As investors, we’ve been used to a private fundraising framework that is being completely turned upside down by the public token sale mechanism.
As a venture investor, evaluating investment opportunities is often your full-time job and decisions impact your career as well as your wallet.
As a venture investor you’re also always given access to a lot of detailed confidential material and the access to the team, in order for you to ask questions. And even if in Silicon Valley deals close in record time, and at the seed stage you have to move fast, for Series A+ you have basically as much time as you want to make an investment decision.
Often, as a venture investor you’re also given information rights and sometimes board seats (even thought we’ve recently seen in many companies that in terms of preventing bad behavior these are fairly useless).
In the ICO world, that’s not the case.
Companies, teams or organizations that lunch public token sales, most often never interact with the final token buyer, and the average token buyer has no way to contact the team other than Twitter or their community tool of choice.
On top of that, ICOs are often on extremely tight deadlines, and are surrounded by a lot of hype.
It’s also usually more technically complicated to due diligence such efforts as code is law, and to fully appreciate what’s going on you need to read and understand the smart contracts behind an offering or the code behind a new protocol.
Given that the fundraising efforts are public plus there is little info and little time, I do believe the diligence efforts should be public as well.
When venture investors see deals they don’t like for some reason, or terms that are not fair, they just pass on the deal, and that’s it.
Because other investors will still be full-time investors that will go through the same process of analysis and diligence, and someone might like the deal. (Oftentimes VCs also interact offline about specific deals to get feedback and ask for things they might have missed, especially in advanced diligence).
In a public fundraising deal, even if reserved for accredited investors in the first phase (the token will reach exchanges sometime), investors aren’t usually full-time professional token investors.
Not everyone has time to dig into whitepapers (let alone understand them) and token sale economics to make a very informed judgment.
Yesterday, I did such an effort given no one would write about it. I wrote my sentiment on the token sale economics of Filecoin.
What has surprised me the most, is that aside from a few notes of dissent and criticism, there has been an overwhelming and amazing reaction online.
This post seems to have changed the perception of the token sale for people, which must mean that they did not know the facts presented in the post. This in interesting because those facts were just hiding in plain sight on the token sale documents. In turn, this means that people are very prone to the hype machine but not many have the time to actually go read and ponder about specific token sales.
This is wrong. But to me it should hardly be surprising: I certainly participated in a few token sales where I did not have much information or insight!
I would surely have loved if someone reported on what they found in the docs (and even more importantly the code) for other projects.
I would have loved if Emin Gün Sirer had started the public conversation with The Bancor Protocol before their token sale had started and I’m sure many others would have as well.
In the new frenzy for digital assets, many entrepreneurs are debating if they should raise money through a token offering or not.
The decision is not that simple.
I’ve obviously been thinking non-stop about digital assets and ICOs for the past months, like many others.
In order to have a successful ICO and, most importantly, a smooth and successful development of the project, protocol, token or dapp, the needs and incentives of many different stakeholders (man do I hate this word, if you have a good alternative please let me know) must be carefully balanced.
It seems that many projects are carelessly dismissing this topic and just gunning for the most cash possible. That might make the developers rich in the short term, but makes everyone poorer in the long run.
In my opinion an ICO or token offering only makes sense if it can align incentives between every actor and ultimately make an application more successful than what it could achieve with a normal fundraising structure.
First, let’s see who’s involved in an ICO?
Founding team
Advisors
Future employees
Early investors
ICO investors
Future token investors
End users of the dapp and thus of the token
Equity holders in the offline-entity
Second, what levers can we act on in an ICO / token design?
Total token supply
Token allocation
Number of coin offerings
Price in pegged currency (-> valuation)
Minimum rise
Caps
Distribution schemes
Inflation
Third, what does everyone want?
This is probably the hardest question, because right now it seems everyone just wants to make a buttload of money.
But let’s try to figure out what are the things we could maximize:
Initial amount raised
Future fundraises
Token price over time
Liquidity of the token
Usage of the platform
Revenues / dividends collected by token owners
Participation from developers and others that can help the protocol
Obviously we can’t maximize all of the above at the same time, but the way we structure token sales and designs can have tremendous impact on the ones we choose.
Unfortunately even the most thoughtful ICO schemes that we’re seeing today are not really thinking that far into the future and only really trying to optimize the distribution and “fairness” of the ICO, which is an important but small part, for it changes very quickly after the ICO.
Let’s try to quickly examine current ICOs schemes:
One-time fundraise: so all tokens are distributed at the beginning, often pre-product
Some tokens reserved for team
Some tokens reserved for advisors / partners etc.
Fixed price per token or fixed valuation
Maybe a cap on the amounts of tokens sold (-> so on capital raised)
In my view, current token sale models are completely suboptimal as they don’t really maximize ANY important thing!
And specifically only play to the advantages of early ICO investors with some sort of disregard for all of the others.
Let’s see how it fares on all of the dimensions we can tweak:
Total amount raised: if there’s a cap, then it obviously doesn’t optimize this. If no cap then you are limiting the amount you can raise by doing one single ICO when there isn’t anything to show for your product.
Token price over time: the thinking here goes that by limiting the supply and distributing it all on day-one will make the token value go up in time. This makes some sense, as long as the demand for that token exists and people want to own it, obviously. For that condition to happen there needs to be vast interest in the protocol and the products built on top of it, which are maximized in other aspects and not by supply dynamics. If instead the goal is for price stability over time so that people can use the protocol without worrying of becoming poor, then this clearly fails.
Liquidity of the token: giving the token on day one to random speculators on the internet doesn’t guarantee a liquidity in the market, and actually might hinder it quite a lot as whales will just hodl as the platform becomes more successful.
Usage of the platform: as above, if the token is fairly priced compared to the usage requirements and is liquid, people can use the platform.
Revenues / dividends collected by token owners: this aspect is most impacted by token and economy design rather than ICO design, but it’s of utmost importance if we’re to gauge the future price potential of the asset. It also impacts usage and distribution of the token (eg. who wants to hold it).
Participation from developers and others that can help the protocol: this can be impacted in the ICO by deciding how much of the token supply to distribute in exchange of work instead of in exchange for “cash”. The problem here is that reserving a random percentage of the token supply is a very complex guessing game as it’s pretty much impossible to predict how much the token will be worth in the future and in relation how much you can incentivize developers.
So, what’s the optimal structure?
Well the easy and obvious answer here is that there isn’t an optimal one, but a few easy changes that could help teams align incentives for everyone include:
Multiple fundraises!
This optimizes a lot of the things we were analyzing, as it gives the project proponent’s control over price / supply / risk for much longer.
Holding multiple fundraisers optimizes the amount raised and controls the token price over time.
Unfortunately, this is much harder to do when everything is immutable on a blockchain. I have a post in draft with a proposal on a structure, that I’ll try to publish soon.
Discretionary ownership!
Deciding who can own the token (at least in the early days, as it’s still a liquid instrument) might seem an “elitist” move but could actually be the easiest way to prevent whales and speculators messing up an economy and ecosystem.
Built-in, disclosed token economics!
If a token has a clear correlation to the success of the platform, more so than just a “well there will be more of a need for it”, then people will have greater incentives to own it and the proponents can tweak which kind of owners they’d prefer (users, speculators, etc.)
To incentivize participation and liquidity, I do think that most tokens would benefit from some sort of demurrage built-in.
Some easy models that could address some of the above:
Probably a topic for other posts (one for each!)
Pre-sales for value-add owners.
Multiple token types.
Early helicopter drops to users.
This is such a nascent issue and theme that I think we need everyone’s contribution. If you have some comments please respond or email me, or better publish your own thoughts!
A number of very interesting posts have come out since I’ve started writing this post (been in draft for a while..):
I’ll be at Blockshow Europe in Munich this week, if you want to meet feel free to tweet at me!
Venture capital has largely remained unchanged since it was invented.
A few months ago I’ve compiled a list of the most innovative VC firms out there (link below). These are certainly important evolutions and innovations but the core mechanic has practically never changed.
And then, suddenly, while every one was trying incremental innovations.. the crypto revolution happened.
My single best investment was one that was unlike any other: I’m obviously talking about the Ether crowdsale that Vitalik launched in 2014, raising $18M. I think we’re now at 150x and going.
This was a totally new and innovative concept. Ethereum sold an initial supply of tokens in exchange of BTC to fund the development of the platform.
Given the fact that the tokens might prove to be extremely useful in the future in order to use the Ethereum blockchain and smart contract platform, people bought them with two intentions: in order to use them, and because they believed they would have appreciated substantially (as BTC did).
Crowdfunding was certainly not new, with already many equity-based crowdfunding platforms fully operational, but for many reasons it didn’t really succeed anywhere.
But the difference here was massive: the value had completely been removed from the equity of the development company and had instead been moved to the protocol being developed and its tokens.
For someone who has always invested in equity, that’s quite the change.
The era of crypto token crowdsales and ICOs
Since then, it has been a whirlwind of new currencies, blockchains and dApps being launched on different platforms.
Some have been exceptionally spectacular, like the DAO, others have been scams, and others have just been unsuccessful.
Why we should pay attention
I think there are three main reasons to pay attention to this new wave:
For the first time in history we have the technology to invest in the protocols themselves (via the tokens needed to use them).
This is just massive, and will open up a wave of development given the new economic incentive being available.
It’s extremely interesting to think about what it could mean, and one particularly cool interpretation is the fat protocol hypothesis from Joel Monegro.
I think this will be a big trend, but I also think there will be some very big successes being built on the application layer, and for those ones the ICO model might not be the best.
2) Problems with the VC model
Many teams have turned to the ICO route because of a frustration with the venture capital model.
VC is by definition very scarce (for good reasons) and thus not available to everyone.
Usually, the “everyone” referenced above means teams in the very earliest stages, teams that are distributed, teams that aren’t in the hot startup hubs and teams that have non-traditional backgrounds.
People got frustrated with this and are seeing ICOs as the best avenue to raise funding for their own projects.
3) VC will have to move fast to capture value
To capture the most upside, VCs always have to invest at the fringes. When the fringes go as far as to change the model, the only way is to adapt.
I think we will see VCs exploring this space and new models more and more as well as token-raisers go more towards a normal fundraising path.
Why this is awesome
More innovation
If more teams and projects can get non-traditional funding, we will see many more teams building crazy new things.
Non-US teams
ICOs and crowdsales seem to be perfectly suited to teams that are not in a hot startup hub, so these teams will probably end up benefiting the most in the short term.
Liquidity
Tokens are fully liquid from day-1. This changes the game massively.
Public
Anyone can become an investor and prove that they can generate meaningful returns.
(I’m not exactly sure on how this compares to the public markets and hedge funds, but) it surely opens up the game to way more people than angel investors and people who have the right pedigree to raise a VC fund.
The problems
It’s not all roses, there might be some tulips too.
Useless tokens
With this new tool available a lot of people are inventing tokens just for the purpose of fundraising, even if their app has absolutely no need for a native token. Olaf Carlson-Wee illustrates this well in the podcast below:
Ether is valuable because there is an expectation that many more dapps will be built on the Ethereum platform and therefore many people will be in need of Ether to use such apps.
But, as an example, the Matchpool token will only become massively valuable if there will be an extremely high demand for it (or assumption of such in the future) — and this would only happen if that single specific app actually blows up. We’ve added quite a few layers of risk here and are getting much closer to a pure VC-based evaluation.
For some companies, a traditional VC route would be much more suited — but the hype is so strong that they can raise millions without ever being questioned by anyone or give out equity.
Misalignment of value captured / no equity
When people invest in a crowdsale, they are purchasing tokens that are usually not backed by any offline security or asset.
This means that if a dapp becomes successful, the token holders would only see an appreciation if the success mechanics generate a strong need for the token.
But in reality, the value could very well be stored in the equity of the company building the dApp as it actually holds the brand, the employees, the knowledge and could be the recipient of different revenue streams.
Were a company to be a acquired, the token holders would see absolutely no reward other than a potential hype-based fluctuation in the price of the token, while the founders would become millionaires.
Every time incentives start to become misaligned, problems tend to soon creep up.
One-time fundraising
Most of the crowdsales we’ve seen to date have no concept of multiple rounds of fundraising. This to me seems completely idiotic. There is a good reason for diving the fundraising process in rounds: risk. You would be crazy to assume all of the risk of a company being successful at the very beginning of its existence, yet this is what most token investors are doing.
VCs instead buy a small piece of the risk at the beginning, and after a while have the luxury to re-evaluate and see if the company has completely failed to deliver on its promises or if they instead did well. The VC can then decide if they’d like to continue putting capital at risk.
This is one of the most blatant flaws of the token space I’m seeing, and I think and hope it will be solved soon.
Given that smart contracts are already being used, it would make sense that these contracts have built in mechanism for fund tranches based on objective metrics (pre-determined tranches are never a great idea, but they’re certainly better than a one-time full-budget investment).
Unsophisticated investors
Most startups don’t get funded for good reasons.
It seems that nowadays any random project can raise funding with a token crowdsale, and most of these projects do not meet even the most basic requirements to be an interesting risk-adjusted investment.
Contrary to popular belief, being a venture capitalist who actually makes some money for its investors, or even just being a non-money losing angel investor, is extremely hard.
Now, on the high of the immense gains made on BTC and ETH, unsophisticated investors think that many of these tokens are great investments, when in fact they are not.
Venture capital actually exists for a reason
Venture capital has been invented to fill a need, and has evolved and survived in its current model because it actually does make a lot of sense.
Getting professional managers to choose the investments and help the companies they invest in has been proven to generate amazing returns, for the ones that do it well.
Creating diversified portfolios makes sense.
Diving fundraising in tranches makes sense.
Only funding the very best teams in the very best markets makes sense.
And so on.
The help that companies get from VCs is also oftentimes non-negligible, and there’s a reason why the best teams want to pick their investors even in a very liquid situation like a hot deal.
So, doing away with the whole structure of VC seems to be too big and too irrational of a change in my view.
Anyone can end up on a “cap table”: in a typical crowdsale, the entity who’s fundraising has absolutely no say on who will end up being an investor. This holds true in the crypto world, and at the same time, the entity will have absolutely no idea who invested.
At the same time, none of the investors will be meaningfully incentivized to take an active role in helping the companies/protocols they invest in.
The argument that crowdfunding fans usually use is one of “community”, saying that by raising from a lot of people a company can create a strong community of people that are willing to help and promote a company. But in reality that’s rarely the case. People invest in many different things and usually have other jobs, plus they are most of the time unqualified to give any meaningful aide (see above).
Scams
There are quite a few scamcoins around, and with the amount of ICOs happening it’s getting harder and harder for investors to dig deep into the merits of each ICO.
It’s also easy for people to build hype for investments as every transaction is public but anonymous, so it could be easy to orchestrate sending millions of dollars in ETH/BTC and then backchannel them back to the investors in order to show that an ICO is successful.
Regulation
To date, most crowdsales have been marketed as asset sales and have thus avoided regulation entirely. But the Howey test is always there and these are starting to look more and more like securities.
There is a real risk that regulators could step in and consider any type of crypto token offered in a bulk one-time sale as a security.
Additionally, any company which would like to have its token backed by some offline security (eg equity) will need to be in full-compliance of regulations, effectively removing a lot of the benefits of the model.
Where do we go from here?
Alesso
Specialized crypto token funds
One certainty is the emergence of digital-only hedge funds like Polychain Capital.
These are brand new entities and players with completely new skills needed if compared to venture firms.
These are the entities that will be able to make money in this new world, as I think most hobbyist crypto-investors will lose money as they won’t have the necessary information and potentially even access.
Traditional venture deals + crowdsales
We’re already seeing this with recent ICOs like Omise which has previously raised more than $25M from traditional VC firms and is now planning a crowdsale.
Startups will use token crowdsales just as the pro startups are using Kickstarter campaigns today, as a launch marketing tactic.
They will do an ICO only when the product is ready, the team is solid, some brand-name VCs are already backing the company, etc. — so that the individual crowd investors will feel much safer about investing.
I think this will be the default route for high quality teams.
Pre-ICO sales: going towards the traditional VC model
I’ve already participated in a pre-token sale with other angels and VCs before a public ICO has even been announced.
I think this will be the future. And the past, to be fair — as in the end this is actually very similar to the normal VC dynamic of today. Teams will look for smart money first from either the best people in the crypto community or from traditional angels and VCs.
I especially think that as the quality of the projects that have ICOs grows, this will become inevitable.
Equity-backed tokens
One of the most interesting things I’m seeing is the use of tokens as a representation of underlying equity interests in businesses and funds.
I’m thinking of examples like TaaS, a normal hedge fund which distributed equity-backed tokens and Blockchain Capital’s new fund, which is adding an evergreen fund offered via a token crowdsale to a traditional venture fund.
This is interesting as it makes a number of things easier in the fundraising process, but it definitely fits into a very clear regulated framework of the sale of a security, so we might end up not seeing that many of these.
Experiments
The reality is that no one really knows what will stick. We will see a lot of interesting experiments of new and creative structures and technologies. Definitely a space to watch with deep interest.
This is such an exciting new space that I’m just glad to be alive at this time and able to witness and comprehend the scale of the revolution.
To keep track of all the new projects being launched in the space, I’m launching a newsletter called Token Economy very soon.
If you want to be kept up to date, you can subscribe on TokenEconomy.co.
