Are you a bull or a bear on this question?
– Crypto equity via ICO is the secret to unlocking innovation capital and is the bridge across the chasm between crowdfunding and public market liquidity. This is the bull case.
– Crypto equity via ICO is a haven for scamsters and needs to be heavily regulated. This is the bear case.
Today we shine a light on that question. First we outline the bull and the bear case. Then we ask some experts to give their views. Bias disclosure: I am a bull, but having seen a few waves of disruptive change I know that change takes a LOT longer than people think and that the early unregulated wave of any disruptive change has a lot of what are politely referred to as “sketchy characters” and less politely as scamsters.
The other innovation chasm
The old saw is “if it ain’t broke, don’t fix it”.
The corollary, for entrepreneurs, is “if it is broke, find a way to fix it”.
The innovation capital business is broken.
Most entrepreneurs understand the chasm between MVP (Minimum Viable Product) and PMF (Product Market Fit). The low cost to build MVP increases supply, but real demand does not change that fast, so lots of MVP ventures fall into the chasm (i.e. they fail).
The next chasm is less well understood. This is the chasm between PMF and Liquidity (via an IPO on the Public Markets and failing that via trade sale).
Today, we don’t see this chasm so clearly because there is a very expensive bridge across it – in a few locations. The very expensive bridge is provided by the big PE/VC Funds. Uber has raised over $8 billion and is still supposedly not ready for an IPO. That is an expensive bridge a) for the Limited Partners (aka the LPs aka the real investors who pay the PE/VC Fund Manager their 2 and 20 cut) and b) for the entrepreneurs (faced with all those preferential equity terms that toss founder and management equity to the bottom of the stack).
Not only is the bridge very expensive, but it is only available in a few choice locations. If you are in Silicon Valley, no problem, there are lots of expensive bridges. If you are in New York, London, Singapore, you have a few bridges. Outside those centres you are scrambling and doing so in the knowledge that some entrepreneur in Silicon Valley just raised 10x what you raised and is planning on using that to crush you.
It gets worse. Unless you do your IPO on NASDAQ or NYSE, you will face a discount. Look at the valuation discount of great companies trading on reputable stock exchanges all around the world. So now you have a second very expensive bridge operated by the “bulge bracket” investment bankers (such as Goldman Sachs and Morgan Stanley) who you use to “take you out to IPO”.
So, yes it is broken. The innovation capital business does need fixing. Whether some variant of the ICO is the fix is what we now turn our attention to.
Crypto equity via ICO 101
ICO = Initial Currency Offering.
It makes you think of IPO. That means it also makes regulators think of IPO.
Yet it is C for Currency, not company shares. You buy a Crypto Currency Token that you can use on the network.
Some examples of ventures that have been funded in this way include:
In all cases, traditional VC were not in control. Sure they could invest alongside everybody else. But they had no information advantage.
The Howey test (from an SEC legal case from 1946) is basically – if it looks and acts like an equity it probably is. Many ICOs fail this test, putting them in the regulatory cross hairs.
Crypto Equity Bear Case
It is very simple to raise money via an ICO. This will bring out honest entrepreneurs who are fed up with the current way of raising capital. It will also bring out crooks. It already has. So far the losers have been people playing with found money. For example if you invested in Bitcoin in 2009, putting some of those profits into Ether in 2014 seems pretty easy, even if you follow it up by losing on the DAO in 2016. It is quite different when Joe Q Public is invested from earnings that took 40 years to accumulate and which he is banking on for a comfortable retirement. If ICO scales, more crooks and more Joe Q Public actors get involved.
Crypto Equity Bull Case
Crypto Equity – done right – helps ventures get across both chasms:
- Chasm 1 between MVP and PMF. The investors are often also the users. They use the tokens on the network. So they help get the venture to PMF.
- Chasm 2 between PMF and Liquidity. The Crypto Currency Token is traded. Speculators provide liquidity.
The fat protocol thin app thesis
This thesis was articulated by Fred Wilson of Union Square Ventures in August 2016. I urge you to read the whole post and the very informed comments from the community. If you don’t have time, these two pictures paint a thousand words:
The original thinking, from 18 months earlier and, amazingly prescient being a few months even before the Ethereum ICO, was from Naval Ravikant (founder of Angel List who we have written about here, here and here).
What do the experts say?
The experts we reached out to are in what I call the “Other BBC” space (Bitcoin Blockchain Crypto), so they will be inclined to a bullish case. If you have an alternative view, please let us know in comments.
My questions to them are:
- Use Case Suitability. Is ICO only suitable to businesses at what USV call the fat protocol layer? This will be very few companies. Or could the ICO, with some modifications and regulations, be used for any company? If yes to the latter, what do you see as the essential modifications and regulations?
- ICO Lessons. What key lessons should entrepreneurs, bankers and regulators draw from the ICOs that have happened so far?
Use Case Suitability
From Fabio Federici
“I think we need to distinguish between two types of tokens. On one hand, we have the tokenization of equity, where the token does not serve any specific purpose in the product/protocol but rather represents a digital form equity as we know it today. While this will improve liquidity and efficiency, I don’t believe this to be a paradigm shift.
On the other hand, we have decentralized blockchain-assets, ranging from currencies (BTC), over commodities (ETH) to application-specific tokens like Golem (a decentralized AWS) or Storj (a decentralized Dropbox) (see @ARKblockchain). These are just some examples blockchain-based assets, where the value of the network is captured by its users, rather than a centralized entity – and that is what will power the next phase of the Internet. I believe that the most exciting use-cases are yet to come. Just like it was hard to imagine Google, Snapchat or Uber in the early days of the Internet, it is impossible to predict the applications that decentralized blockchain protocols will enable.”
“I am a bull/bear crossover on this subject because of the lack of oversight even by the industry to make sure proceeds are used in a manner that will not cause a domino affect of disgruntled coin holders in an empty network.
Not everything needs regulations but given that the retail market is just learning of the crypto currency, the industry needs to mature so this can be a very viable method for companies to utilize. Unfortunately at the moment we are not seeing that and my bear comes out because I am seeing first hand, how companies are using ICO as a form of equity raise and not having a care if the person purchasing their coins makes any return on that investment.”
“In future, any company will be able to take advantage of the ICO route. No regulatory changes will be necessary, because Lykke will acquire the necessary legal licenses and future ICOs can happen under the Lykke umbrella, www.lykke.com“
From Fabio Federici:
“I think it is important to distinguish between the tokens representing pure equity, and blockchain-based assets that serve a purpose in a protocol. While the first is just a digital version of what we know today, the latter represents a new type of asset class.
Also, one should always take a close look at each asset before making a decision, whether it’s building on it, investing in it or regulating it. Many factors play into the evaluation of these assets, from the aforementioned purpose to the fundamentals, the code, the team and many more. We are still in the early days – ontologies and (e)valuation methods have yet to be developed.
The main lesson for me is to keep an open mind and evaluate each token or asset individually. We are in the midst of the rise of a new asset class that will change the world.”
From Oscar Joffre
“ICO’s are here and need guidance. They are not used to harm but to really bridge the large funding gap we have globally for companies. The industry can choose to be proactive and self-regulate, which in the end will be better than regulators injecting in.”
“The new future has started – entrepreneurs, bankers and regulators have understood that ICOs are a new reality and are essential funding tools. They combine cost efficient funding with building a motivated network of supporters.”
Crypto Equity is a gamechanger – if done right.
Those three little words – if done right – cover a lot of complex detail.
We can leave that to regulators in each jurisdiction to create their rule books. That can take a lot of time and will devalue the frictionless cross border nature of ICOs today. Or the community can create a self-regulatory code of conduct as Oscar Jofre suggests. We have opened a thread on Fintech Genome where this initiative can be crowdsourced.
Bernard is a Fintech thought-leader & deal-maker.
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