Will Blockchains Disrupt Venture Capital?

Note: These insights were compiled by Travis Scher, who is an employee of Digital Currency Group. They are not intended to represent Digital Currency Group’s position on these issues.

We’re in the midst of a speculative mania in cryptocurrencies. The total market capitalization of all blockchain-based tokens has risen from $7bn at the beginning of 2016, to $18bn at the beginning of 2017, to over $50bn today. As cryptocurrency awareness spreads and investments in tokens grows, some are claiming that blockchain technology is beginning to disrupt and democratize the venture capital industry. This sounds lofty, but what does it mean in practice?

Below, I discuss four trends: (1) decentralized organizations raising money from the crowd via initial coin offerings (“ICO’s”), (2) traditional companies launching tokens and raising from the crowd via ICO’s, (3) VC funds investing (directly or indirectly) in tokens, and (4) the emergence of new decentralized funds.

While these trends are real and exciting, and I believe that all internet-focused VC’s should be paying attention, I doubt the net effect will fundamentally change venture capital. Successful venture capital is about the quality of people and their investment process. Blockchains will not abrogate the need for deep due diligence, or the valuable, personalized support that VC’s provide. However, once the risks associated with tokens are better understood, blockchains may serve as a valuable tool for venture investors.

1. Decentralized Companies Raising Money via ICO

The first notable trend is the increasing number of decentralized organizations raising significant amounts of money from the crowd via token sale. I previously wrote that I am skeptical about today’s ICO’s, and the recent explosion in offerings has mostly reinforced my view that the hottest new blockchains aren’t solving real problems and these new tokens do not offer compelling value propositions. (I also discussed the regulatory risks, which is mostly beyond the scope of this article — see Coinbase’s Securities Law Framework, Marco Santori’s Appcoin Law series, and Chris Padovano’s Decentralized Legal blog for more).

Examples of questionable projects raising seven- or eight-figure ICO’s abound:

• Gnosis, a decentralized prediction market, raised $12.5mm in 10 minutes at an effective $300mm market cap, despite the fact there is no strong argument that its token needs to exist (the platform, which runs on Ethereum, could just as easily be powered by Ether)
• Cosmos, an “internet of blockchains” that aims to enable “interoperable blockchains”, raised $16.8mm in 30 minutes (I believe that we need blockchains applications to reach a mass audience before we need blockchains to “interoperate”)
• Qtum, a protocol for decentralized applications, raised $15.4mm (Ethereum and Ethereum Classic serve the exact same purpose, and both have very strong developer communities, but no apps with any real traction today — so I’m not convinced there is room or a need for a competitor)
• Lunyr , a decentralized encyclopedia, raised $2.6mm (I think Wikipedia is good enough)
• Matchpool, a decentralized matchmaking protocol and dating app, raised $5.6mm (their homepage includes a button to buy its “Guppy” token but doesn’t explain why it needs to exist in the first place)

The sums being raised aren’t mind-blowing in the grand scheme of things, but are probably 5–10x the amount that equivalent companies could have raised in the venture capital market.

I find this experimentation fascinating. And I understand that one justification for these token sales is that their decentralized nature means that they have no inherent business model, thus disqualifying them from traditional VC. But almost none of these projects would have been attractive to experienced investors anyway, because VC’s, unlike today’s token investors, generally require that a business is solving a real problem (Juicero notwithstanding). Additionally, the vast majority of these projects have failed to present a compelling argument as to why they need a new token to execute on their vision.

To be clear, I do believe a handful of open blockchains will succeed in actually delivering value to end users. These will be the ones where the projects are narrowly focused on building a decentralized model that operates more efficiently and/or delivers enhanced privacy and security relative to the comparable centralized model (e.g., Bitcoin). We at DCG will continue to seek out these opportunities and are excited to support the great entrepreneurs behind them. However, there is a real shortage of these projects today and the gap between reality and hype is massive.

2. Centralized Companies Raising Money via ICO

Another trend is an increase in traditionally organized companies launching adjacent tokens. Two early startups to issue their own tokens while continuing to operate a traditional corporation are Ripple, whose XRP token can be used to execute cross-border payments, and Factom, whose Factoid token can be used to pay for time-stamped database entries that are hashed onto the bitcoin blockchain’s “immutable ledger.” Now, a number of VC-backed companies and even venture firms are getting in on the action.

Most of these companies are launching open protocols and accompanying tokens that support their business or product in some way. For example, DCG portfolio company Brave is launching the BasicAttentionToken to reward users for viewing ads. This token will be integrated into the company’s web and mobile browsers. And DCG portfolio company Protocol Labs is launching and Filecoin, which will reward those who rent out the excess hard drive space. Filecoin will run on Protocol Lab’s distributed file system, IPFS. These are independent “use” tokens that aim to better align internet users’ incentives.

It will be interesting to watch how these tokens effect these companies’ businesses. Generally, today’s best practice dictates that the proceeds of a token sales are collected and held by an independent Swiss Foundation (or similar) and used to support development of the open protocol. The for-profit business maintains its pre-ICO cap table and continues to operate as usual, possibly keeping a share of the tokens, granting its investors the right to pre-purchase some tokens before the ICO, or being paid fees by the foundation for development of the protocol.

So, what you have here are some VC-backed companies doing ICO’s that will hopefully benefit the VC’s (either directly through appreciation in value or indirectly by driving other revenue streams for the company). But there are many possible outcomes; the new tokens could (1) succeed independent of the VC-backed company (e.g., the BAT token is not tied to the Brave Browser), (2) fail to gain adoption even as the company thrives (e.g., Brave currently uses Bitcoin for a similar purpose, and the browser could gain mass adoption due to its enhanced privacy/ad-blocking features), or even (3) become useful without gaining significant independent value as an investment (e.g., Filecoin could become widely used but worth basically nothing depending on the how the “cryptoeconomics” play out in practice). You also have companies like OB1 that are building open decentralized protocols and decentralized applications (in OB1’s case, OpenBazaar) that utilize existing tokens (in OB1’s case, Bitcoin). In fact, this was how many people envisioned tokens like Bitcoin and Ethereum would be used in the first place, but these models have become rare as ICO money has become easier.

Many of these venture-backed startups are proceeding under the assumption that the token will be treated as a security by regulators (unlike the decentralized organizations, which are hoping that their tokens will be classified as software or some other form property). However, securities regulations (in the US, at least) place strict restrictions on the transferability and marketing of the private securities. Unfortunately, this abrogates many of the advantages of doing an ICO in the first place.

Another class of companies are raising or contemplating raising straight equity via ICO. They not only need to comply with regulations, but also need to figure out how to handle traditional investors rights and cash flows. If they manage to get this all right, they’ll basically be doing crowdfunding campaign using a trendier name. True, these tokens will be more easily traded than traditional private equity (from a technological perspective if not from a legal perspective), and these companies are providing a glimpse of what a future with tokenized private securities will look like (similar to what Chain is doing with Nasdaq). But as we saw with the decentralized organizations launching ICO’s, the companies in this category have struggled or would struggle to raise money using traditional channels, and their primary motivation is to capitalize on the current ICO frenzy (which may or may not last).

3. Venture Capital Funds Investing in ICO’s

Meanwhile, more traditional VC’s are seriously exploring investing in crypto-tokens. This started a few years ago, with indirect investments. DCG raised money in 2015 from Bain Capital Ventures, FirstMark Capital, OMERS Ventures, Oak HC/FT, and RRE Ventures (we’re a corporation, not a traditional VC), and today we hold Bitcoin, Ethereum Classic, and Zcash. Super angel investor Naval Ravikant has backed a crypto-fund called MetaStable, and elite VC firms Union Square Ventures and Andreesen Horowitz invested in a crypto-fund called Polychain Capital.

Now, venture capitalists with blockchain expertise have started directly investing in tokens. Blockchain Capital (which did its own $10mm ICO) and Pantera Capital (a blockchain-focused VC) are backing a project called 0x, and Tim Draper (who is an investor in dozens of bitcoin companies) is backing a project called Tezos. Behind the scenes, I’ve noticed a major uptick in established firms going down the blockchain rabbit-hole and seriously exploring investment in tokens or crypto-funds (with some going back to their LP’s to confirm they would be comfortable with this). Some smaller VC’s are even toying with the idea of setting up their own crypto-funds. For the most part, though, there is still more exploration than action. The individuals at the bigger firms diving deepest are usually junior-level VC’s who have been tasked with figuring out what the latest iteration of blockchain hype is about.

We’ll see some surprising entries to the world of ICO’s this year as many VC’s now appear willing to make token investments, if only to make sure they don’t miss out. But I also expect the trend to abate by the end of the year unless we see protocols delivering real value and solving real problems.

4. Decentralized Funds Raising Money via ICO and Investing in ICO’s

The last area where some are claiming that VC is being disrupted is the emergence of decentralized, blockchain-based funds issuing their own tokens to invest in other tokens. The first was The DAO (short for “decentralized autonomous organization”), which raised $160mm in the largest crowdfunding campaign of all time last summer. That project ended in spectacular failure. But the death of the DAO hasn’t stopped others from launching similar concepts. ICONOMI, a “decentralized crypto-fund platform” and TaaS, a heavily marketed “tokenized closed-end fund,” raised ICO’s of $10mm and $7mm, respectively.

Fundamentally, investing in and by these funds isn’t very different from individuals investing directly in ICO’s — it’s crowdfunding with a cryptographic token instead of traditional equity. However, this is the category I’m most skeptical of, because I doubt these funds will perform well and I think they are ripe for fraud.

Another concern stems from the fact that, as the ICO market heats up and gets more press, there will be more scams and frauds (perhaps only discovered when the tide comes in). My instinct is that these types of decentralized funds will be the most attractive for crooks, because they don’t really need to prove they have a unique idea or any code to get going, and they’ll be able to funnel money into other fraudulent projects.

Theoretically, these decentralized funds could hire centralized management (and function similarly to crowdfunding platforms BnkToTheFuture or FundersClub, or traditional mutual and index fund), and some are actually planning to go this route. But this could trip various securities and investment company regulations, and if one was to comply with applicable regulations, it’s not clear that this could be made available to the crowd (in the US at least) nor what value this structure would be adding (other than capitalizing on hype).

Conclusion

Venture capital and new crypto-tokens are intersecting in a number of new ways. So how will this affect the venture capital industry? In the short-term, ICO’s will continue to impact what investors are thinking about and effect how relatively small amounts of capital are allocated. In the medium-term, the number and size of crypto-funds will grow and a few decentralized protocols of tremendous value that deliver actual value to end users (not just speculators) may emerge (thereby benefitting those VC who get involved early). And over the long-term, blockchains may become pervasive and touch everything, as the internet does today.

But I doubt that VC be disrupted and displaced by open blockchain. I don’t believe the crowd can replace experienced early-stage investors, who play the critical roles of sorting, signaling, and, most critically, support. As the recent mania elucidates, the masses will be unlikely to match VC’s in picking out promising early stage tech projects. Additionally, because of their incentive structure, professional investors frequently uncover issues in the course of their diligence that individuals with no personal contact with founders could never know about. Furthermore, for better or worse, the stamp of approval by a prestigious VC can be extremely helpful for an early-stage startup seeking customers, employees, or future funding. Finally, and most importantly, VC’s help young companies grow — they open up their rolodex of personal contacts, and provide advice around hiring, scaling, raising money, crisis management, personal founder issues, and more. Every successful entrepreneur can point to a few investors or board members who were essential to their success. I don’t see how something like the DAO can replace these functions.

So, I do believe that all internet-focused VC’s should be following this space and forward-thinking VC’s should seek out ways to add value to this emerging ecosystem. However, I don’t believe that blockchains will “disrupt” or displace venture capital.