The Problems With ICOs
Preamble: please note, I am an investor, blogger and podcaster in the Crypto space. I have only raised capital once, for my tech startup (Bantr), which ultimately failed. I am not a VC and don’t understand all the nuances of Venture Capital. These are my thoughts as I look at the market through my lens. Please critique as necessary.
This article is written in two parts:
- Part 1: The Problems With ICOs (this)
- Part 2: The Opportunity with ICOs
The ICO Death Spiral
The ICO market has successfully proved the token model for raising capital works, but the failure to deliver value beyond speculative investor returns combined with a Crypto bear market risks pushing this new model into a death spiral.
There are too many (questionable) ideas, raising too much capital, from impatient investors, with few, if any, delivering products and/or value to the market. The speculative recycling of profits from ICO to ICO works in a bull market, but when investment capital dries up, and token prices consistently dump on exchange listing, the model breaks.
While speculation exists in the stock market, experienced investors have value indicators to support their decisions:
- The Price-to-Book Ratio (P/B)
- Price-to-Earnings Ratio (P/E)
- The PEG Ratio
- Dividend Yield
Even with tech startups, the old model of building an audience and figuring out the business model later is dead. Investors want value; making a piece of technology might be valuable to the founders, but it only creates value when people use it in a way that generates revenue.
At some point these startups must:
- Replace the investment capital which funds generated by the business
- Deliver a return to investors
ICO projects have raised capital based on weak business models and/or unproven token economics which will not be able to deliver on either of the above.
The 2019 crypto bear market has exposed the inherent weaknesses in many of these business models and flaws in the token valuation theses which many white papers were reliant upon.
Show Me The Money!
In a market flush with capital, even in these bearish times, there is a willingness to throw good money after bad ideas. While experts declare that this is the most significant opportunity since the dawn of the Internet and the entire market cap for Crypto Assets is in the hundreds of $billions, where are the products? Where is the traction? Where is value being created?
The ICO market is ignoring the painful lessons of the dot-com bubble and investors are losing money. A lot of money.
Crypto/blockchain startups are not unique and they will not create value just because they use a blockchain and some will argue that most do not need a blockchain at all. They are tech startups, facing the same challenges as any tech startup. Thus, any deviation from sound economics model will not end well.
So let’s not pretend these Crypto startups are anything other than a tech startup facing the same questions:
- What problem are you solving that people are having?
- How will you solve this problem?
- How will you find users for your solution?
- What is the value exchange which ensures economic viability?
Bitcoin has this:
- Problem solved: money transfer requires a trusted third party
- Solution: a network of distributed nodes to validate balances and transactions
- Traction: word of mouth
- Financial model: proof of work
Bitcoin has succeeded without investment capital, what tech startups call bootstrapping, but the stark reality for any startup, crypto or not is that:
- If you are not solving a problem, you won’t find users
- If you can’t find users you won’t build traction
- If you don’t achieve traction, you won’t generate revenue
- If you don’t generate revenue, you will run out of capital
- If you run out of capital, your project will die
- If your project dies, investors lose money
- If investors lose money, they have less money to invest in new ideas
Alas, the ICO death spiral!
The problem is that most of these founders are finding solutions to problems which don’t exist, which don’t require a blockchain, which aren’t delivering a usable product and are creating new problems with poor treasury management and holding faith in unproven token models.
Finding the Crypto Golden Geese
Amidst the chaos of nonsense ICO projects is an opportunity for all startups. The dot-com bubble burst because the ideas were delivered before the market was ready. Over-investing in infrastructure ahead of consumer adoption collapsed the entire market when revenues did not hit projections. As capital ran dry and investors realised that these companies had unrealistic models, many collapsed under the weight of their burn rate.
Out of the ashes came the golden geese. New business models of search, social and e-commerce built upon realistic models were able to raise capital and grow into some of the largest companies in the world.
The crypto market is repeating the same mistakes, over engineering the infrastructure before application use cases are proven. The red herring is that all ideas must be decentralised to create value, yet the underlying blockchain infrastructure presents an opportunity to build new centralised models upon decentralised protocols.
Coinbase is a great example, as Brian Armstrong said in his article: Is Coinbase creating a centralized or decentralized financial system?
“There will be both centralized and decentralized products which help create an open financial system.”
Centralisation is not a bad word! .
Follow The Money
Money will always flow towards the point of least resistance and innovations in blockchain tech have reduced friction in the flow of capital and created a fairer system for investors:
- 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
Blockchains (decentralised ledgers) have few use cases beyond what Bitcoin and the clones provide. They are a buzzword for selling conference tickets and exciting investors. The $280m Parity wallet freeze highlights the risk of immutable records and smart contracts, and there is little evidence that the trade-off is something the corporate world wants.
The focus on decentralisation is a distraction from the opportunity. Taking crappy crypto/blockchain projects out of the ICO mix and replacing them with startups solving genuine problems could well be the golden goose of crypto.
Raising capital is hard, I know, I have been through the hustle, therefore a problem, and what do we do with problems? We solve them:
- Problem: raising capital for startups is hard
- Why is it a problem: it is hard to get meetings; it is hard to get a commitment as it requires a small number of large cheques; it takes a long time (weeks to months) and comes attached with preferential strings for the investor
- Solution: raise capital through an ICO
- Why is it the solution: a global pool of liquidity, fractional investment, programmable equity, asset liquidity and share issuance on the blockchain
The crypto world does not need to be a walled garden of blockchain and decentralised projects, the innovations listed above can be used by any company or startup especially with innovations in tokenised securities.
Raising capital in the crypto liquidity pool vastly reduces the time it takes to raise money and gives more control to investors. It opens up investment to more people and increases liquidity.
The Broken ICO Model
The ICO model is broken because of market immaturity. Inexperienced investors are providing inexperienced founders with capital and what ICOs gain in access to liquidity they lose by not having experienced Venture Capital money:
- Retail investors lack the objective scrutiny of experienced VCs
- Crypto hedge funds have exacerbated the FOMO
- Sums of capital raised break the incentive model for founders
- Capital not raised against milestones
- Lack of transparency around founding teams
- Detachment between investors and founders post capital raise
- Lack of mentorship
Furthermore, assets are often traded in open markets ahead of product delivery. Investors trade speculative value in volatile markets, open to manipulation, often distracting founders from the goal of creating a product which people use.
Equity in traditional startups is rarely traded until:
- Product/market fit
- Proven revenue model
You know, a sustainable business.
Think Spotify, Facebook, Tesla etc. Speculation exists, Tesla is a great example, but with Tesla, they are changing the automotive world, not just promising to, and they have delivered over 250,000 cars. ICOs are raising IPO levels of capital before meeting any of the above conditions on the promise of a whitepaper.
Let’s call this what it is: lunacy!
A prosperous economy requires real value to be created, an exchange of money for goods or services which give value on both sides. What value has Crypto delivered outside of MoE and SoV: Cryptokitties?
The Problems for Investors
The argument that Crypto is one big Ponzi scheme holds true if the investor mindset is to invest, take a 10x return and move on to the next project. It requires a never-ending supply of new investors and new speculative projects.
The Ponzi argument is further proven by the number of ICOs now failing to hit their hard cap targets. The well is dry, the market has run out of new investors to exploit with the false narrative of endless crypto riches.
Many retail investors will have lost money during this bubble and will likely not return to the market. This isn’t a bad thing, while I support an open playing field for wealth creation (SEC accreditation sucks), not everyone has the skills or mental strength to be an investor.
Investors need to shift their mindset to investing in value creation and demonstrating patience. The 10x hunt is counterproductive to the market.
The Problems for Founders
The market and structure for ICOs does not help founders either. Many lack the skills to take an idea to market. Furthermore, founders are juggling new problems created with the ICO model:
- Treasury management & crypto volatility
- Custody (a number have had their capital stolen)
- Unproven and unsuitable token models
Once founders have raised capital, they have one goal: achieve product/market fit. Therefore, delivering a product to market, which enough people will use and pay for.
The ICO model has solved the problem of raising capital but has created new problems which many founders have failed to address. ICOs will often hold funds in crypto, which creates two new problems:
- If prices crash before the raised funds are converted back into fiat then their runway changes (bills are usually paid in fiat)
- The wallets are a honeypot for hackers, and there are too many examples of Crypto startups having their investment capital stolen
Furthermore, many are building these businesses based on unproven token models, where M = PQ/V, I’ll cover this in part 2 of this article. Baking utility into the token has allowed startups to raise funds yet utility comes with problems:
- Traction is hard; therefore the value of a token could drop to marginally above $0 if they deliver a product which struggles to find a significant number of users
- The underlying mechanics of many tokens ensure there is no incentive to hold the token as this will incur a price risk, Kyle Samani wrote about this in his article Understanding Token Velocity
- Token-based products are likely a usability nightmare for the average Joe who sits outside of Crypto
Founders need to shift their mindset to solving problems, understanding product/market fit and derisking their burn rate.
While not perfect, the VC model has evolved into a formulaic problem-solution factory for building startups, yet the VCs hold the purse strings and create the rules in their favour. ICOs are a paradigm shift in raising capital, creating an open market for investors and allowing founders to write the rules back in their favour, but they risk failing to deliver by not addressing unnecessary new problems.