ICOs: Normalizing the future

Cryptographic tokens and blockchain, the technology behind them, are disrupting the procedures inherent to a number of industries, including venture capital. Predictions that this means the VC model is on its way out, however, may be premature. 

Concern that crypto-based financial technology represents an existential threat to the industry crystallized last year when the amount of capital raised globally by traditional seed-stage equity funding was surpassed by token sales, or initial coin offerings (ICO). With this structure, exposure to a company’s upside is acquired in the form of virtual units that carry no ownership rights. 

In at least one counterintuitive but important way, the rise of ICOs simply reflects the status quo. Entrepreneurs have traditionally seized any opportunity available to get their businesses off the ground, sourcing capital from friends and family in the absence of formal VC support. Indeed, a recent study by Global Entrepreneur Monitor found that 95% of start-ups worldwide were self-financed and only 0.2% of US small businesses received venture capital. 

The ICO phenomenon can therefore be contextualized as both a natural evolution in the entrepreneur’s playbook and a game-changer from the investor perspective. VCs will continue to flex their advantages over competing sources of capital, but to maintain this relevance, they must respond to the new financial realities that ICOs have brought into focus.  

“There have always been ways for start-ups to raise money outside of VC. We’ve seen corporates be very active, then the evolution of the Kickstarters and peer-to-peer lending – and now it’s ICOs,” says Jarlon Tsang, a managing partner at Eight Roads Ventures Asia. “But ultimately, entrepreneurs still recognize that it’s about more than just raising the money. Any good company can raise money in various ways. The most important part is what value-add venture capital brings.”

Restricted access

The popularity of ICOs has been pronounced in the blockchain segment itself. According to data from CoinDesk, CB Insights, and IFCERT, annual ICO funding for blockchain start-ups totaled $2.4 billion by the third quarter of 2017, compared to only $1.6 billion for VC. As of the October-November period, the gap was widened further, with $3.8 billion coming from ICOs and only $1.9 billion from VC.

One of the fundamental issues with this shift is that tokens mimicking too many properties of traditional equities – including voting rights and exposure to cash flows – are increasingly being tracked by authorities as securities. This has precipitated a global regulatory crackdown on ICO issuances, led in Asia by sweeping reforms across Greater China and Singapore.

As a result, direct VC participation has been limited. Singapore-based Golden Gate Ventures, is often cited as one of the more progressive Asian firms in the ICO space, having provided early backing to Omise, a Thailand fintech player that has raised at least $25 million via ICO and about $20 million across two conventional VC rounds. But the firm, like many VCs, remains restricted by a combination of regulatory hurdles and the rusty machinery of a 40-year-old investment model.

The Monetary Authority of Singapore has effectively cut VCs off from much of the region’s most prospective ICO activity by insisting that companies with security-like tokens must do business as listed entities. This compliance burden is often unpalatable to the entrepreneurs and takes institutional money out of the equation. 

At the same time, GPs are restricted by traditional LP agreements that require more company control than tokens are able to offer when they’re not under securities law. For Golden Gate, the solution includes plans to establish a crypto-focused fund as well as keeping a close watch on how ICOs are finding their place in existing financial industry protocols. 

“It would be very unwise for anybody to ignore it,” says Kenrick Drijkoningen, head of growth at Golden Gate. “You can only call it hype for so long. It just reminds me so much of the early days of the internet, when people were saying it was just a place for criminals. ICOs are hardly three years old so no one knows where it’s going, but in the end, I don’t think it will be extremely different to what we have today in the equity space.”

As regulations evolve and the nuts and bolts of token investment models are streamlined, VC participation in ICOs will increase. The benefits of uptake will include improved sector networking, lower administrative and transaction costs, and increased liquidity for portfolio assets. Potential to realize outsized returns is also a major draw for VCs, but it carries with it some of the more unfortunate aspects of ICO investing.

Hyped up

For many token issuing companies, rapid value accretion is supported almost entirely by a dangerous cocktail of hype and a lack of practical crypto technology understanding among investors. Runaway ICOs in insufficiently sophisticated companies have emerged as perhaps the biggest risk factor for investors at both the institutional and retail level. Wariness around this phenomenon has to some degree created an opening for VC, especially in the early stages of the ICO process when discounts are often offered to investors with reputations that could add gravity to a public launch down the line.

“People who are doing ICOs could completely bypass VCs, but they do talk to us, largely from a pre-sale perspective,” explains Kuo-Yi Lim, a managing partner at Monk’s Hill Ventures. “There are a lot of dodgy proposals out there, so VCs can still play a role by giving some validation. Some of the more serious founders see value in that, which is why they’re reaching out to VCs and want us to participate early.”

Oversized ICOs are nevertheless seen as a practically ungovernable symptom of the mob mentality that comes with crowdfunding-style exercises, as well as the greed that can flare up among start-ups and investors alike. It is common for blockchain and investment professionals to offhandedly describe 95% of token sales as scams.

Martin Lim, co-founder and COO of blockchain-enabled power sector marketplace Electrify, shares this view. His company was said to have attracted $1.2 billion in ICO pledges earlier this year only to prudently snuff out the wildfire at a hard cap of $30 million. Participants included at least one VC with a mandate that permits the purchase of tokens without control rights, Japan’s Global Brain, as well as Wendell Davis, a co-founder of cryptocurrency Ethereum, and Jun Hasegawa, CEO of Omise. The plan, as with many ICOs, was to keep the investor base as diversified as possible. 

“You’ve got to realize that a significant holder of your tokens has a strong influence on you and your community,” says Lim. “If they feel you’re not running your business correctly, they can dump your tokens. If they hold 5-10% of your tokens, that could tank your price, so it’s not all hunky dory for the ICO company. Instability is always in the back of an ICO project’s mind because of the ease of liquidity.” 

This perspective adds complexity to the conventional wisdom that ICOs equalize the balance of power between VCs and portfolio companies by ceding decision-making control to entrepreneurs. It may also provide investors with a valuable reminder that maintaining alignment of interest with start-ups will have to be approached from new angles in an ICO context.

The challenge here arises from the notion that there is likely to be significant variance between the value of a company’s equity and its tokens. Much of the difficulty in calculating this difference is related to the volatile nature of broader cryptocurrency markets, which can influence the price of company tokens even if they are not strictly currency-style instruments such as Bitcoin.

The most reliable way for investors is to deal with this issue might be to match founders’ ratio of equity and token ownership. In any given company, value accretion may be more prominent in either equity or tokens, but alignment can only be assured if investors and entrepreneurs have similar levels of exposure in each camp. Maintaining this balance is expected to become easier as the systems that facilitate ICO execution mature.

“Control is absolutely a concern because if I’m investing in an ICO or a token sale, I have no governance, and zero rights to anything,” says Golden Gate’s Drijkoningen. “For now, that’s why I’m still asking for equity to go with a token sale. But over the next five years or so, I think you’ll see companies issuing equity in token form with all the same rights attached.”

Credibility counts

Adapting VC to an environment increasingly touched by ICOs will likewise entail a new set of due diligence processes. Familiar precautions will include analysis of the start-up team, including its reliability and track record, with an emphasis on experience in blockchain-related fields. This provision can be complicated at the level of the ICO advisory board, however, where the inclusion of big names in the crypto world can infer a false claim to expert knowhow.

AlphaBlockchain Solutions, a Singapore-based consultancy for the ICO industry, notes that this method of ramping up credibility usually entails stacking advisory boards with top-ranked experts from ICO Bench, a ratings service for professionals in the industry. For example, Vladimir Nikitin, who routinely ranks among ICO Bench’s top-five advisors, appears to be spreading his services impossibly thin. 

“He’s an advisor on probably more than 20 ICOs, so how can he provide advice on all of them at the same time?” says Darryl Lo, founder and CEO of AlphaBlockchain. “That’s one of the red flags that we look out for.”

Lo also emphasizes that investors must be aware that ICOs do not give them a complete picture of a company’s minimum viable product and that large hard caps may be sign that the tokens involved have little potential to increase in value. He advises VCs to hire specialized staff or outsource certain services to third parties, noting that there is still little general understanding of crypto technology, how token communities are effectively managed, and ICO marketing strategy.

VCs that are already disrupting the investment industry from within seem to be responding to these cues intuitively. Australia-based FollowTheSeed, for example, is credited with overhauling the traditional VC model by replacing a decades-old methodology of subjective, network-based deal targeting with a more inclusive and efficient data-driven approach. The firm is currently preparing to take this strategy to the ICO space by partnering with specialist funds and focusing strongly on securing its digital privacy.

“You have to have the best technologists and cybersecurity experts on your team in the crypto world,” says Andrey Shirben, a founding partner at FollowTheSeed, who has been investing in crypto since 2013. “The bigger risk is not the token depreciating in price; it’s being hacked and losing all your tokens. That’s why we are building everything from the ground up, investing very heavily in cybersecurity, and putting security technology first – way before we invest in a project.”

Other staffing priorities will include public market skills, which are currently absent from most VC payrolls but essential to operating in the more liquid environment of tokens. This could necessitate recruiting from the hedge fund and day trading industries, as well as closer work with the market maker intermediaries that are expected to drive activity in the virtual marketplaces of the future.

Token liquidity has always been a relative notion because demand is seen as dependent on a combination of the fundamental strengths of the underlying company in a particular market context and the erratic moods of the crypto-buying public. The exit uncertainty that comes with this issue has helped make pricing ICO risk and reconciling the investments with LPs the top priorities for fund managers. Further, it suggests an advantage for investors with streamlined decision-making processes such as captive GPs and single-LP funds.  

VCs are tracking most of their progress on this front in discussions with nimble family offices and small endowments. Pension funds and other large institutions, by contrast, are expected to embrace ICOs more slowly, seeing the risk factors as a threat to their conservative reputations regardless of the economics. The relatively widespread acceptance of ICOs by VC players in the more systematized US market hints at how this scenario is likely to resolve into universal uptake in due course.

“Pre-selling services to a customer or user base is an extremely interesting, and I think legitimate, way to fund a business,” says Paul Szurek, vice president at US-based Insight Venture Partners. “It will carry massive implications for the future of venture markets – but we need a utility token framework and regulatory oversight that will put in the right qualifications and guardrails to protect against scamming. That regulation, by the way, might come from private companies inside the industry rather than from government agencies.”

Legal attention of this kind is expected to lead to tokens taking on more characteristics of preferred stock or, reversely, the tokenization of venture capital. As this convergence plays out, the role of VC investors as the gatekeepers of innovation will be eroded to some extent. But more clarity in the mechanics will drive adoption and result in a self-perpetuating technological modernization process for the asset class.

“We witnessed a big wave in 2017 and the beginning of 2018. Now it’s starting to cool down with increased regulation, but the next wave is imminent, and this time, it will play by the rules,” says FollowTheSeed’s Shirben. “The Wild West cannot continue if we really want this industry to scale up and mature.”

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• Topics
• Technology
• Fundraising
• Early-stage
• Greater China
• Southeast Asia
• Venture
• Golden Gate Ventures
• Eight Roads
• Monk's Hill Ventures
• ICO
• Cryptocurrency