The Opportunity with ICOs
Yesterday I published Part 1 of How to Fix The ICO Market, where I discussed the problems with ICOs from the perspective of both founders and investors. In Part 2 I am going to discuss ideas for fixing it.
As I mentioned in Part 1, crypto and blockchain startups are fundamentally no different from traditional tech startups, and therefore face the same challenges of raising capital, bringing a product to market and gaining traction. They have one goal: to create a viable business, ensuring success for the founders and a return for the investors.
As a reminder from Part 1, innovations in blockchain technology have created a frictionless and fairer system for raising capital:
- Always on connected liquidity pool: cheap and fast transfer of value globally
- Open system: where digital wallets and exchanges enable anyone (outside of US accredited investor rules), to be an investor
- Asset tokenisation: allowing for fractional asset ownership recorded in the same infrastructure as digital money
- Initial coin offering: a new model for raising capital
The ICO opportunity is open to all tech startups; thus in Part 2, I will focus on how ICOs can be improved to benefit both founders and investors.
First He Giveth Then He Taketh Away
Before I look at ways to fix ICOs, I am going to outline what we gain and what we lose by raising capital this way.
What We Gain
- Reduction in time to raise capital
- A wider pool of investors
- Improved terms
- Improved efficiency with share issuance on the blockchain
- A fairer playing field for those with less capital
- A wider pool of opportunities
- Transparency with online comms channels
- Collaborative research with other investors
- A liquid market for trading equity
What We Lose
- The objective scrutiny of Venture Capital money
- Mentorship from large cheque investors
- Incentive model (when too much capital is raised)
- Predictable burn rates with fiat raised capital
- Security of traditional banking system (ironically!)
- Traditional economic modelling (specific to utility tokens)
- Due diligence on founders
- Tried and tested goal orientated rounds of fundraising
- A feedback loop between founders and the large cheque investors
- Stable valuation model (equity traded too early)
In summary: we gain a more liquid market for startup capital but create new issues around project/team due diligence and volatility/custody risks with Cryptocurrencies.
So How Do We Fix ICOs?
With the goal of creating more sustainable businesses with ICOs, I have identified three areas of focus:
- A transparent and open system for ICOs
- A shift in the approach from founders
- A shift in the model for how capital is raised
1. A Transparent and Open System for ICOs
The token model and vague regulatory rules have reduced friction in raising capital. Anyone with an idea can create a whitepaper, website and ICO, and raise $millions from a global investor base.
This frictionless system of raising capital has created three new problems:
- Proliferation of scams
- Proliferation of poor ideas by incapable teams
- Speculative trading of tokens when little to no value has been created
While some investors have made great returns by speculating, many investors have lost money to scams, ideas which have not shipped or are ‘holding bags’ of tokens for ideas which will most likely fail.
Where VCs and retail investors lost money in the dot-com bubble, caught in the Internet hype cycle, the market has evolved into a mature model.
Successful VCs know what to look for in founders and ideas, they know how much capital to raise per milestone, and provide mentorship support.
While the ICO market is a fairer system for investors, it lacks the objective scrutiny of venture money; therefore retail investors are unknowingly investing in poor ideas and holding worthless debt tokens.
By creating an open, transparent and collaborative system for ICOs, better ideas can be socially validated, thus decreasing risk for investors. This Darwinian system for finding value will lead to more successful projects raising funds, benefiting both founders and investors alike.
Tell Me About Such a System
Because an open and frictionless economy for raising capital is vulnerable to exploitation, an open and transparent system for validation is required.
The ICO approach is to pitch their idea across a suite of owned, SaaS and external platforms, building trust across owned media, comms on SaaS platforms and validation on external review sites:
- Owned website: concept, whitepaper, founding team and ICO terms
- SaaS platforms: Slack, Telegram etc… for comms with investors
- External: independent review sites such as ICO Bench
Investor research is disparate and often lacks due diligence and transparency, allowing for the proliferation of scams and weak ideas.
But trust is being created with new platforms, Coinlist validates teams and investors and Messari validates ideas, but these sites are still centralised entities and a collaborative platform for ICOs could group the disparate trust elements into a single standardised, transparent system, whereby:
- The whitepaper is open to critique
- An internal KYC system validates the founding team
- The business model is defined and open to review and criticism
- The ICO terms are standardised
Such a system would be a central authority for ICOs, socially validating ideas and founders, thus eliminating scams, highlighting poor ideas and reducing investor risk.
A similar scaled approach to crowdfunding platforms would set ICO terms such that experienced investors can buy a direct mentoring relationship with the team, de-risking their investment and providing increased protection for retail investors. Consider where crowdfunding platforms such as Kickstarter, have different pledge levels, ICOs too could have premium investment packages which allow a more direct relationship between the founders and the investors, explicitly reserved for those with experience.
Edit: since writing this my view has changed, I would expect that early stage investment is likely monopolised by venture capital money.
2. A Shift in the Approach From Founders
Comparisons with the dot-com bubble are common. Readily available capital has seen a flood of new ‘big ideas’, with few, if any, shipping products which will achieve scale.
This surplus of failure is/will reduce confidence that founders can deliver and will increase the lens of scrutiny before investors part with their money. To support founders, I have outlined four things they can to do to increase their chance of raising capital.
Step 1: Solve a Problem
This sounds so simple right? But there is a considerable problem within the ICO market of founders solving of problems which do not exist. If you are not solving a problem, you will struggle to build traction. Users are fickle, and traction is one of the hardest things with startups. Many a founder has raised capital, worked hard to ship their product only to struggle with user adoption. Believe me when I tell you this is hard!
Founders must validate their idea before raising capital:
- What is the problem?
- Does the problem exist?
- Do enough people have the problem?
- Can you solve the problem?
- Will they pay for the problem to be solved?
- If they won’t pay for the problem to be solved, is there an alternative revenue model to support the business (think Facebook ads)?
Taking a successful centralised idea and decentralising it, is not solving a problem. In almost every instance your project does not need a blockchain, and the concept can be developed on a centralised database, be more efficient and deliver the same objective.
Now, this does mean that your idea is dead and has no value. You just don’t require a decentralised network of nodes creating new blocks as you don’t require censorship resistant, permissionless, trustless records. You probably need a database; you probably don’t need that database to be a blockchain.
Step 2: Develop A Realistic Business Model
Once you have validated your problem, you need a business model to ensure longevity. The concept of an idea first, revenue later is dead. Investors need to know how you will build a sustainable business model.
If we agree that an ICO is a great way to access capital, we need to decide the type of token you will use: utility or equity?
A quick primer if you don’t know the difference:
- A utility token gives the holder future rights to a product or service
- An equity token gives the holder equity in your company
Let’s start with a utility token; if this is it, then I am going to guess the utility is something which has been shoehorned in to allow you to use the token model to raise funds. The utility token is largely built upon a hypothetical and unproven model which will most likely fail for most startups.
To understand utility tokens and value, we are going to have to dive into the world of velocity. As with part 1, I recommend Kyle Samani’s article, Understanding Token Velocity. Don’t worry if you find the concept hard to follow, you are not alone. If you are considering a utility token then you must have a solid understanding of Crypto Economics to ensure that your token will create value for investors.
The underlying token mechanics will dictate whether a token has value. In the real world, these projects will denominate their services in fiat currency; therefore users incur a price risk by holding tokens for any time longer than required to purchase the service. Kyle gives a great example of concert tickets.
Kyle identifies many ways to reduce velocity to give the token value, but I struggle to see the benefit of creating an entirely new economic model outside of the fiat system as it adds a layer of complication for users when we have already identified that traction is hard.
Furthermore, many teams are reliant upon the token as a source of capital for funding operations; this will create further downward pressure on the price to fund operations.
Note: although the Howey Test is there to prove whether something is a security or not, not a single person investing in your ICO utility token is doing so for any other reason than to make money.
I have little belief in the utility model and predict that virtually every utility token is going to sink in value to marginally above $0 once they ship their product and their tokens are traded under real market conditions.
All investors in utility tokens will want a return, which means selling their tokens in the open market. For those who wait until after the product has been released are gambling on this new unproven token economy working, the product achieving some level of instant traction and a model which reduces velocity.
If there is no instant traction then the token value will be reliant on incentive mechanism for holding the token and/or speculation on future demand. With Crypto investors demonstrating little patience, a token could easily dump which would have negative consequences on the project by crushing the value based on the current market cap model for Crypto.
This questions why even have such a token model? Why build a new complicated economic model for business? Why invent an entirely new monetary token which requires a new economic model when we already have monetary units with agreed value. If your problem is with fiat, then use Bitcoin or Ethereum which have already demonstrated some level of stability within the volatile Crypto markets.
If you still insist on creating a utility token, please ask yourself this question: if the utility token could not be used as a vehicle to raise funds, would you even use a token within your business model?
A more practical approach is to:
- Create an equity token which delivers value based on project success in the form of dividends (proven business model for the majority of the economy)
- Use a stable currency as the monetary unit for users accessing the service
This new token model is an unnecessary complication for founders and users. I recommend reading the Steve Krug book on usability, Don’t Make Me Think.
Using Crypto as a gateway for these products is a barrier to adoption. Replacing fiat options such as a credit and debit cards or Paypal with a plethora of Cryptocurrencies and tokens will reduce the size of the addressable market.
Step 3: Traction
If you build it, they will not come. DappRadar provides a live report on the current rate of adoption with DApps.
Traction is hard, traction in Crypto is proving harder. I understand the argument that we are early, but there are significant hurdles for founders to consider:
- Who will use your product?
- How will you create awareness?
- How will you convert them?
- Why will they keep using your product?
- How will you retain them?
If you haven’t considered your marketing and onboarding alongside the user experience, you may created a beautiful product which nobody is using. Traction must be part of your pitch to investors.
Your company will only be successful if you achieve product/market fit. I’ll recommend you also read The Lean Startup by Eric Reiss and Running Lean by Ash Maurya. Product/market fit is not about shipping a product that people use, but by shipping a product which is used at scale and generates revenue.
Step 4: Ditch the Whitepaper
If you found a problem which is worth solving, built an economic model and understand how you will build traction, then you are ready to pitch. If you want to increase your chances of raising capital, then I recommend you ditch the whitepaper.
The whitepaper has become synonymous with ICOs, yet they are similar to the old business plan which banks would require for small business loans. They are too long, too technical for most investors and are too rigid for startups working on product/market fit.
To raise money, you only need a pitch deck, something which any potential investor can review in minutes. Investors are short of time; they don’t need a 50-page whitepaper, they require a few simple questions answered. My favourite example of this is the AirBNB pitch deck.
This deck quickly tells an investor, everything they need to know:
- What is the problem being solved: without this there is no market
- How it will be solved: the solution the team has
- Validation: evidence that there is a problem
- Market size: size of the opportunity
- Product: what the solution looks like
- Business model: the economic model
- Market adoption: how the product will achieve traction
- Competition: the alternatives customers have
- Competitive advantages: why you will beat the competition
There are two additional slides which you may wish to consider:
- Funding: how much money you need to reach specific milestones
- The team: your experience and why you can solve the problem
This is all you would ever need for a first meeting with a VC and it is all you need for your ICO.
3. A Shift in the Model for How Capital is Raised
While the free flow of Cryptocurrencies has reduced friction when raising capital it has created new problems around custody and volatility, adding unnecessary risk to the goal of creating a viable business.
Project Funding — Currency
Raising funds in a volatile Cryptocurrency while paying for operations in fiat is a risk to your burn rate. It is okay if you raise funds at the start of a bull run and the value goes up, but if you raise £3m in ETH and the price crashes 70%, you will have under £1m and likely one-third of the runway you had. Let’s call this what it is, nonsense, stupidity and a gamble.
When calculating the funds you require, they should be to take you to a specific goal, either a development milestone at which point you are ready to raise new funds or to scale where the funds of the operation pay for themselves.
If you insist on raising in Crypto and do not instantly convert them into fiat, then you require a treasury management function. This would be no different from a traditional tech startup investing their startup funds in the currency markets, which they never do, why? Because it makes absolutely no sense at all.
Keep things simple, know your burn rate, know how much capital you need to hit your next milestone and raise enough money, converted into your local currency for this. Do not distract yourself with market volatility.
To de-risk further, you may want to consider raising your funds in a fiat pegged stable coin. You can still access the global Crypto liquidity pool and your investors can convert their BTC and ETH into the stable coin. Many Bitcoiners are not keen on stable coins but in the short-term they will most likely provide a good alternative to the volatility of crypto.
Project Funding — Amount
Crypto startups are raising too much money. Tech startups raise over multiple rounds with a goal of hitting specific milestones. In an ideal world, you won’t raise any money until you have at least developed a prototype or minimum viable product, and if you haven’t, your first raise should be to achieve that.
In my interview with Jill Carlson, she explained how Crypto startups are raising their seed round and IPO at the same time. This is madness; a company which launches an IPO looks very different from when it raises its seed round. They are yet to prove product/market fit and may pivot to an entirely new product during the process.
By raising 10’s or even 100’s of millions, you are raising funds as if you have a product in the market with customers and revenue.
Milestones may vary, but for ease, let’s use the following model:
- Seed round: develop beta product, available to market, ready for customer use/testing
- Round A: product/market fit
- Round B-D: scaling
With the above, investors can invest in the round at a risk profile which suits them, with fewer tokens available in later rounds for risk/reward.
Tokens should not trade until rounds B-D when product/market fit has been achieved. Therefore trading is not just speculative but against a real and proven business model.
Another reason you don’t want to raise too much money is that it values the business ahead of value creation. This becomes a problem for investors in that the company can’t generate the revenue which justifies the token valuation. Did Tezos need to raise $252m? Did Filecoin need to raise $257m? Did EOS need to raise $4bn? The size of these raises creates unnecessary pressure on valuations and expectations of investors.
Project Funding — Custody
The nature of free-flowing cryptocurrencies has created a honeypot for hackers. Too many ICO funded startups have lost significant chunks, even their entire investment due to wallet hacks.
We have already highlighted holding Crypto as a risk to the project runway, combined with the threat of hacking; there is no justifiable reason to hold any amount of Crypto, less than required for Crypto funded operations. As such, the entire Crypto raise she be converted into the local currency and held in a bank where the business operates and pays for services.
A new model for a third party custodian to host the ICO and convert funds to fiat would reduce this risk for founders.
Like any bubble, excited entrepreneurs are seduced by greed rather than the opportunity where the goal of creating wealth has outpaced the goal of creating value.
The success of Bitcoin has led to a wave of Crypto, blockchain and decentralised ideas, which will fail in almost every instance. In the shadow of this, there are people with great ideas unable to access capital.
The ICO market is drowning in poor ideas yet there is an opportunity to use the innovations within Crypto and blockchain to unlock liquidity and create value with ideas outside of the blockchain space, in the centralised world.
By using the innovations of blockchain and Crypto while reducing risk and ensuring the sanity checks of the VC world are available to founders, a new wave of startups will arrive which create value for users, themselves and their investors alike.