During the August holidays I spent some time in a lake house in the Rocky Mountains where the history of Native Americans, Homesteaders, Miners and Moonshiners was much in evidence. It seems quaint in hindsight because we know what came after (big cities, mechanised farming, massive wealth creation). It was not quaint at the time. It was rough and tough, just like the ICO gold rush of 2017.
The Ethereum releases of Frontier, Homestead, Metropolis and Serenity track this same trajectory. Ethereum is currently somewhere between Homestead and Metropolis. Ditto the disruption to Innovation Capital that the ICO gold rush of 2017 is signalling. We are in the homestead/gold rush/moonshine era and will be moving into the big city/mechanised farming era.
That trajectory implies a few big company winners.Our thesis is that the disruption to the Innovation Capital business that the ICO gold rush of 2017 is signalling heralds something much more interesting, which is a more sustainable version of capitalism that will benefit the many not just the few. This mega trend shift is what we call Digital Cooperatives.
The ICO disruption to the Innovation Capital business.
Disruption has winners and losers. The winners in this case is everybody – the 99% if you like. The losers will be the few firms who currently control the spigots of the Innovation Capital business.
I don’t use the term Venture Capital because that term now denotes one business model for Innovation Capital – the 2 and 20 compensation model for VC firms, mostly clustered around Sand Hill Road in Silicon Valley. I refer to that now as Wall Street West, which works closely with the firms across the country in Wall Street East that do the big money transactions (IPOs, big M&A, Bond Markets). In the founding days of VC and Silicon Valley, it was utterly different from Wall Street. As VC grew in economic importance, the bonds between the two tightened, with talent and deals moving easily between the two worlds. This wealth creation mostly bye-passed Main Street. The future of Digital Cooperatives will be about the Main Street real economy. It will be exciting for the 99% and boring or even disturbing for the 1%.
Software is eating the world. Software drives the economy and is disrupting every market. This means that software is now too important to be left to a few firms on Sand Hill Road and Wall Street.
The job of Innovation Capital is to fund innovation that changes the world. The VC to IPO model did that brilliantly for a long time, but it is increasingly broken (see this post for more) and has been ripe for disruption for some time. The ICO is the first step in that direction. Like all disruptive innovation it arrives first with a lot of sketchy characters. The ICO gold rush of 2017 makes The Wolf Of Wall Street seem tame and that is hard bar to vault over!
Like all disruption, the ICO appears wild and chaotic and filled with sketchy characters, with ventures that are totally unregulated and often skirting the law. In short, we are in the Napster era. What comes after will be more like iTunes and Spotify, not free but much cheaper and more convenient and totally legal. When was the last time you saw a retail store selling CDs? Who mentions Napster other than as a historical footnote?
I see three fundamental drivers of change from the ICO disruption:
A better way to manage early stage technical and market risk.
A shorter path from garage to liquidity.
The enabling innovation coming from the protocol layer.
These three fundamental drivers of change will enable a more sustainable version of capitalism via Digital Cooperatives. First lets look more closely at those three fundamental drivers of change.
A better way to manage technical and market risk
VC Funds manage risk. Like any investor, they like the upside potential and want to minimise downside risk. VC want to invest when as much of the risk as possible has been eliminated. This is what the LPs pay the GPs to do.
VCs have to time that entry carefully. As one VC put it to me “we want to come in just before an entrepreneur can get a bank loan”. The boom in mega PE/VC funds is partly explained by bankers reluctance to lend post GFC. If you have to wait longer for a bank loan, that mega equity round may look more attractive – even if the preferential equity terms give founders some agita.
Preferential/Convertible Equity is a hybrid Debt/Equity instrument for a good reason. Debt makes risk management easier for passive investors (even if it wipes out common equity owned by founders and management in the process).
Risk management is what LPs expect from GPs. They want the massive upside without the massive risk. That makes sense as long as entrepreneurs have no other option. Thanks to ICO, entrepreneurs do now have another option.
This focus on risk management means VC GPs work hard to avoid two types of risk. You can look at the ICO market through the prism of these two types of risk: Technical Risk & Market Risk.
If you invent a cure for cancer (or longer lasting/cheaper/safer batteries or other change-the-world technology), the market is huge and ready. There is lots of technical risk, but there is no market risk.
Professional investors have had a “run, don’t walk” attitude to technical risk. Imagine Vitalik Buterin pitching a Sand Hill Road VC for Ethereum in 2014. Would they have seen a future Bill Gates? Probably not; the first filter of technical risk would have killed the deal. Bill Gates did not raise money until Microsoft was already profitable. In contrast look at the individuals who bet early on Ether in 2014; they had some ability to assess the technical risk of building a decentralised computer, because they were developers first and investors second.
Now imagine a Biotech or Cleantech venture with a massive market but lots of technical risk. Biotech or Cleantech scientists who can assess that technical risk can use ICO mechanisms to vote with their wallets by buying in early. Those scientists will be the technical smart money voting on Technical Risk. Professional investors will follow that technical smart money.
Most ventures funded by VC have zero technical risk. Look at ventures such as Facebook, Twitter, Uber and AirBnB; the early technology was trivial.
When it comes to market risk, that risk gets taken by founders, friends and families and the occasional Angel; they have to get the venture to Product Market Fit before VC will invest. If you build an app and find a market, VC cash will help you scale; VC today is growth equity after market risk has been eliminated. The problem occurs when everybody wants to fund after market risk has been eliminated; that will cause the innovation funnel to dry up.
Fortunately the ICO model also helps manage market risk, because the early visionary users are also the investors.
Again Ethereum is a useful case study. Ethereum’s early visionary users/investors also built the early DAPPs; they had the tech chops to do so, as well as the financial motivation because they owned some ETH. In contrast, in some 2017 ICOs, the early investors are speculators who don’t use the product. They speculate based on some hype in a YouTube video; these ventures will probably fail. A promising sign is when, like Ethereum, the early investors also build stuff with the new technology coming from the ICO; that is when passion, expertise and capital are aligned.
The progression from the Napster era to the iTunes/Spotify era means coming to terms with the complex legal, technical, tax, organisational and marketing issues related to launching something like an ICO that includes a beneficial interest in the venture that means that a) it is a better deal for investors b) it is definitely a security and will be regulated as such. The companies that lead this next wave of innovation will not shy away from securities regulation; they will embrace it. This won’t be easy but the prize is a big one.
Although the legal, technical, tax, organisational and marketing issues related to an ICO that is legally a security are complex, they will be fixed because the prize is so big. The reason is that the next phase of the ICO market does not simply change the early stage. More critically also the next phase of the ICO market also changes the late stage. In the late stage one word matters most – liquidity.
A shorter path from garage to liquidity
The future of ICO is more than crowdfunding.
The simple reason is liquidity. If you invest in a private company via crowdfunding, you are locked in until there is an exit or until you do some complex bilateral negotiation where you will tend to be at an informational disadvantage. There have been some opaque grey markets in private shares but they are nothing like public equities in terms of transparency, price discovery and liquidity. In contrast, you can trade ICOs almost like you can trade public equities; you have to learn a few new techniques, but it is possible. The ICO market has price discovery, shorting and all the other market mechanisms that enable liquidity.
Liquidity is a game-changer. It is why the O in ICO is like the O in IPO. The difference is time and statistical probability. The journey from garage to IPO is at least 10 years vs instant liquidity for an ICO. The statistical probability of an early stage venture getting to liquidity is less than 1% in IPO vs 100% for ICO. Ventures can languish in small cap hell on both markets but that means below $2bn in IPO world and below $200m in ICO world.
Liquidity has measurable value as shown by the liquidity discount given by the tax man.
Liquidity is a game-changer because it makes early stage so much more accessible to Josephine Q Public. A Fund or a Professional Angel can live with illiquid investments. Everybody else wants something like the stock market where they can check price and sell if needed without getting anybody’s permission; whether they choose to be active traders or buy and hold investors is a choice they can make.
Sorry, I would like to make you rich but the SEC won’t allow me to do that
The ICO market of 2017 has been like the Casablanca scene – “I am shocked, shocked, to learn that investing has been going on here”. The ICO issuer has to pretend that a Coin has no beneficial interest that makes it even remotely like a security. That pretence makes it totally legal, indeed sensible and respectable, to offer worthless Coins to unaccredited investors (Josephine Q Public) while offering equity and other security like beneficial interest to accredited insiders (aka Funds and Professional Angels).
The SEC has been fighting the last war. Rather then bemoan that fact and call for the SEC to change (and grow old waiting), entrepreneurs will figure out how to legally offer security like beneficial interest with all the low cost/convenience of the ICO model. Steve Jobs did not tell consumers to stop downloading free music or tell music labels to stop suing customers; Jobs offered a cheap/convenient and legal service called iTunes.
Some commercial ventures simply need a better funding model. Some ventures also need a different operating model, which brings us to impact investing and digital cooperatives.
First, lets look at the last of the three big drivers of change – the enabling innovation coming from the protocol layer.
The enabling innovation coming from the protocol layer.
The current phase of the ICO phase of is based on one picture (which comes from Fred Wilson of Union Square Ventures):
There are two possibilities here:
One: this theory is wrong. The big value creation in the Decentralised Internet will be at the App level of the stack, just like it was in the Centralised Internet era.
Two: this theory is correct and there is some massive opportunity at the protocol layer.
My thesis is that there is no value capture at the bottom of the stack, but a lot in the middle and that the value creation at the top of the stack will be done through Digital Cooperatives (which we will come onto later in this post).
First, why do I believe there will be no value creation at the bottom of the stack? This is what I call the commercial TCP/IP layer mirage.
The commercial TCP/IP layer mirage.
TCP/IP is often used as an example to describe the protocol layer opportunity in the ICO market. What if you could invest in a commercial equivalent to TCP/IP for the decentralised Internet?
TCP/IP obviously enabled massive value creation – at the app layer. You could say “value creation was at the protocol layer but value capture was at the app layer”.
The reason that the commercial TCP/IP layer investment thesis is a mirage is simple. Internet protocols such as TCP/IP, SMTP or HTTP would not have got the same traction if some commercial entity controlled them and was extracting a fee.
Ethereum is the closest thing we have to a protocol layer for decentralised Internet. The Ethereum founders debated vigorously what model to follow. They opted for a non-profit Foundation model. I doubt it would have got the same traction if it had been a commercial venture at its core.
Wintel was a different era that won’t be repeated. Nobody will ever repeat the level of dominance that Microsoft and Intel had at the bottom of the stack. Chasing that dream is a recipe for burning capital.
However, just up a notch from the bottom of the stack is the middleware layer. This is where a lot of enabling innovation is happening.
The middleware layer of the Decentralised Internet
During similarly early days of the Centralised Internet, in the mid to late 1990s, we had a market that generically was called middleware (between the app layer at the top and the OS/DB at the bottom). If you can remember things like Web Application Servers you have carbon-dated yourself.
The Decentralised Internet era has a similar middleware layer emerging. This time the services relate to things such as Identity, Provenance, Data Validation, Exchange and Payment that a) all apps need and b) will be done quite differently in the Decentralised Internet era.
The App Layer benefits massively from using these middleware services. The mantra is “write less code”.
The App Layer will be great for the world, less so for VCs, because so much of it will be non-profit or owned by cooperatives. For the kind of value capture that VCs like, the middleware stack will be great. The App Layer will have a bigger impact but will not primarily be funded by VC. The App Layer will have a lot of what we associate today with Impact Investing, but even this will be changed by Blockchain.
Family Offices (Single and Multi) usually have a big Impact Investing focus. The idea is to “do well by doing good”, by investing in ventures that will generate a reasonable economic return while also changing the world for the better. Impact investing makes sense for them because Family Offices are investing for multiple generations and they want to leave their future generations with a better world, not just with money.
Whatever the social mission (saving the environment or financial inclusion or reducing inequality through economic empowerment or better health or eduction or…), impact investing is about getting the balance right between profit and social good. Impact ventures are for profit in the sense that they generate profits by selling goods and services for more than they cost; they are not dependant on philanthropy to sustain themselves. They pay employees and contractors through this profit. They may also distribute some profits to shareholders who funded the early stage, but this is not the shareholder primacy world of the past. That is why impact ventures are often and incorrectly labelled non-profit. They are for profit; it is just that producers (employees and contractors) and customers are as important as investors.
Technology and ICOs are impacting this by bringing the idea of Digital Cooperatives into focus as a way to a more sustainable version of capitalism.
Capitalism in Crisis
Capitalism as we know it today is in crisis. Communism failed visibly after the collapse of the Soviet Union. It is clearly a failed system/ideology. Sadly, when Capitalism lost it’s natural enemy, after the collapse of the Soviet Union, Capitalism also started to fail. During the Cold War, the West had to convince people in both the developed and developing world that their system was better for the people by spreading wealth broadly. After the Berlin Wall collapsed, wealth went to a smaller and smaller group of people. Without a stake in the capitalist system, people moved to populism of both the left and the right and this came to a head in 2016 with Brexit and then the resurgence of the left wing of the Labor Party in the UK and the election of Donald Trump in America. Populism of left and right could destroy capitalism, which will be a disaster because the alternative (communism) has already been proven to fail.
The best hope for a revised and sustainable version of Capitalism comes from the concept of a digital cooperative where producers, customers and owners are aligned. We can see the early signs of this in some of the best ICOs. The ICO model is ideally suited as the funding and governance mechanism for Digital Cooperatives.
The idea of Cooperatives is not new. It works in many markets; think of Community Banks and Coop grocery stores for example. These are Customer Cooperatives; the shareholders are customers.
One example of a Customer Cooperative is Vanguard. The customer in this case is a shareholder of the funds. There are no outside investors. This structure allows Vanguard to charge very low expenses and this is what Efi Pylarinou on Daily Fintech dubbed the Vanguard effect. It makes Vanguard the real disrupter in the Wealthtech segment of Fintech. When they started in 1975, their average expense ratio was 0.89%. By 2014 this had dropped to 0.18%. Given their scale, network effects and customer ownership structure, nobody can undercut Vanguard on price and in a commodity such as ETF, price is the deciding factor. The growth numbers (tell the story:
- 32 years to reach $1 trillion in assets
- 8 years to get to $2 trillion
- 3 years to get to $3 trillion.
At the top of the WealthTech stack are the Single (SFO) and Multi Family Offices (MFO) where the shareholders are the owners. Intermediaries to SFO and MFO still get paid if these intermediaries deliver value, but they do not control the game in the same way that intermediaries serving the less wealthy control the game.
In short, ownership matters.
In the analog era there were many Worker Cooperative experiments. They mostly failed due to a simple alignment of interest issue. If employees are owners it is too simple to get employees to vote for a pay increase that will make the business unprofitable; it is a tragedy of the commons. The resurgence of left wing populism is bringing back these ideas, but they are likely to fail for the same reasons.
A Producer Cooperative aligns better with the reality of the Gig Economy (which is the norm in the Rest of the world). The Producer Cooperative is based on free agents such as doctors or drivers. We have profiled some examples on Daily Fintech (such as a Dentist Cooperative). The idea of a Producer Cooperative is simply that the ownership of these gig economy networks remains primarily with those who provide the services in those networks. These free agent entrepreneurs will be much more thoughtful about when and how to raise prices than a salaried employee might.
There are also User Cooperatives.
Imagine if Mark Zuckerberg’s next door neighbour at Harvard had the same simple brilliant idea for a social network and built a good enough product, but decided to offer the first few thousand users a big % of the equity. He or she would be very wealthy (albeit not as wealthy as Mark Zuckerberg) and few thousand people who made it happen would have had their lives changed.
In the case of social networks, the User is also the Producer; they produce for free in return for getting a free service. They are also the Product being sold to advertisers. So a User Cooperative is slightly different from a Producer Cooperative.
A Digital Cooperative (whether Customer or Producer owned or some combo) applies digital efficiency to the simple idea that ownership should be shared among those who create the value.
A well designed ICO enables a Digital Cooperative. Again the Ethereum ICO is an example. The early Ethereum investors were also the early producers and the early customers building the DAPPS. Through this simple alignment of interest, Ethereum overcame both technical and market risk.
In many cooperatives, the ownership is incidental. You care about the good prices at a Community Bank/Vanguard/Coop Grocery; your ownership stake is incidental. The ICO with its liquidity makes that ownership more valuable but it is still not the primary consideration. The ICO with its liquidity will enable many more Digital Cooperatives to thrive. It may become the primary form of company in the future.
The ICO disruption took everybody by surprise.
That is why they call it disruption. If a lot of people forecast a trend, it is less likely to be disruptive.
Many people wrote about how the VC to IPO innovation capital business was broken; but although the problem was obvious, no real change happened for decades and the status quo seemed locked in forever. Many people wrote about how Ethereum would enable new crypto economic markets and governance structures, but that seemed highly theoretical and geeky. Many people wrote about how real time settlement using blockchain would change how the capital markets operated, but that seemed limited to the B2B realm. Nobody connected all three dots to show how a completely new permissionless network would emerge so rapidly in 2017 offering:
- A better way to manage technical and market risk for investing in early stage ventures.
- A shorter path from garage to liquidity to enable ventures, both for profit and non-profit, that would never have seen the light of day in the old model.
- The enabling innovation from the middleware layer of the protocol stack that reduced the time/cost to create the world-changing applications of the Decentralised.
- A new form of impact venture, the Digital Cooperative, that promises an inclusive, sustainable model for the future of capitalism.
Bernard Lunn is a Fintech deal-maker, author, investor and thought-leader.
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