Ask Three Questions Before You Jump Into That Hot ICO
ICOs are the new, new, new hot thing. They are powered by blockchain technology. Entrepreneurs are teeing up offers, money is flowing, and some early investors have made a killing. Should you jump in? Here are three questions of consider before you click to invest.
ICO stands for “initial coin offering”, referring to the first public sale of a “cryoptocurrency” (a currency based on information technology), like Bitcoin. Companies starting businesses based on blockchain technology typically create a cryptocurrency as part of their business model. They can raise money by selling the currency itself, rather than issuing debt or stock. A colleague recently remarked, “A year ago no one was talking about ICOs, and now they are a big factor in venture capital.” He points out that 37 ICOs have raised about $2 billion in 2017 to date, probably more than has been raised in seed venture capital. Fortune’s Term Sheet newsletter reports that big name investors like Andreessen Horowitz and Bain Capital Ventures are investing in ICOs.
Why are ICOs so exciting? It’s all about the money, both literally and figuratively. First, there has been a strong price run-up in the most successful cryptocurrencies: digital currencies based on encryption technology such as the blockchain. The chart above shows the price history for two of these: Bitcoin and Ethereum. Currency holders have made handsome returns. Plus, currencies are liquid by design, so investment cycles can be shorter and [in principle] investors can cash out at will.
And ICOs have compelling advantages for entrepreneurs. They are non-dilutive: the entrepreneurs sell a currency they have created and keep 100% of the equity in their company. They are lightly-regulated: structured properly, cryptocurrencies have [so far] avoided regulation by the SEC as securities. Some cryptocurrency issuers are soliciting buyers with email blasts. And cryptocurrency investors have none of the governance rights and protective provisions of shareholders.
Since the ICO investment goes into the cryptocurrency, not the company, you should ask: how do cryptocurrencies make money? This is a new field and there is a lot to learn still. Cyptocurrency promoters argue the case as follows. Blockchain start-ups aim to create an “ecosystem”: an economic system in which many participants come together to do business for mutual benefit. Examples of ecosystems include marketplaces (e.g., stock exchanges), information exchanges (e.g., credit bureaus), communications platforms (e.g., email or Facebook), and payment mechanisms (e.g., Fedwire or Bitcoin). The value of these ecosystems increases rapidly with the number of participants (i.e., “network effect”). As a result, in a given domain the ecosystem that grows fastest can become a hugely valuable and powerful natural monopoly (e.g., Facebook). By design, the cryptocurrency is required to access the ecosystem: if you want to do business in the marketplace or trade your information, you have to buy and sell using the cryptocurrency. Hence, the success of the ecosystem will create demand for the cryptocurrency: the greater the number of participants and transaction quantity and value, the more people will want to buy and hold the currency. And, the entrepreneurs usually pledge that the supply of the currency will be fixed or severely limited. So increasing demand should drive up the price of the currency.
Bitcoin itself is a simple example. It was designed primarily as a medium of exchange (a way to pay) that is secure, global, easy to use, and free from control by banks or governments. The compute-intensive Bitcoin “mining” (i.e., creation) process assures that the supply will be constrained. People buy and hold bitcoins to be able to use Bitcoin as a medium of exchange conveniently, which creates demand for Bitcoins. Growth in the volume and value of Bitcoin transactions adds to this demand.
The questions you should ask before making a ICO investment flow directly from the logic of cryptocurrency value creation. I suggest three major areas to drill down.
1. How successful with the ecosystem be? Is the user value strong, the technology powerful, and the time right? This is the fundamental business due diligence analysis for any venture investment.
2. Will the start-up offering the ICO to be the winner in this ecosystem? That breaks down into several questions. Is this the winning team? Team quality is the biggest factor for the success of a venture. Can the team succeed without the support that investors normally provide? In addition to guidance and introduction to customers and resources, investors provide governance by serving on the board of directors, and sometimes that is needed, as recent events at Uber have shown. Can the company raise enough money to win? Winners in big ecosystems often raise billions before their dominance is secure: e.g., Facebook and Uber. ICO fundraising is inherently limited since the company pledges to limit the amount of cryptocurrency it issues. After the ICO, it will need to raise large amounts of money by other means. Does the team have what it takes to do this? Only the winning company in a successful ecosystem is likely to have strong demand for its currency, producing price increases and liquidity for holders.
3. Does ecosystem success assure a strong run up in cryptocurrency value? Cryptocurrencies are a good vehicle for speculation, and that probably explains a significant part of the value run-ups we have seen so far. As Fortune Term Sheet put it, “Despite talk of ICOs being scams and/or pump and dump schemes, VCs are warming up to the idea. Why? Profits and liquidity.” Some of the investors in cryptocurrencies are chasing a quick profit. This speculation can turn around in an eye-blink: after the pump comes the dump.
But doesn’t ecosystem success assure strong inherent value? It helps, but the link may be looser than it appears. We’re early in the development of cryptocurrencies and their infrastructure. If you want to pay with a cryptocurrency today, you need to set up a special account and manually move value back and forth to legacy currency (e.g., dollars). That friction gives you a reason to keep a balance in the cryptocurrency. But in a few years the translation in and out of the major cryptocurrencies may be frictionless. For example, recently I spend a couple of months traveling to the four Nordic countries, each of which has a different currency. I thought I would need five kinds of cash in my pocket and frequent trips to the currency exchange bandits. I soon realized you can pay for everything with a credit card in the Nordics, and the bank translates everything to dollars with zero friction. I had no need to hold a balance in foreign currency. The same may happen with Bitcoin and other successful cryptocurrencies: payment technology will make them invisible. This reduces demand to hold the currency, even as the related ecosystem prospers.
The only certainty here is that cryptocurrencies are not the philosopher’s stone: a legendary tool that transmutes lead to gold. I expect that highly valuable ecosystems will be built on blockchain/cryptocurrency technology, and ICO investments offer participation in those ecosystems with shorter holding time and easier liquidity. However, ICO investments combine the substantial risks of seed-stage venture investment with the unproven dynamics of cryptocurrency value and a healthy dose of speculative risk. What could go wrong? This is not for the faint-of-heart or the shallow-of-pocket.
First published @ blogs.forbes.com/toddhixon on October 23, 2017.