The Reimagining Of Risk Capital

Startups pattern themselves off the capital available to them. The creativity and diversity of strategies around how crypto economies are funded is not only the first and (so far) most powerful disruption in the blockchain space, but a force that could allow true innovation in the structure and approach of crypto organizations themselves. Put differently, fundraising is crypto’s first killer app.

Photo by Jimi Filipovski on Unsplash

A common critique of the blockchain space is that is a technology without real use cases. In this view, 2017 was the story of half-baked ideas raising billions of dollars without any institutional oversight through an invented mechanism from hundreds of thousands if not millions of people from around the world.

An observant person might at this point think to ask something along the lines of: “Wait a second. How much was raised? And how much more was that than traditional seed VC? And how many people participated? And how did this all happen outside the bounds of any previously existing capital institutions?”

In the frothy excitement around all the potential transformations that blockchain enables, we haven’t truly grappled with the disruption already at the doorstep: the reimagining of risk capital.

How Tokens & ICOs Changed Fundraising

The idea of applying crowdfunding to venture capital isn’t new. Since the beginning of the social web era, companies like Kickstarter and IndieGogo have brought the power of groups to interesting new projects. While these platforms captured consumer imaginations, the logistical and legal hurdles around equity crowdfunding meant that, by and large, the payoff for participation remains pre-ordering the product and enjoying the satisfaction of supporting cool things.

The crypto space added two major new dynamics to the concept of crowdfunding that, it turns out, fundamentally transformed its ability to power capital formation.

The first of these was tokenization. Tokens are the way value is exchanged in a crypto network. In a mature crypto marketplace, when people provide the supply of the thing the network was created to provide, they earn their reward in the form of the network’s token.

In the context of Bitcoin, for example, miners earn rewards for validating transactions on the chain, enabling the public consensus about transaction history that is essential to the currency’s value proposition. Through this mechanism, the network utility has grown over time as a larger and larger percentage of the total available token pool comes online.

The idea of an ICO was to speed up the network effects crypto economies needed to mature by seeding tokens to the community through a financial sale. If people could pay to buy some initial allocation, it could solve for the capitalization the company needed to build out its protocol while also getting tokens into the hands of the users who could presumably then use them to exchange value. All that was needed was a mechanism to do the actual sale.

Enter smart contracts. Ethereum’s innovation created the mechanism through which a company could allow outside actors to exchange their bitcoin, fiat or ETH for a new token.

Etherium itself held one of the earliest ICOs in 2014 (although not, actually the earliest, being pre-dated by Mastercoin in 2013). It was not until 2017, however, that investors really started to take note of the market. In May, for example, the Brave browser’s token sale for its Basic Attention Token raised $35 million in 30 seconds, showing that not only were there big dollar amounts available, but that the capital efficiency and the effective speed of closing were totally unlike anything in the venture world.

As ICOs become more popular, companies had to develop strategies to ensure that it wasn’t just super rich individuals buying tokens. Bancor, a decentralized exchange designed to make conversion between tokens easy and instantaneous, raised $153 million in ETH in 3 hours, including 150,000 more ETH than they originally intended to ensure that a broader diversity of investors could be involved.

When all was said and done, companies raised (depending on your source) somewhere between $4b and $6b in ICOs in 2017 — meaningfully more than the amount raised through traditional seed financing.

Interestingly, this boom was caused not by massive institutional investors getting involved, but was by and large a retail investor revolution. Three categories of investors shaped the year.

The first were traditional venture investors. At the beginning of the year, many publicly or privately kicked against the trend, recognizing that, for the first time, the singularity of their capital for new venture formation was threatened. Others were more forward looking, and understood that software eating the world included themselves as well. By the end of last year, not only were the traditional venture firms dipping their toes into the water, many of their partners were investing personally in deals that were too out of scope for their LP agreements.

The second group were retail investors who had never had the chance to participate at scale in new venture formation. The United States’ general approach to investor protection is that only the already-rich get to participate in risky startups. While that approach does cut the downside potential of losing more than people can afford to lose, it also bolsters inequality by cutting off one mechanism for those with less to move up the economic ladder. Part of what made the last year so exciting was that, for the first time, those with the appetite for risk could put smaller dollars to work.

The third group weren’t defined by their background but by the capital opportunity they saw. Tokens have a fundamentally different liquidity profile than private equity offerings. As the ICO process quickly standardized around a private sale with discounted tokens followed by a public sale at a set starting price followed by listing on exchanges, many saw the opportunity to arbitrage that liquidity. The result was an explosion of hedge funds and investment vehicles to provide capital and then withdraw an equivalent amount or more just a few months later. By early 2018 there were more than 220 such funds.

The Emergent Diversity Of Crypto Investment Strategies

Despite this diversity of new actors, the predominant investment logic for crypto and ICOs in 2017 effectively came down to a rising-tide-lifts-all-boats scenario. So much new money kept coming into the space that token prices across the board rose and rose.

Underneath that pattern, however, an incredible diversity of ideas and investment theses were percolating.

Crypto investment differs from other startup investment in a few essential ways.

First, although token offerings make look enough like securities offerings for the SEC to regulate, tokens are not equity. Unlike venture capital, which tends to be locked up for a decade or more, tokens are liquid from the get-go. This liquidity profile gives investors a huge array of public market-style tools to apply to early stage markets.

Second, many crypto companies look more like online economies than traditional for profit companies. The priority of emerging protocols is not to extract the most rent from their network of users for the financial benefit of their owners. It is instead to encourage as much value exchange between members of the network as possible.

Transacting around a different type of asset in the context of organizations that have different types of goals and motivations has created interesting challenges and opportunities for investors.

One example: we are only just beginning a conversation about how to value crypto economies.

“Cryptoassets” author Chris Burniske and his partners have done amazing work plotting the “J Curve” of crypto economies which shows a progression from speculative value (Discounted Expected Utility Value or DEUV as he labels it) to realized value (Current Utility Value).

Tushar Jain and Kyle Semani of Multicoin Capital have been driving an important conversation around the impact of token velocity (in other words, how often tokens trade hands) on long term token price growth, which is starting to impact how project leaders think about the token dynamics they’re designing into their system.

The sort of questions and dynamics are leading to a flourishing of different strategies for investing in the space.

Burniske mentioned above along with former USV-er Joel Monegro runs Placeholder VC, which is effectively a traditional model VC where the partners make a small handful of bets, own equity, and get their hands dirty helping portfolio companies.

Multicoin Capital describes itself as a thesis-driven hedge fund that combines “venture capital economics with public market liquidity.” In podcasts, the company has described that it looks at every investment through at least two lenses: is this a project they believe in long term, and are there short term token price dynamics that create financial opportunity?

On the other end of the spectrum, companies like Blocktower Capital are bringing more public style investing strategies to the space. Rather than investing in ICOs, the company builds on the experience of investing partner Ari Paul, who was previously a portfolio manager at the University of Chicago’s endowment, to generate value through token trading.

Others are exploring an index fund approach, effectively making a bet on the space as a whole without relying on bets on specific tokens to generate returns. The Bitwise Hold 10 was the first index fund in the space, holding the top ten currencies based on a 5-year diluted market cap model and rebalancing their portfolio monthly. While the minimum $25,000 investment to get involved in Bitwise still limits it as an investment vehicle for some, it is massively more accessible than the crypto hedge funds and more traditional VC style firms that tend to have minimums closer to a half million or million dollars. Coinbase has recently also announced an Index fund.

Some investors are betting even more broadly. Serial entrepreneur Rick Marini for example founded Protocol Ventures as a fund of funds to invest in the leading capital allocators in the space, specifically seeking out a diversity of strategies. Protocol has investments in companies that run the gamut from private, venture style investing to more public market style investing. Because the fund-of-funds is continuously fundraising, it can effectively rebalance based on where it directs that new money if one or another strategy appears to be driving better returns.

Even as the radical boom times of 2017 have crashed into what Nic Carter labeled a crypto recession in early 2018, and some of the more fly-by-night hedge funds that were created last year fade into the ether, new financial entrants are coming in.

Last week, for example, Business Insider reported that Travis Kling, a former portfolio manager at Steve Cohen’s Point72 hedge fund was jumping into the space and raising a $50m fund. The fund was newsworthy both in terms of the pedigree of the asset management talent involved as well as the size of the fund.

Another pronounced trend in the space is companies competing for the protocol layer launching funds to invest in projects that build on their protocol. EOS has been incredibly active, recently announcing a new $200m joint venture fund for Asia that brings the company’s total VC initiative to $600m. Ripple has been throwing its weight around through investments as well, ranging from investing directly in a storage & physical goods marketplace Omni to investing in one of the industry’s largest venture firms Blockchain Capital.

As this activity expands, there is a growing critique as some investors in the space view the activity with skepticism, both from the standpoint of whether that capital was intended to be used for such a purpose and from the simple efficacy of whether startup companies can also be successful fund managers

Other companies are taking a more academic, R&D style approach to investing in their ecosystems. Stellar runs a “Partnership Grant Program” which invests up to $2m in projects that build the financial inclusion ecosystem. Just this week, Protocol Labs (the company behind Filecoin) announced a new “research and grant” program.

Why The Reimagining Of Risk Capital Matters

What’s clear is that even as the frothy trading market recedes, there is incredible diverse energy going into reimagining risk capital for crypto startups and crypto economies.

The fact that the strategies are so diverse matters for two reasons.

First, the next stage of maturation of the crypto capital markets involves the entrant of new institutional actors like family offices (and eventually endowments and almost assuredly lastly, pensions). These sort of institutional investors are going to themselves have diverse risk profiles, and the greater the diversity of capital strategies (and fund manager profiles) available, the more likely they are to find a match and jump in.

Second, startups tend to pattern their models after the types of capital available to them. It is a common story in Silicon Valley that a promising company, filling an important market need, warps its models to justify venture capital investment even if that model and those expectations aren’t ultimately right for their business. To bastardize an expression, when the only capital tool you see around are hammers, you do your best to be a nail.

The projects being created in crypto represent a diverse and interesting tapestry of networks, economies, and traditional for profit businesses. By having a similarly diverse array of capital strategies surrounding the space, it’s more likely that those companies actually find their way to the model that makes sense for what they’re trying to build.