Blockchain investments and the new problem asset for conventional VCs

in investments •  2 years ago

By Jake Brukhman, Co-Founder @ CoinFund. You can also read this piece on Medium.

As of Q1 2016, in excess of $1.1 billion in private capital has been invested in blockchain and Bitcoin startups by traditional venture capital firms and seed investors. But as decentralized applications and marketplaces continue on the road to maturity, there is a problem. VCs might be asking themselves — are we investing in the correct asset class?

Venture capital firms invest in the equity of private companies — they buy ownership in the corporation, act as advisors and resources for founders, and exercise control as part of the board of directors. They have a well-established legal framework for investments, for forming venture capital funds, and for exercising governance over their portfolio companies. In the hedge fund world, managers buy and manage assets (such as stocks) which their clients could in principle buy and manage themselves; but investors come to venture capital for the benefit of their unique access, relationships, and influence over portfolio companies.

Meanwhile, many startups operating in the blockchain space have simply bypassed traditional VC financing by using a radical new fundraising model: they generate capital by pre-selling their platform’s cryptocurrency prior to the development phase. In essence, each blockchain project with its own cryptocurrency is effectively born with a native business model and financing mechanism — a highly disruptive idea to the VC business. These sales help conserve company equity for founders, have raised over $200M in a single round, and create a base of early stakeholders and promoters for the project.

However, with the advent of blockchain products that run public, cryptocurrency-based networks outside of the direct control of their parent companies, the source of equity investor returns is less clear. The very investment structure is about to shift, and all eyes are on the cryptoassets.

This is especially true of products like OpenBazaar, Augur, Sia, StorJ, Mediachain, and SteemIt. These are examples of blockchain companies where, once the network is in production, it becomes autonomous and self-perpetuating. While the parent company is still the main authority on the technology, the network is no longer obligated to adopt their code updates or follow their lead. Where Amazon is the ultimate centralized arbitrator and rent-collector of its marketplaces, the parent company of a decentralized network becomes a respected curator and advisor to the network with diminishing advantage over any other player willing to assume a similar role.

This of course presents a problem for equity-holding participants: how will the curator company generate revenue? What is the viable business model to be deployed? And: if the company fails but the network succeeds, will I be left behind?

Two investment opportunities in blockchain companies

Some projects, such as OpenBazaar, are the first to admit their diminished influence. “There is no central authority controlling trade, taking a cut, or monitoring data,” wrote OB1, the parent company of the OpenBazaar network, in their funding announcement last year. “As a result, companies such as OB1 cannot act as a central authority on the network. OB1 will aid decentralized commerce by offering services such as dispute resolution, store hosting, and more.”

Union Square Ventures, a participant in the OB1 funding round, readily recognized the dissonance between private equity investments in companies curating a public, decentralized marketplace. “This begs the question,” wrote Brad Burnham of USV, “of how OB1 can be a for profit business that will generate a return on the investment we are announcing today” while acknowledging that “there is no way for a central authority to leverage network effect market power to extract rents from the participants.”

In a similar line of thinking, StorJ Labs, the curator company of the StorJ decentralized storage network, see themselves as providing “Data-as-a-Service, as well as. . . tools and APIs for. . . the average business and consumer” rather than maintaining and profiting from the network itself.

In other words, most curator companies are brainstorming offering “value-added services” to their decentralized networks for that sweet growth class of mainstream customers who hardly know, or care, about decentralization. Helping customers to “build tools and APIs” sounds an awful lot like technology consulting. And while centralized “hosting” may be necessary to convert blockchain un-savvy mainstream businesses, it is a weak business model to throw at a network whose value proposition is decentralization.

The larger point is that for decentralized applications there are not one, but two, investment opportunities: the speculative value of platform cryptoassets which tend to appreciate with network utilization and general success of the network, and the upside of the parent company business model embodied in private equity investments. As more and more companies in the blockchain space crowdfund autonomous cryptoasset-backed protocols, equity-holding investors are stopping to ask themselves whether they should be adding this new, digital asset class to their portfolios.

Why native cryptoassets matter

In this new dynamic of decentralized services, exposure to platform cryptoassets seems to provide a hedge against a brave new world of business models which have not yet been proven. As equal participants in the network, companies have to overcome a high standard of quality and innovation in order to successfully compete on a level playing field, indeed, with their users.

“The Augur project has ‘made its money’ from the REP token sale,” says Ron Bernstein, founder of InTrade and Augur advisor and investor. “Augur REP value now grows with the throughput of the open source platform. Private returns come from new invention on top of the platform.”

As an example, a private enterprise can build a market making business for prediction markets on Augur. By intelligently providing liquidity to strategic prediction markets, trading for profit, and collecting market creation fees, there is a short-term business a company associated with the platform’s development is particularly well-suited to undertake. In Augur, increased liquidity is exceptionally good for the product as it is highly likely to increase its overall throughput: a low barrier to entry and more markets translates into more users. Yet, the way that risk unfolds for market makers is that once competition starts to heat up—imagine, for instance, a battle for the best market making AI—only players who are Augur REP holders have an offset against sharp competitive drop-offs in opportunities.

On the other hand, in the decentralized storage space companies like Sia or StorJ will have a harder time raising money against “value-added” business models. Storage is a commodity, and especially when the value proposition of the platform is efficiency and lower cost, revenue falls off too. Should Sia and StorJ do some form of “market-making” like adding their own proprietary storage to increase network capacity? Maybe. But without a new economics which contains a Bezosian “virtuous cycle”, such as in the Augur system, more storage does not translate into more users. For the equity investor, the success of these value-adds is now correlated with the size and ability of the company sales team to sell alternative products to small-to-medium businesses, a rather uncharted territory for blockchain.

Looking at new cryptoasset economics based on the “speculative capital” business model invented by SteemIt — the new, growing social publishing platform which compensates its users for quality content and curation — virtuous cycles are central to maintaining the health of the system. “Buying and holding Steem is a way of owning and participating in a new age Reddit and Ebay in a decentralized, fungible way,” says SteemIt’s CEO Ned Scott. “It’s also an opportunity to bolster business operations by increasing a person or company’s influence in the marketplace through added ability to promote their goods and services.”

Mainstream users of SteemIt enjoy incredibly low entry barriers: they can post content and get compensated in cryptoassets right away without the learning curve of buying cryptocurrency, and the value of their holdings is upheld by the market demand for the platform asset. In turn, larger entities like content publishers and advertisers could eventually create demand for the asset by purchasing influence and audience reach, thus validating the long-term position of asset holders. Today, SteemIt’s ability to literally pay acquisition costs directly to customers has translated into impressive growth. “If you extrapolate our current growth metrics,” says Ned Scott, “we could be in the millions of users by the end of the year.” And if so, then the core growth opportunity of the SteemIt platform will be embodied in its cryptoasset, long before any major traditional funding round had a chance to take place.

Finally, in marketplace platforms that facilitate payments in Bitcoin, the lack of a native cryptoasset may be a downside because the private equity business model is the sole investment opportunity. “It’s a team bet,” says Ron Bernstein. “Can these guys build a good enough product such that there’s more incentive to just use and improve it than to compete against it?”

Overall — and this is the point — if decentralized platforms are poised to take off, risk-averse investors stepping into untested waters may be better off taking advantage of the high-growth and high-liquidity characteristics of the platform cryptoassets themselves.

Challenges and paths forward for conventional VCs

As cryptocurrency is increasingly seen as a legitimate asset class and as the economics of particular products make cryptoasset growth opportunities more and more attractive, our team at CoinFund predicts that traditional investors will venture into cryptoasset investments sooner rather than later. Today, from the cultural and regulatory viewpoints, there are still many nuances and challenges.

In the cryptoasset asset class, the line between venture capital and stock investing is terrifically blurred. Investors can engage product teams directly and use cryptoassets as a digital proxy for private equity while taking advantage of high liquidity and net all the pesky paperwork. But diversified holdings of this asset class are reminiscent of stock portfolios. The practice of cryptoinvesting requires technical expertise in the securing, trading, and managing positions on 24 hour markets, and it may go against the grain of the VC investment style to assume a vocation similar to that of hedge fund managers. Are conventional VCs comfortable with a shifting role that falls outside of their usual investment model?

From the perspective of the product team, platform cryptoassets serve multiple useful purposes. Not only do they drive the product’s decentralized network, cryptoasset sales conserve company equity. When purchasing cryptoassets, VCs would find themselves less board seats and their typical governance structure. Is a form of passive governance in their investments acceptable to VCs?

Finally, while the overall demeanor of regulatory agencies has been decidedly open-minded toward cryptocurrency and “distributed ledgers”, but as Shingai Thornton points out in his excellent survey of U.S. regulatory activity to date, there is still “significant action” to be expected from the SEC, the CFTC, FinCEN, and even the Department of Homeland Security on the topic. Solid legal research has been done on crowdsales and DAOs which suggest avenues for decentralized crowdfunding compatible with securities laws, but court cases are yet to cement the legitimacy of this type of offering and legal departments will be wary of treading this new territory.

At CoinFund, we are excited to watch the arena of blockchain investments develop and evolve. New economic models that enable fundraising, low entry barriers, and decentralized commerce are truly compelling investment opportunities in the blockchain space. We hope to see more conventional investors taking the lead and paving the way for cryptoasset investments in the future. If you are a VC thinking about these issues, we’d love to hear from you!


Jake Brukhman is co-founder at CoinFund, a blockchain technology research firm and proprietary cryptoasset investment vehicle. CoinFund’s team brings together expertise in high technology, quantitative finance, private equity research, and social innovation research to generate insights into this exciting growth space. CoinFund provides consulting and research services to investors and companies interested in blockchain technology. Follow us on Twitter or join the discussion on our open community Slack.

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The article has provide guidance of how new platform can generate tremendous user growth.

Very well written! I've definitely thought of the difficulty for investors to cope with the company they've invested in no longer retaining control of their "product", and am interested to see how these sorts of investments shake out in the future.

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Thank you! In some sense what's happening here is that companies who have blockchains and cryptoassets are disrupting the traditional VC -- they don't need them any more for bootstrapping their ideas.

Great article, good questions. It answered some of mine too. I've been struggling with the idea that all crypto currencies right now function as pump and dump pyramid schemes. It's all speculation. Their actual value has yet to be realized and its questionable if that value will translate to a return for anyone holding their currency.
I'm especially interested in private blockchains. I worry that it is the intention of these cryptocurrencies to crowd fund their startup and then sell off the tech to private companies with no compensation for their crowdfunders.

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Interesting!

Truly brilliant article. I think the timing was right, the context of releasing it here was fitting to the content. I now have a whole new swarm of ideas spinning around in my head.

When you start to really consider the scope of what Steemit and other blockchain companies are hoping to accomplish and then stop to consider how VC's are thinking... seeing the long term potential is only a few mental connections away.

Thanks Jake!

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Thank you, @wingz, glad you enjoyed the piece. As always, feel free to join the discussions on our Slack if you're interested in this line of thinking.

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Thanks, I think I will :)

The information will be good my country,because we are yet to kn about..blockchain

i like your post ! great information.
I just read your story while i am stuck in Thailand without money. I also wrote a story about. You can read it if you want :)

Good thoughts here and I agree with you on traditional VC. I think we're just seeing a move away from traditional VC as a whole. Traditional VC was/is so valuable, not only b/c of portfolio access and expertise, but a simplified investment process.

VC firms can provide access to capital in larger sums that would require a lot more fundraising, paperwork, and hassle to do from individual investors. However, this is exactly what the blockchain solves, for the most part. Therefore, the value of a VC firm is highly diminished.

VC firms will have to pivot more towards the advisory and expertise side and be much more comfortable operating more like a hedge fund. In short, I just don't think the traditional way capital is managed and invested is going to apply and it's going to take a whole new breed of investment firms to support crypto.

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That's really hard to see right now, but I think this is right on. VCs threw themselves onto blockchain companies in the traditional way, the only way they know how. I think what will occur shortly is that they will realize the traditional model doesn't apply or at least is not effective at giving them returns. The natural next step is cryptoasset investments. Then, and if something like SteemIt proves "self-bootstrapping" works, then this will be an uh oh to VCs everywhere.

very nice article

This is great info I think that this will be huge much bigger then reddit or any other social media sites. This one has so much positivity and reinvestment opportunities, plus it will help start so many new and clever business !!!

Wow, a lot of informacion. Let me see if get the head around it. Future looks very interesting .
Yes its true Steem looks like the right crypto currency for normal people to get into the blockchain technology.

thanks, that was very interesting. articles like this gives a value for steemit

Thank you for your interesting article.

Its true we reaally understand what this teting to say...i completly ageee with this