Notation Capital — LP Memo re: Blockchain

June, 2017

[Republished from our internal LPAC (board) memo a couple months ago, and a followup to our Notation + Crypto post. Our hope is that this might be useful for other institutional VC firms considering investing in the space, and for blockchain founders thinking about raising VC before a crowdsale or ICO. For folks already deep in the Bitcoin and Ethereum ecosystems, skip to section IV or V].

I. Overview:

Having closely followed the blockchain ecosystem for the past five years, actively investing both personally as well as through betaworks, we believe Notation as a firm must formalize the practice of making investments directly into crypto assets. We believe that many of the crypto related companies and decentralized projects being launched today will have a transformative impact on the technology industry in the next few years, as well as other sectors like finance and insurance, healthcare, and government over the next decade.

In the sections that follow, we provide some background on the blockchain space, a deep dive into the new token based structure that is emerging around the Ethereum ecosystem, why we believe it’s necessary to invest directly into crypto tokens and assets (in addition to more traditional startups building around the blockchain ecosystem), and the types of crypto projects that we believe we’re uniquely suited to partner with via Notation. We also discuss some of the key ongoing risks, regulatory considerations, and possible implications for the Notation Capital LPA.

II. Blockchain Background:

In 2009, Satoshi Nakamoto released the bitcoin whitepaper, and shortly thereafter version 0.1 of the bitcoin software, which launched the bitcoin network and blockchain, as well as the first units of bitcoin cryptocurrency. On May 22nd, 2010, Laszlo Hanyecz bought two Papa John’s pizzas for 10,000 BTC, roughly equivalent to $25M today :-)

The bitcoin protocol and cryptocurrency represent an advancement in a number of important disciplines including computer science, mathematics, and cryptography. At it’s core, the bitcoin blockchain allows for peer-to-peer transactions, cryptographically secured using the proof-of-work method (assuming no node controls more than 50% of the network’s processing power), that can be executed outside of the traditional financial system and without a centralized third party. In theory, this enables irreversible Internet-native transactions with near zero fees and eliminates certain types of fraud.

One of the most interesting and important attributes of the bitcoin protocol is that nodes in the bitcoin network collectively maintain a public ledger (blockchain) of every single transaction. In addition to the core transaction data, this publicly maintained database allows participants to write code and other types of data into the blockchain, stored as a publicly verified timestamp. As we’ll discuss in detail, this concept of a publicly distributed and trustful / verifiable database has inspired a large number of new “decentralized” projects that are now coming to market, many of which are being launched on the Ethereum blockchain.

III. Ethereum Overview:

Although Bitcoin was a hugely innovative technology advancement, it also has a number of limitations, many of which have become more apparent as the network has grown and matured in recent years. In the past year, the most divisive issue for the bitcoin community has been the blocksize debate, which limits the amount of data that can be inserted into each transaction as well as the speed and number of transactions that can be processed by the network in each block. This has led to increased transaction fees, settlement times as long as 20 minutes, and limitations on the types of products that developers can build on top of the Bitcoin blockchain.

In response to many of these issues, the Ethereum network was proposed by Vitalik Buterin in 2013 and launched in mid-2015. There are a number of differences between the Ethereum blockchain and the Bitcoin blockchain, but a few important ones to mention:

  1. Ethereum uses a Turing Complete programming language called Solidity that allows for much more sophisticated protocols and decentralized projects or “smart contracts” to be built on the network. The Ethereum Foundation has also released robust documentation for the platform and has built a vibrant developer community.
  2. The Ethereum block time is set to approximately 15 seconds rather than about 10 minutes on average for Bitcoin, allowing for much quicker settlement times.
  3. Ethereum has an inflationary economic model compared to Bitcoin’s deflationary approach, and also has a different method for costing transactions (fees) depending on their computational complexity, bandwidth use and storage needs.

In the past two years since Ethereum’s launch, the number of nodes running on the network and developers building on top of the platform has increased exponentially. The Ethereum platform is designed for developers to build “decentralized” protocols and applications (dApps) using smart contracts built in the Solidity programming language. Many new Ethereum based projects are also issuing their own tokens, called “ERC-20” tokens, which are tied to and interoperable with the Ethereum platform, exchangeable into Ether, and have utility specific their particular decentralized network.

Here are some specific examples of dApps built on top of the Ethereum platform:

  1. Augur — Augur combines the power of prediction markets with a decentralized network to create accurate forecasting tools — and the chance for real money trading profits. Nodes on the Augur network earn “REP” tokens for verifying the validity of wagered outcomes.
  2. 0x — A decentralized crypto exchange and protocol for trading tokens p2p. This is particularly interesting in that it could be disruptive to centralized crypto exchanges like Coinbase.
  3. Storj — Decentralized cloud storage whereby nodes on the network earn Storj tokens for lending their spare computing power.
  4. Livepeer (Notation I Investment) — An open platform for decentralized live video broadcasting. The Livepeer project aims to deliver a cryptoeconomically incentivized protocol and open media server for live video broadcasting, resulting in a cheaper, more scalable, and more decentralized live streaming solution than anything on the market today.

Although there are many attractive reasons for smart technical teams to build on top of the Ethereum platform (or others yet to be launched), one of the most compelling is the wildly capital efficient nature of these projects, as well as potential scale. A small development team can release reasonably feature complete Ethereum based dApps within months. Because of the decentralized nature of these projects, the network itself runs the computing infrastructure rather than the founders or a centralized company. The one caveat is that the current legal and regulatory setup costs for decentralized protocols are more expensive than for a typical startup, but we expect this to come down in the next few years as the legal and regulatory environment becomes more well defined.

If some the most talented developers were building mobile apps for the iOS platform in 2008–2015, we see the best technical talent now flocking to the Ethereum and Bitcoin platforms. We expect this trend to continue in the years to come, but also recognize that there may well be new foundational blockchain platforms that have not yet been built, and so we’re watching closely for those as we spend time in the crypto dev communities. Tezos, Zcash, and Litecoin are a few examples of other interesting, newer protocols with unique features that could act as important platforms in the future.

IV. Decentralized “Crypto” Projects — An Entirely New Corporate Structure:

One particularly hot crypto topic as of late is the concept of an Initial Coin Offering (ICO). We will discuss our views on these opportunities in the next sections, but first it’s worth taking a step back to examine the structure underlying an ICO, as well as its purpose.

Many of the decentralized protocols and apps that are being created today are also employing a fundamentally new approach to their corporate structure. One simple way to think about many crypto projects is to view them through the lens of open source development. No single person or corporate entity owns the Bitcoin or Ethereum network, for example. These protocols are overseen by foundations, similar to Linux, and kept running by a network of decentralized nodes all over the world.

One key difference between crypto projects and traditional open source projects is that they come with built in economic incentives. “Tokens” are awarded for adding value to the network, be it development resources or computing power or verification of outcomes, and the value of those tokens naturally increase in proportion to demand for the platform. In this way, participants in the network participate in the value created by the network, alongside the founders and investors at the center of the project.

In the past couple years, a common structure has emerged to fund these efforts, although it’s worth mentioning that this is still an area of significant debate, and there is not yet an agreed upon standard across the blockchain ecosystem.

At the moment, one common structure at the time of an ICO looks something like this:

  • A Foundation is formed in Switzerland and creates a fixed number of initial tokens
  • 10% of the tokens are issued to the founding team. Many projects today issue these tokens via smart contracts so that the founders can only sell small portions of these tokens over time, similar to vesting concepts for traditional startups.
  • 10% of the tokens are issued to the Foundation for future employees and contributions to the project.
  • 80% of the tokens are issued to the public via a crowd sale (also called an ICO), some portion of which may be issued to investors pre-ICO.
  • Additional tokens may be issued / awarded for adding value to the network over time — this could be viewed as expected dilution for initial investors and participants.

It’s important to clarify that a crypto token does not represent equity in the business (there is no company), but rather the unit of exchange that future customers can use to pay for whatever service the platform offers. In a recent blog post, Balaji Srinivasan from a16z likens tokens to paid API keys. As demand for the platform increases, so too should demand for the tokens, thus increasing their value over time.

The real purpose of an ICO is to seed a protocol’s network with participants that will actually use the token. In practice, however, the ICO market has been dominated by speculators, with the bulk of tokens being purchased by investors rather than users. While we’re happy to see capital funding great teams experimenting with blockchain technology, we’re more bullish on companies that choose to see their ICO as a path to more than just fundraising.

  • Numerai is an example of a project that has done this well. Having raised a traditional round of venture capital, they chose to issue their tokens exclusively to their user base of data scientists, in proportion to their contributions to the network to date.
  • As Livepeer considers the best way to distribute their token around the launch of their network in the next few months, they’re actively thinking about ways that they can ensure the token is issued to video networks and nodes that will actually have use for the underlying tokens. This is how the project will build defensible value, not in selling the tokens to speculators who will quickly flip the ICO to the next buyer.

V. Investing Directly into Cryptocurrencies — Why It’s Important:

We wrote a blog post a couple months ago about how Alex and I have been following and participating in the blockchain community since 2013, as well as some general thoughts on the crypto token space. While at betaworks, together we built one of the early U.S. gateways into Ripple. And because betaworks was structured as a holding company, we were able to lead investments directly into $BTC and $XRP, both of which today are valued at more than 100x our cost basis. We believed at the time that the purest expression of our confidence in these new technologies would be buying bitcoin and other coins directly.

Today, we see two main strategies to build blockchain exposure via Notation. The first is to invest in traditional companies built around the blockchain ecosystem (currency exchanges, security solutions, data/analytics). We continue to watch closely for opportunities in these verticals, and expect to make more investments here. The second is to invest directly into coins and tokens available at the core protocol layer, structured like the decentralized projects described above, which is where we continue to believe that the bulk of the value in the space will accrue over time. Joel Monegro from USV wrote an exceptional post last year called “Fat Protocols,” which does a great job explaining the economic rationale behind this thesis. In looking backwards over the past five years, this theory has proven true — the best investment you could have made in the space was simply buying Bitcoin and Ether directly.

While some of the core foundational blockchain infrastructure has been built in the past five years, Ethereum being the most important developer platform today and the cause for so much new activity in the space, we believe there is a lot more blockchain infrastructure yet to be built — dozens of new fascinating foundational platforms and decentralized protocols are now being launched, some of which will result in extraordinary investment returns in the years to come. Similar to Bitcoin and Ether, we expect the value for these new projects to accrue most significantly and directly to their related tokens.

VI. Notation’s Approach to Blockchain Projects:

Notation’s reason for being and core strategy is to work with compelling technical founding teams at the infancy of a idea, primarily capital-efficient Internet projects based in NYC. Given our backgrounds building dozens of these projects ourselves, we believe we’re uniquely positioned to evaluate and bring value to teams building companies at this stage, which we refer to as “pre-seed.” We like to lead these initial rounds of financings, which tend to be $1M or less.

Putting corporate structure aside for the moment, many of the blockchain projects we’re meeting in NYC fit our core strategy well. Blockchain teams tend to be highly technical in nature, building capital efficient Internet projects, and raising small amounts of pre-ICO money to pay for initial protocol development and legal costs. Livepeer is a great example — we’ve known the founders Doug and Eric for years, two strong developers in NYC, and began the conversation when they first started outlining their project eight months ago. Like many of the pre-seed rounds we lead, we led a sub $1M round via a SAFE in exchange for future issuance of tokens when they do their token distribution.

Pre-ICO crypto projects have many of the same needs as traditional startups — they need to hire great people, solve technical challenges, think through marketing and go-to-market strategies, as well as plan for capital raising. These are all functional areas where we excel and can have a real impact on the pre-ICO crypto projects that we choose to work with. It’s also worth noting that properly evaluating crypto projects requires a deep level of technical expertise and diligence, and so we have a real advantage here compared to many other NYC-based investors.

So our strategy for the crypto startup market looks functionally equivalent to our plan in the traditional startup market. It’s worth noting that Pre-ICO rounds are generally the ONLY round of private financing that crypto projects do before offering their tokens to the public.

A few more tactical details to note:

  • Similar to pre-seed companies, we prefer to lead or co-lead pre-ICO rounds of funding, focusing on highly technical founding teams that we know well, primarily in NYC.
  • At the moment, we structure these investments via SAFE in exchange for crypto tokens that represent a specific % of the outstanding float when issued.
  • Like any investment we make, we intend to hold these tokens for the long-term as the project builds exponential value over time. However, token ownership has a key advantage in that it becomes relatively liquid when the project does an ICO.
  • We may consider strategic investments into crypto funds where we believe we might increase our access to the kinds of projects described above or where we’ll gain significant insight and learnings into the blockchain space overall.

Some additional questions we’re considering:

  • How should we think about ownership targets compared to traditional startups? How should we value the liquidity premium associated with crypto projects / tokens?
  • Should we consider selectively participating in ICOs where we have a strong long-term view on the project but may not have a close personal relationship with the team?
  • How should we be modeling loss ratios compared to traditional startups?
  • How should crypto projects think about capital raising efforts post-ICO, if at all?
  • Is there a way to actually model intrinsic value based on network usage?
  • Given the liquidity of token assets, as mentioned above, at what thresholds should we consider capturing gains and returning capital to our LPs?

VII. Other Key Risks / Items to Consider:

  • Investor Rights — Crypto tokens lack many of the basic investor rights one would expect when making an equity investment in a traditional company. This is reason to be cautious, and why we’ve only considered investments into projects where we have deep levels of comfort with the integrity of the founding team. One caveat here is that many blockchain projects, by their very nature are open source, and thus are built with high levels of transparency. Livepeer, for example, publishes weekly updates and has a public github repository.
  • Token Security — Security for any crypto asset must be taken very seriously. Our belief is that the only secure method is via cold storage. We use a hardware solution for cold storage, which we’re happy to discuss in detail, but needless to say this is one of the most important items to consider when buying crypto assets. We do not believe that storing crypto assets on any third party exchange, including Coinbase, is fully secure.
  • Dilution — As discussed above, the “cap tables” for crypto projects look very different than a traditional startup. Most crypto projects are structured to be inflationary (ie. additional tokens are issued over time for miners / nodes that add value to the network), but it’s unclear how this dilution will compare to traditional startups we invest in and how we should think about protecting our position over time.
  • Long-Term Structure — It’s worth mentioning that although many decentralized crypto projects are currently choosing to pursue a structure similar to the one mentioned above, this may not be the case longer-term. The Foundation structure is still very much an experiment, and for reasons related to legal, regulatory, team or node incentives, it’s quite possible that we may identify more optimal corporate and investment structures for decentralized technology projects over time.
  • Other Specific Risk Factors — Included in Exhibit A below are other specific risk factors related to cryptocurrency investing. Note that these were prepared by our counsel, Cooley LLP.

VIII. A Few Notes on the Regulatory Environment:

The current regulatory environment as it relates to Bitcoin, Ether and other cryptocurrencies remains highly uncertain. From Coincenter’s deep dive into the “Framework for Securities Regulation of Cryptocurrencies:”

“The unintended result, however, will necessarily be a confounding cavalcade of seemingly contradictory conclusions: “bitcoin is a commodity” (per a 2015 CFTC ruling), “bitcoin is property” (per IRS guidance), “bitcoin is virtual currency” (per FinCEN guidance), “bitcoin is money used for money transmission” (per various state money transmission regulators).”

The most common opinion that we’ve encountered from conversations with lawyers, former regulators, and others in the blockchain community is that Bitcoin today is regulated most closely as a commodity by the CFTC.

Given its novel nature, the token regulatory environment is even less certain. In a recent analysis by Debevoise & Plimpton LLP (in partnership with Coinbase, Consensys, and USV), the firm found that many tokens are unlikely to be considered securities according to the Howey test, and may in fact be closer in nature to franchise or licensing agreements.

However, just last week, the SEC released its first investigative report on crypto tokens, specifically analyzing the DAO token, and concluding that it should be regulated as a security. We think this statement and analysis is encouraging in that it’s the first time the SEC has commented on tokens specifically, and the analysis is thoughtful and rational. The major question going forward is how the SEC analysis will apply to other types of crypto tokens, many of which exhibit very different properties than the DAO token.

Overall, we believe more clarity in the regulatory environment will be beneficial for the entire blockchain space as both founders and VCs balance the desire to pursue innovative funding models and technologies, while carefully adhering to the appropriate legal and regulatory frameworks. We’ve been in regular touch with Marco Santori from Cooley, who’s one of the leading lawyers in the field at the moment, and we continue to watch closely for any comments from regulators.

IX. Final Note on Notation LPA Considerations:

As we continue to dig into our blockchain strategy with our LPAC, we may propose certain amendments to the Notation LPA in order to more expressly call out our investment activity in crypto assets. This may include broadening the purpose clause, addressing the use of “Securities” and “Portfolio Company” as defined terms throughout the LPA, and considering the impact of crypto investing on investment restrictions. We’ll keep everyone updated as we continue to dive deeper on these items with our counsel. And as always, we’re here to answer any additional questions or feedback you might have.