History does not repeat, but it does rhyme. Blockchain is like 1994 – early days of the Web before the Netscape browser helped the Web go mainstream. That mantra has been repeated so many times that it is also like 1999 – hype and overvaluation in many areas.
This is Part Three (Chapter 1) of The Blockchain Economy book. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index/table of contents of The Blockchain Economy book please click here
Other chapters in Investing in The Blockchain Economy cover:
- Utility Tokens (a key to a network/platform).
- Early Stage Equity via Security Tokens (fka Venture Capital).
- Tokenised Real World Assets (fractional ownership of some “hard value” asset).
- Payment Tokens and Stablecoins (aka new currencies).
- Non-Profit Tokens.
This chapter will give the historical perspective on why 2018 in the Blockchain Economy is like 1994 and 1999 in the Dot Com era and how to build a portfolio based on that knowledge by describing:
- The three big changes that Blockchain brings to investing.
- Blockchain is the 4th Wave of disruptive change in the digital era.
- The 5 lessons we learn from past waves of disruptive change.
- What those 5 lessons teach us about building a portfolio.
- Why this time is different because the funding model is different.
- Humans say don’t classify me, I am an Investor/Contractor/Entrepreneur.
- The Blockchain Economy is like 1994: not very useful yet.
- The Blockchain Economy is like 1999: hyped and over valued.
- How Family Offices aka “muppets on steroids” are writing the future of Fintech & Blockchain & Wealth Management.
The three big changes that Blockchain brings to investing
- Real time settlement. Investors like liquidity. Investors may want to buy and hold (or “hodl” in cryptoland) but the ability to sell early because something has changed is prized by investors. Blockchain brings real time settlement to many more types of asset – such as early stage equity through Security Tokens.
- Easy fractionalising. This is the ability to take something big that only rich people can buy and offer fractional ownership. The concept is not new – think Mutual Funds – but Blockchain brings fractional ownership to many more types of asset. Think of owning a % of the the cash flows from a commercial building or oil well. That is possible today through structures such as Limited Partnerships, Blockchain just makes it easier to create these kind of structures, thus dramatically increasing the market size and reducing transaction cost and friction.
- Trust through verifiability and immutability. Blockchain is more than a distributed database. It is a distributed database where every transaction is visible to all and you don’t need to trust any intermediary to maintain that database. Although we are currently in a phase with lots of scams and shady operators, this verifiability and immutability will lead to a more transparent and fair market over time.
Blockchain is the 4th Wave of Disruptive Change in the Digital Era
- Wave 1 was the pre Web Internet. This was invented as a decentralised network for use by the US military by DARPA (the network survives even if one node is destroyed). This was pre-commercial, only used by higher education and military. It was also decentralised, which is why the current Blockchain wave is referred to by some people as redecentralisation – it is a back to the future phase.
- Wave 2 was the Web wave, from the Netscape browser and through the Dot Com bubble and burst. This is when the Internet went commercial. It is easy to mock the hype of the Dot Com era, but in hindsight almost all the innovations we now use were started in the Dot Com era. Most failed and many of those ideas were picked up later by entrepreneurs riding the next wave. Even digital cash, which we now call Blockchain & Cryptocurrency, appeared first in the Web wave (and failed in that era).
- Wave 3 was the Social Media wave, emerging from the rubble of the Dot Com nuclear winter. The book that inspired me at the time was Wikinomics (How mass collaboration changes everything), which was published in 2006. Dan Tapscott did an amazing job of describing why social media was not just a fad but something that would change the world; it inspired me to start blogging in 2007 and then become the COO of ReadWriteWeb in 2009 and then create Daily Fintech in 2014.
Waves 2 and 3 are the Centralised Internet. Today centralised looks like the norm, but the verdict of history will be that it is a brief interlude between the original decentralised DARPA and the new decentralised Blockchain Economy.
- Wave 4 is the Blockchain wave. This wave is even bigger and rolling even faster because it builds upon the two earlier waves. The ability to transfer assets over the Internet matters because more than half the 7 billion people on our planet already have access to the Internet.
One fundamental thing changes in the Blockchain wave. In earlier waves you could transfer copies of content over the Internet. In this wave you can transfer value over the Internet, because the Blockchain protocol solves the double spend problem (if I give you a $10 bill, I no longer have it, whereas If I send you a digital file, it is only a copy and each digital copy costs virtually nothing).
The 5 Lessons we learn from past waves of disruptive change.
- Change takes longer than forecast.
- Change, when it happens, is even bigger than even the wildest forecasts.
- The winners are hard to forecast early and those winners are massive.
- The early adopters are critical but totally different from mainstream.
- There is a valuation crash between early hype and eventual value creation.
What those 5 lessons teach us about building a portfolio
Portfolio diversification is critical for investors – some things don’t change. The number of investments in a portfolio is a debatable point, but less than 10 is certainly considered high risk. So, how do investors get diversification?
- 1. Change takes longer than forecast. Therefore,most entrepreneurs will underestimate how much capital they will need. The single biggest reason new ventures fail is they run out of cash. As an investor, you have to assume that however much cash you put in at the start is only a small amount of what you will need to put in; so plan for that.
- 2. Change, when it happens, is even bigger than even the wildest forecasts. Therefore, there is a lot of money to be made.
- 3. The winners are hard to forecast early and those winners are massive. Therefore, a few big winners will more than make up for all the losers – power law distribution. That mantra had been repeated so often that it has become conventional wisdom and you don’t get an edge from conventional wisdom. The next section explains why this time is different and why we may get a more bell curve distribution – that is less conventional wisdom which may give you an edge.
- 4. The early adopters are critical but are totally different from mainstream. Therefore, find an old copy of Crossing The Chasm and read it to absorb one big lesson – you have to win over the early adopters even if they look weird and the market looks tiny. Attempts to market disruptive propositions direct to mainstream are doomed to burn a lot of capital.
- 5. There is a valuation crash between early hype and eventual value creation. Therefore, keep plenty of powder dry to invest after the valuation crash. Nobody can tell you when this valuation crash will come (if somebody claims to be able to give the timing, they probably also have a bridge to sell you). So, don’t wait till after the valuation crash to invest anything. Remember that Google was first funded in 1999. Refer back to point 1 above – invest a little now and a lot later.
Why this time is different because the funding model is different
The phrase “this time is different” is easy to mock. It tends to get used to hype valuations. However in this case, something is different and this difference should impact how investors think.
What is different this time is that the disruptive technology is being used to change how early stage investing is done. That is what the whole ICO and tokenisation change is all about. In all earlier waves of change everything changed – except the business of early stage investing.
In the Pre ICO era, a few elite VC funds dominated the business of early stage investing. This led to few massive winners and lots of losers. In network theory, it was a power law distribution. These big, elite VC Funds, what I call Wall Street West, did not care about the 99% of ventures that failed as long as they got a big stake in the 1% that had massive returns.
To use baseball/cricket analogies, investors can win with more singles without relying on hitting the ball out of the park. The reason is the simple but powerful force driving the whole ICO/Token disruption – instant tradeability. You can invest and – subject to lockup provisions – exit/take profit as soon as the price is above what you paid. You may choose not to take profits, because you expect the price to rise more, but it is your choice. That is a game-changer for early stage investors. It also will enable a more normal/bell curve distribution. For example, you may buy in at 3 and exit at 6, or wait in hope it gets to 30 or 300. In the artisanal VC model, cashing in early was tough and the big investors called the shots.
Humans say – don’t classify me, I am an Investor/Contractor/Entrepreneur
When you talk to the people who are making things happen in the Blockchain Economy and you dig below the PR surface, the wonderful rich complexity of human beings eliminates the artificial barriers defining somebody as either an investor or an employee/contractor or an entrepreneur.
Today you can meet many people who are all three. They are investors and employees/contractors and entrepreneurs This blurring of the boundaries is one of the differentiating factors in this wave of change. In earlier waves there was a clean boundary between investor, employee/contractor or entrepreneur.
Today you meet people who:
- buy/sell some Bitcoin and Altcoins (they are investors).
- pay the bills by working for somebody else as an employee/contractor.
- build their own venture as a side project in their spare time (they are an entrepreneur) and wait until they see enough traction before quitting the contract/employee gig.
This is one human with three hats. You have to engage in real conversation and dig below the PR surface because that human is practically focussed on pitching one of their three hats:
- If they see you as a smart crypto investor, they will pick your brains to help make them a better investor.
- If they see you as an employer, they will pitch their value as an employee/contractor.
- If they see you as an angel investor, they will pitch their MVP.
So in a normal professional setting you only see one hat, not the human who wears all three hats.
This wearing of multiple hats goes against conventional wisdom. When reality diverges from conventional wisdom it means that the (usually unspoken) theory behind that conventional wisdom is no longer valid:
- Theory = only a wealthy person can invest. Reality = tell that to the techies who invested early in Bitcoin or Ethereum, most of whom had way more tech smarts than cash (they now have both). There is some move by regulators to only allow wealthy people to invest in early stage tech, but it is likely that the toothpaste is already out of the tube. You can argue that investing in these coins is dumb, but you cannot deny that people are investing, some of whom are way smarter than the wealthy investors who are supposed to be the clever guys at the table.
- Theory = An entrepreneur must quit their day job before building a product. Reality = it is so cheap to build a Minimum Viable Product (MVP) and nobody wants to fund this stage of a venture, so a side-project is the best way to get past this stage. Being an investor makes you more conscious of what may work for your own venture.
- Theory = Employees are expected to follow orders and complete tasks. Reality = many employers are entrepreneurs with relatively young companies who prize employees who can think outside the box and bring innovation to the table.
This matters because building a portfolio – so essential – is is much harder for entrepreneurs and contractors/employees.
- Entrepreneurs have the weakest diversification aka highest concentration risk. They are the risk takers in this ecosystem. Most big waves create a window of opportunity of about 10 years when the market is open to new venture; the wave lasts much longer, but most of it is after the market has consolidated and the winners have been declared. It also takes about 10 years to build a business with sustainable value. An entrepreneur can create one, maybe two ventures in that time; you could build one to Product Market Fit, sell it before it is big, move onto the next one. So, the maximum diversification for an entrepreneur is 2 or maybe 3, which is a massive concentration risk in investor terms. That is why entrepreneurs need so much equity to compensate for that risk; after exit they can build their own portfolio as investors. Note: a few superstar exceptions, such as Steve Jobs, Jack Dorsey and Elon Musk, prove this rule.More on this in the future chapter aimed at entrepreneurs.
- Contractors/employees can get more diversification than entrepreneurs, but less than investors. A contractor/employee can work for 3 to 5 ventures during that 10 year window. That is better diversification but still high concentration risk. If you change jobs every two years, you can work for 5 ventures during those 10 years. If you get options in all of them, you now have a portfolio of 5. That is concentration risk, but with some luck it may pay off. Note that with a 4 year vesting, you will only get 50% of those options if you leave at 2 years; if the venture looks like a winner you may “roll the dice” and accept concentration risk by staying.
Whether you are investor or an employee/contractor or an entrepreneur, you are sitting on the same surfboard looking at the same wave. Don’t worry, this is a huge wave with masses of opportunity.
The Blockchain Economy is like 1994 – not very useful yet
The key word is yet. The direction of travel is clear.
Imagine somebody in 1994 telling you how to make money in the Internet Economy. All I got in 1994 was somebody showing me how to send an email over the Internet (thanks Charles). My takeaway was:
- I can only send an email to a few people and none of them are people I know.
- It is harder than sending a fax.
Wrong takeaway. A couple of years later we had the Netscape browser and then Hotmail. The rest is history.
The Blockchain Economy is like that today. There are not yet many services that make our lives easier/better. The only thing that gets attention is investing/speculating/trading – should I buy/sell xyz token? We will come onto that in a later chapter. There are some use cases with real traction today, but they are niche (for example raising capital). Ask somebody whose work is totally unrelated to Blockchain if anything Blockchain related has made their lives easier/better and at best you will get a blank stare.
History does not repeat, but it does rhyme. Each wave is different in subtle ways, but all waves have a lot in common and so you can learn from looking at past waves.
The Blockchain Economy is like 1999: overhyped and over valued.
Egregious overvaluation examples are not hard to find:
- ventures that do not even have a Minimum Viable Product (with only a Minimum Viable White Paper) raising over $1m.
- Raises for early stage ventures over $1 billion (first Telegram and then EOS with $4 billion).
There are still reasonable deals at reasonable valuations and don’t forget that the investors who put money into Google in 1999 did well. Those Google investors in 1999 might not have done so well if they had invested at a multi-billion valuation. You could argue that Google’s huge valuation today – about $782 billion as I write – would have justified them raising $1 billion on a $4 billion valuation in 1999. The problem is that raising $1 billion makes an entrepreneur less motivated to do the hard work of building a valuable business.
How Family Offices aka “muppets on steroids” are writing the future of Fintech & Blockchain & Wealth Management.
Updated March 2019
“Muppets” is the derogatory term coined by the smartest guys in the room on Wall Street for the “dumb” retail investors. The people who invested early in Bitcoin and Ethereum are retail in the sense of being individuals and not part of the Legacy Finance world. Yet they are now (even at these bear market prices), seen as smart wealthy investors.
This is a huge inversion. It now looks like “dumb money” from retail muppets has become “smart money” (which used to come from institutions). The reality is that Bitcoin & Ethereum “investors” could evaluate tech and market risk. They might have known nothing about investing but they did know that the technology was feasible, the team was good and if the team developed something that worked it would change the world and make a lot of money.
Warren Buffet in his early days was another dumb retail muppet – who made a fortune. There are many other famous examples; these were all from an earlier era, for some reason it is viewed as impossible today. Here is an interview on Daily Fintech with a recent example who is not famous (lending not equity).
What all of these dumb retail muppets share is that they have no explanation risk. If a “smart money” intermediary makes a bet that goes wrong they have to explain themselves to their investors. If a retail investor makes a bet that goes wrong they have to learn from their mistake and move on; mistakes are part of the learning process.
Family Offices are like retail investors in that they make their own decisions and have no explanation risk. The difference is obviously that Family Offices invest far bigger sums than classic retail investors. Family Offices are Retail investors with clout. Watch what Family Office do in Blockchain Finance to see the future.
Let’s look at a recent example – the pre IPO round for Silvergate Bank.
The recent news is a pre IPO round. Forget the usual roster of Big VC Funds. This deal was done by a Family Office:
“The Witter Family Offices announces its investment in Silvergate Bank, in advance of the bank’s Initial Public Offering announcement. Silvergate is a provider of innovative financial infrastructure solutions and services to participants in the nascent and expanding digital currency industry. The Company filed documentation for an initial public offering on November 16, 2018, to raise up to $50 million.
Sherry Pryor Witter, Managing Partner, Co-founder and CIO of the Witter Family Offices, welcomed the opportunity to partner with Silvergate. Given the explosion of digital currencies and blockchain technology in recent years, Sherry was aware that the space was ripe for opportunity.Taking an equity stake in Silvergate was a way to invest in digital currency with less risk of the volatility often associated with the emerging technology. “We believe that finance-related technology and solutions need to continue to advance to support future economic, demographic and global changes,” Sherry said. “One area that we are looking at is crypto, not only the asset itself, but the supporting infrastructure to increase its velocity and application. We believe that Silvergate saw an opportunity to bank cryptocurrencies by providing technology solutions to exchanges and crypto companies when others only saw risk.”
Getting into the Pre IPO round of a leader in Blockchain Finance is not easy
Big VC sell their access to deal flow as a USP. Getting access to quality deal flow in Blockchain Finance is a big deal because Blockchain Finance is Version 3 of Finance:
- Version 1 was Analog Legacy Finance. This was the era of investors such as Warren Buffet and Peter Lynch, when stockholders painstakingly researched the fundamentals of individual companies and held those stocks for a long time.
- Version 2 was Digital Legacy Finance. This is what is often called Fintech; our definition at Daily Fintech includes Version 3. Digital Legacy Finance was when computers took over trading and long term hold meant more than a second. In this market, the individual retail investors were derided as muppets and individuals invested through institutions rather than directly. Due to Buybacks and Mega Private rounds, there were fewer individual companies to invest in and the whole game moved to trading indices based on reading Central Bank tea leaves or front-running retail investors using High Frequency Trading.
- Version 3 is Blockchain Finance. One key difference is that in Version 2, everything changed except the business of investing, trading and value exchange. In Version 3 Blockchain Finance, the Funds themselves are facing to deal with disruptive change to their own business. This is when we will see tokenised assets go mainstream and when the old fund intermediary model (first raise funds, then invest) will be disrupted by an inverted model (first invest, then get passive investors to follow you for a fee).
Family Offices feel no threat from the disruption as they invest direct.
Bernard Lunn is the CEO of Daily Fintech and author of The Blockchain Economy. He provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).