At Plaza Ventures we are studying blockchain (and digital currency), looking for enterprise applications that will gain real traction. As for ICOs, we’re keeping a wary eye on what is now an over-hyped and somewhat dangerous phenomenon for mostly pre-revenue companies with under-developed business plans. Will ICOs change the VC business?
Blockchain will impact our business for sure, over time, but we remain committed to well-managed equity financings for B2B growth-stage companies with accredited investors, proper governance structures and active oversight of company operations at the Board level. Would we participate in a mature company ICO (e.g. Kik)? Perhaps, and only if the economics make sense to us.
Below, our analyst, David Hao, explores the history and rise of ICOs.
The invention of Bitcoin by Satoshi Nakamoto in 2009 revolutionized online payments by allowing individuals to bypass traditional intermediaries like banks and processors, such as PayPal, for the first time. More importantly, however, was the introduction of the cryptocurrency’s underlying technology, known as blockchain, which allows users to validate transactions on a shared peer-to-peer public ledger without any central body. Blockchain technology has since given rise to a new form of raising capital, known as Initial Coin Offerings (ICOs). ICOs have garnered tremendous attention in 2017, bringing forth a surge of skepticism, greed, regulatory scrutiny, and perhaps most alarmingly, massive amounts of paper wealth.
What is an ICO?
Traditionally, entrepreneurs have turned to venture capital firms or angel investors to raise funds for their companies. ICOs, also known as token sales, provide a new, unregulated option. In an ICO, entrepreneurs put forth the design of their own custom smart contract token, built using blockchain, in a whitepaper that proposes their business model and founding team. Details in the whitepaper will include the problem the platform is trying to solve, management structure, development pathway and use of funds. Individuals who decide to invest will then deposit an established cryptocurrency, most commonly Bitcoin or Ethereum, and in turn receive a private key that gives them access to the corresponding number of new tokens. In essence, ICO investors are betting that as the proposed platform grows, so too will the value of the coins.
Figure 1 – 2017 ICOs by Category (Source: CoinSchedule)
Many parallels can be drawn between an ICO and a traditional equity fundraise in a private company. Most notably, while ICO investors do not explicitly own a percentage of the platform (company) as they would in an equity fundraise, many proposed platforms are designed such that each token a stakeholder owns equates a vote on the platform. This effectively creates a governance structure akin to equity ownership. Likewise, as the platform proliferates, the value of each stakeholder’s tokens will grow, just as a slice of equity would. One key difference and strength of ICOs, however, is liquidity. Whereas traditional investors must wait for an exit event like an IPO or acquisition to liquidize their positions into cash, ICO investors may freely trade their tokens like any other cryptocurrency. The caveat, of course, is that most ICO tokens are still highly illiquid compared to mainstream tokens like Bitcoin.
A Lawless Land
Investments, particularly those in privately held corporations, are heavily regulated in the US and Canada. In Canada, in order to qualify as an accredited investor (one who is legally permitted to invest in private companies, including venture funds), you must have a net income before taxes that consistently exceeds $200,000 (or $300,000 when combined with your spouse) OR financial assets worth more than $1M net of related liabilities OR net assets worth $5M or more. To bypass such regulations, ICOs typically portray themselves as contributions or donations. The Ethereum protocol itself characterized its 2015 ICO as a “donation.” Of course, the Security Exchange Commission (SEC) of the US has not been happy. In a US Supreme Court case SEC v. Howey, the legal definition of a security was established, which calls for the following three criteria (the “Howey Test”) to be met in order for something to be considered a security:
- An investment of money…
- …in a common enterprise…
- …with an expectation of profits, predominately from the effort of others.
It is easy to see how ICOs may fall squarely within this definition. However, the decentralized nature of blockchain technology allows platforms to weasel out of legal scrutiny by leveraging regulatory arbitrage. Countries like Switzerland have become a safe haven for blockchain entrepreneurship due to their looser laws concerning securities and their definition of nonprofit associations, which many ICO projects claim to be. On July 25, 2017, the SEC issued a definitive statement, warning that the offering and sale of digital tokens “are subject to the requirements of the federal securities law.” The SEC further warned of the high risk of fraud among ICOs stating, “Investing in an ICO may limit your recovery in the event of fraud or theft. While you may have rights under the federal securities laws, your ability to recover may be significantly limited.” Though ICOs have continued to skirt just beyond the reach of regulatory control, growing government intolerance is contributing to changing tides. On September 4, 2017, the government of China banned all ICOs and digital currency launches as “illegal public financing” over concerns that ICOs were disrupting the country’s financial order. This ban contributed to a sharp drop in cryptocurrency prices across the board.
Figure 2 – Cryptocurrency prices following news of China’s ICO ban (Source: Coinmarketcap.com)
As of August 2017, all-time cumulative ICO funding has reached US$1.78B. Incredibly, ICOs have already surpassed all historical VC investment in the blockchain space, which stands at $1.7B since 2010. Among the most prominent ICOs, Ethereum’s own fundraise in 2015. However, 2017 has by far seen the most ICO activity. Tezos, which presents itself as a generic and self-amending crypto-ledger seeking to solve the scaling problems of legacy cryptocurrencies, raised a record high $232M in the two-week window of its July 1 ICO. Block.One, an enterprise blockchain framework which will provide higher throughput for decentralized organizations, raised $183M in just five days following the ICO’s June 26 launch. Bancor, a decentralized liquid method for the exchange of any compatible ERC20 crypto asset, raised $153M on June 12. Many ICO projects have also taken on more functional roles. Filecoin, the much-anticipated token that will eventually power a distributed file storage system, opened its ICO on August 10 after closing an “advisor” sale that raised $52M from over 150 investors, including Sequoia Capital, Andreessen Horowitz, Union Square Ventures and various angel investors from the valley. Kik, the popular chat platform, became the first $1B public company to announce an ICO, when it did so in June 2017.
Figure 3 – Cumulative ICO Funding As of August 24, 2017 (Source: CoinDesk)
Skepticism and Scrutiny
All the excitement surrounding ICOs and cryptocurrencies, in general, have prompted eerily poignant comparisons to the tech bubble of the early 2000s. With hundreds of millions of dollars in Bitcoin and Ethereum pouring in mere hours after each ICO’s launch, there is a real threat of pile-in investment pushing valuations far beyond reasonable limits. Furthermore, the sheer number of competing crypto platforms ensures that not all of them can succeed. As of September, there were 135 ICOs in 2017, up from 46 in 2016. ICOs are built on the blindly accepted assumption that blockchain apps will become mainstream and valuable, but as more ever-so-slightly-differentiated blockchain applications enter the market, the average value of each diminishes. Adam Back, CEO of Blockstream, poignantly points out that the rise of Bitcoin-alternatives poses a threat to all cryptocurrencies that seek to replace fiat money, tweeting, “A future where a clone-coin over-takes Bitcoin is not good, as it damages confidence in store-of-value & even digital scarcity as concept.”
It is hard to imagine the “true” value of ICO blockchain apps being worth even their book investment value of $1.78B. Despite the hype, blockchain is not yet a mainstream concept. Whereas your grandma knows and may even use Facebook, you’d only get raised eyebrows in response to blockchain. With so much dumb money (and scarily, the “smart money” too) poured into platforms that ultimately serve an extremely tiny and niche community, there are major questions over whether the total market size is large enough to provide returns to all participants. After all, the value of blockchain applications (and their respective tokens) are singlehandedly dependent on their userbase. If everyone decided to stop using Bitcoin tomorrow, each Bitcoin would instantly become worthless.
Furthermore, Blockchain applications face even sharper hurdles than traditional, centralized ones, due to the intrinsic, sluggish nature of decentralized platforms. TechCrunch’s Joe Evans offers an excellent example:
“Consider Facebook. Imagine that Facebook was a decentralized social network that returned fully half of its revenue (not profits, revenue) to its users. That means the average Facebook user would receive … a whole US$1 a month. That is not enough to make people want to use a clumsier, slower Facebook that innovates far less rapidly. It isn’t enough for decentralized networks to be more equitable. They have to be better. Or they have to do something that centralized networks cannot.”
Peter Thiel’s mantra that proprietary technology should be at least an order of magnitude better than its nearest substitute in order to gain mainstream adoption would be a tough sell to blockchain optimists. As well, investors face not only execution risk, but also technical risk. The DAO, a decentralized autonomous organization that sought to provide a new decentralized business model for organizing both commercial and non-profit enterprise, had a vulnerability in its code that was exploited by attackers in June 2016, allowing them steal millions of the DAO’s ICO funds, which was then the largest crowdfunding effort in history. Consequently, the price of Ethereum dropped more than 35%. While the potential upside from ICOs is so far unrivalled, so too are the risks.
The Current Verdict on ICOs
Blockchain has an inevitable place in technology of the future, and so too do ICOs in the realm of fundraising. The benefits that blockchain touts address the biggest issues that today’s centralized networks face, being: security, access, friction, and trust. However, investors would do well to be wary of ICOs in 2017, as the yet unregulated and unproven landscape leave them open to unprecedented risks. The ICO ecosystem embodies survival-of-the-fittest, and the dust has yet to settle to reveal any real winners. No doubt ICO activity will continue to prosper into the tail end of 2017 and beyond, but whether it will ultimately serve as the backbone of our next technological leap or simple fuel for greed remains to be seen.
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