Earlier this year, Notation announced that we had begun to make token investments in early-stage blockchain projects directly out of our venture funds. Since then, we’ve made several early-stage token investments that fit our broader core thesis — investing in technical pre-seed teams and projects in NYC. The point of this post is not to opine on the valuations of bitcoin or cryptocurrencies broadly, or any one project in particular, but to create the beginnings of a framework that we might use to compare the valuations of early-stage blockchain projects to traditional startups at a similar stage.
Blockchain project valuations, across the spectrum, have risen dramatically in value over the past year, and it’s not unusual to see early-stage projects raise at $100M+ valuations pre-launch. Is this crazy? Perhaps. But in digging deeper, we found that early-stage blockchain projects likely warrant a valuation premium compared to traditional startups. What follows is our analysis, and our rough estimate of how much. This is meant to be the start of a conversation, so please do let us know if you agree, disagree, or might adjust some of our assumptions below…you can find us on twitter or email us at firstname.lastname@example.org and/or email@example.com.
- Liquidity (1.6x Premium) — The liquidity horizon for early-stage blockchain projects issuing tokens is much shorter than equity in traditional companies. In many cases, this ranges from several months to a couple years, rather than say 7–10 years for a successful startup. How does one assign a value to a much shorter liquidity horizon? Aswath Damodaran, a professor of finance at NYU, has a good presentation on the subject here, and highlights that there are a number of different approaches to determining liquidity premiums. Damodaran states: “The simplest way to think about illiquidity is to consider it the cost of buyer’s remorse: it is the cost of reversing an asset trade almost instantaneously after you make the trade.” For the purposes of this exercise, using Damodaran’s private company liquidity methodology, we calculated an approximate liquidity valuation discount of about 50% for seed stage startups, and only about 20% for pre-ICO blockchain projects, when comparing both to public market stocks. So in isolation (which we realize is difficult), we believe a blockchain project at a similar stage to a traditional startup should demand at least a 1.6x premium for the differences in liquidity, and quite possibly more.
- Dilution (2x Premium) — When investing at the pre-seed or seed stage, an investor must expect a significant amount of dilution for successful startup investments over time. It’s safe to assume at least 20% dilution through Series A and Series B rounds, and marginally less in growth rounds at Series C and later. So it’s not uncommon for an initial seed investment to be diluted by 50% or more when it reaches growth stage or liquidity. Cap tables for new blockchain projects are highly varied, and there are still many experiments being run in this regard, but it’s not unusual for a new blockchain project to carve out 80% of the float upfront on day 1 for a combination of presale investors, contributors to the project, as well as crowdsale participants. In practice, this means that early pre-ICO investors are buying a portion of this 80% pool, and future token sales come out of the pool, rather than being dilutive to early investors, the founders, and other participants. As a result, it’s common for early investors to see minimal dilution leading up to an ICO, meaning they maintain their ownership amount up to a liquidity event without having to invest additional reserves. It’s worth mentioning that post-ICO, the inflation schedules for blockchain projects are widely varied and in many systems, one’s ownership of the total float will decrease over time post-ICO liquidity.
- Investor Rights and Protections (.9x Discount) — An investor in traditional startups will often receive a number of investor protections, including information rights, preference in the capital structure, followon rights, among others. In theory, investor rights should have real value when comparing to blockchain projects, but in practice, given the time to liquidity, we assign a relatively small premium here, somewhere in the range of 10%. Once a blockchain project is publicly tradeable post-ICO, the simplest way to vote on the performance of the founding team and the project, is whether or not investors buy, hold, or sell their token positions. It’s also worth mentioning that we’re starting to see more investor protections added in pre-ICO SAFTs akin to traditional startups.
- Regulatory Risk (.87x Discount)— The environment surrounding blockchain projects remains highly uncertain. It’s quite possible that the SEC takes significant action in the months to come that makes it more difficult for blockchain projects to do ICOs, and thus achieve liquidity. While we believe long-term that a more certain regulatory environment is a huge net positive for the blockchain ecosystem, in the short-term, SEC actions could dampen the value of the liquidity premium outlined above. If we assign a 50% probability of a significant SEC action in the next year, we think it’s reasonable to assume that the liquidity timeline for blockchain projects gets pushed out to 4 years rather than say 2 years, which would imply a liquidity discount for an early-stage blockchain project at approximately 30% rather than the 20% described above, when compared to public stocks.
- Security / Custodian Risk (.9x Discount) — It’s more likely for a token investor to lose their holdings (due to negligence or a hack) compared to a traditional startup investor permanently losing their stock certificate. However, we believe that sophisticated security procedures, as well as institutional level custodians that are coming to market like Coinbase, make this risk relatively minimal long-term. Nonetheless, it exists today, and so we assigned a 10% discount to early-stage blockchain valuations as a result.
Combining all of the factors above — Liquidity (1.6x), Dilution (2x), Investor Rights (.9x), Regulatory Risk (.87x), and Security Risk (.9x) — We believe it’s reasonable for the average blockchain project to be valued at a 2.25x premium when compared to a traditional startup of a similar stage. Of course, this is far from a perfect analysis, and there are many more variables that might be taken into account, but we think this serves as a very basic gut check for early-stage blockchain valuations that seem to have skyrocketed in recent months. Is a $100M valuation pre-launch too high? In most cases, almost certainly. But should a blockchain project be valued like a traditional startup at the same stage? We don’t think so.