No, ICO Market Caps are Not Crazy. The Reason is Basic Economics

The author, Dr. Nicholas Adams Judge, is a cofounder of RootProject. The other cofounder is Chris Place, a Y Combinator alum. Their nonprofit’s pre-ICO just passed 200% of its funding goal and is open until July 28th, 2017. An easy way to understand their model is here.

There is a misperception about the very basics of valuation in most coverage of ICOs. An eye-popping market cap number from a brand new ICO is brought up. It’s compared to some VC funded start up. The conclusion is we’re in a huge bubble and this is crypto madness. Somewhere a blogger pats himself on his back for being so clever.

*Ew.*

Markets try to price assets on a risk-adjusted basis. They just do. They’re wrong plenty of the time. But investors are attempting to value their holdings on a risk-adjusted basis.

Think of a typical seed round. A VC firm puts in, say, $1 million for 10% of a company, effectively valuing it at $10 million. That VC firm needs the company to succeed or be bought. Most any other outcome involves the VC firm losing $1 million (that’s the key part).

The same VC firm puts in $1 million into the token of a new firm, whose token is already on exchanges. The market is sufficiently liquid such that there is a .95 probability a stop-loss order (and order to sell at a given price) will be filled. They place a stop-loss order 10% below current price levels, as they expect the asset to appreciate.

The VC’s firm’s risk is,

10% * $1 million = $100,000 +

.05 * $1 million = $50,000 (that 5% chance the currency becomes illiquid before a stop loss order kicks in. This is greatly overstating the risk from illiquidity, but let’s do that just to be safe.)

That equals $150,000 that is truly at risk. In our case, the VC firm should accept risk about 7 times the rate of that based on a start-up’s illiquid equity.

This is a simplification. There’s plenty of other basics to consider: volatility, information costs, and so on. However, the basic point that escapes people that somehow prefer traditional VC standards — MVP + traction — over ICO standards— credible founders + credible plan — remains: Asset liquidity isn’t a detail. It’s a fundamental part of the definition of value.

Personally, I welcome the crypto-begun eventual demise of the traditional VC model. I want to see the bridge between ideas and reality get shorter.

Democratization of finance — just like the democratization of governance — means the process will get messier, but better.

Read about rootproject here. Want to help use a cryptocurrency to end extreme proverty? Join the 750 people that have signed up to our Slack channel in ten days here.