward its network of data scientists that contribute to its algorithms based on their effectiveness.
So what does this mean for VCs today?
Alternative fundraising mechanisms like ICOs do not necessarily cut VCs out of the picture, since ICOs are open to VC involvement too. In fact, the most successful ICOs were more likely to have benefitted from some level of VC involvement. The key difference between direct VC funding and VC involvement in ICOs lies in the balance of power. ICOs put a substantial amount of power back into the hands of startups since they have the freedom to outline the terms of a deal in the smart contract code, which not only allows for complete accountability and transparency, but also limits the value-add of VCs. Participating in ICOs has additional implications for a VC’s business model since portfolio managers will be forced to adopt a more active trading strategy given the liquidity of token assets, and legal and compliance teams will have to be increasingly vigilant. It is also important to note that the limited partner model and funding policies of VCs may prevent them from even considering investments with this level of legal and regulatory ambiguity. For this reason, many VC firms today prefer to invest indirectly into ICOs through cryptocurrency hedge funds and Bitcoin futures contracts.
The most interesting alternative however, involves VCs taking advantage of ICOs to fundraise for themselves. With the launch of the First Digital Liquid Venture Fund, Blockchain Capital raised $10 million in six hours with a token that was compliant with securities regulations. It is without a doubt that ICOs will be a recurring theme in the SWOT analyses of many VC firms, ultimately proving to be just as difficult to ignore as they are to capitalize on.
