The Economics of VC Exits In The ICOs Era
The Economics of VC Exits In The ICOs Era
In my previous blog post, I wrote about how ICOs are contributing to an evolution in ownership by providing a cheaper alternative to IPOs for tech startups, and how we moved from asset ownership, to business ownership, to now economy ownership. In this post, I’m writing about how I think of ICOs and reverse ICOs as a new exit strategy for venture capital funds.
Crypto vs. Stocks Performance
The top-performing stock market in 2017 was in an emerging market and it achieved a 117.7 % growth, while the most developed ones such as S&P 500, Nikkei and even the Nasdaq Index, they all achieved less than 30% growth, and this is considered the best year since 2013!
On the other hand, crypto assets by far out performed stock markets! Bitcoin was up 1390% in 2017, Ethereum was up 8981%, Litecoin was up 5572%, Dash was up 9337%.
To compare apples to apples, a crypto index fund that holds the top 10 crypto currencies by inflation adjusted market capitalization, the Hold10 Index Fund, grew by 2183% in 2017.
ICO vs. IPO Returns
Have a look at the returns since IPO vs. returns since ICO sorted by date of offering. For those offerings started in Q1 2017: The top performing IPO since Q1 2017 achieved a return of 666% (AnaptysBio). While the lowest performing ICO since Q1 2017 (TaaS) achieved 734% returns, and the top one (Qtum) achieved 14627% returns! ( all returns were taken as of Jan 20, 2018)
VC Funding vs. ICO Funding In 2017
According to Pitchbook report and Geekwire article earlier this month, VC funding in 2017 hit a record high of $84b, that was invested in 8,035 companies across the U.S.. However the number of deals went down by 6.5%. The biggest contributor to this drop was the number of seed stage deals which went down by more than 13.3%! The trend is not only in the US, global VC data shows a similar down trend for seed stage VC funding.
This means there is more money going to bigger companies, while smaller startups are not getting as much as last year, or are they?
A look at ICOs data for 2017 shows that $3.7b were invested in 235 tech startups. This include startups working on Infrastructure, Finance, Payments, Data Storage, Drugs & Healthcare, Gaming & VR, Commerce & Advertising, Identity & Reputation, Art & Music, Real Estate, Events & Entertainment, Legal, Energy & Utilities and even Social Network projects.
I listed all these classifications to show that it’s not just open-source crypto currency projects, this is affecting all industries that VCs invest in.
One would argue that seed stage startups are slowing abandoning the VC ship, and going for the bigger, cheaper and easier market to raise initial funding from, which far exceeds what an early stage VC would invest. At one point the total monthly ICO funding has exceeded the total monthly VC funding.
VCs Investing In Crypto and ICO Startups
In the past few years we also witnessed an era were many VCs started to invest in ICOs, sometimes alongside equity, and sometime with no equity at all. In his famous blog posts: Notation+Crypto and LP Memo re:Blockchain, Notation capital partner Nicholas Chirls explained the firm’s thesis of investing directly in main crypto currencies on one side, and in blockchain startups equity and coin tokens before they launch their ICOs on the other side. They are basically trying to get a stake of the fat protocols of our times.
Other examples include Draper Associates, Blockchain Capital, Pantera and many others. Pantera for one has several funds, some dedicated to Crypto currencies and some for startups in this domain, and they’ve already seen astronomical returns of 25,000% in no time compared to the 8–10 years traditional VC fund terms.
Reverse ICOs and VC Term Sheets
Many startups have launched ICOs after receiving traditional equity VC funding (referred to as Reverse ICOs). Dror Futter, a lawyer for startups and VCs shared how layers and VCs were surprised by the speed at which ICOs took over startup land. In his fantastic article: We Never Thought of That, he explains how ICOs provide non-dilutive financing alternative to companies and how the outdated standard documents used for venture funding do not address ICO events.
At least in the current environment, there is reason to believe that demand for tokens will be greater and drive up relative prices for tokens. Equity holders may find reduced demand for their equity. Further, if the tokens remain outstanding at the time of an exit, it is difficult to predict the impact of outstanding token pools on exit valuations in either an acquisition or IPO scenario. — Dror Futter.
Moreover, he explains that VCs usually manage risks by investing small amounts first, then double down on winners, but with ICOs in the picture, venture funds may have reduced opportunities for follow-on funding. He also asks many other very interesting questions, like what happens to convertible notes if the company never raises a priced round, and goes for an ICO? Would venture investors have a right to participate in ICOs? What happens to their anti-dilution protection? or liquidation preferences?
ICOs As The New VC Exit Strategy
I guess you saw this coming, I am building a case for a new VC strategy where:
- Fund terms are shorter (3-4 years),
- VCs invest in the equity or convertible notes of seed startups (as traditional shares or even as equity tokens or convertible note tokens),
- Exit at the time of their currency tokens ICOs (or Hodl a little longer) where their shares (or equity or debit tokens) convert to currency tokens.
Note: for point number 2, the tokenization of traditional shares/securities is already a thing, Delaware has already legalized it. Companies like Aragon, Bitshares, Jibrel, Polymath, has already started, and projects like RSK is building an exchange to trade tokenized shares/securities. If you’re interested to learn more about why this is needed, Nasdaq published a long article about the tokenization of real-world assets here, and Stephen McKeon explains that in details here.
Granted, a new term sheet is needed, but this is a learning curve similar to the development of the existing standard terms. Terms sheets now are way different than term sheets 10, or 20 years ago. So we shouldn’t wait until we come up with the perfect term sheet to start a new investment strategy.
Same applies to the valuation methodologies for crypto startups pre-ICO, it’s a new era and no one has figured it out yet, but hey, startup valuations has always been tough! Notation capital published a blog post detailing their take on valuing blockchain startups in comparison to tradition startups and what premiums can be applied at pre-ICO stages.
One could argue that this is still not regulated enough to invest in, but hey! Uber, Airbnb investors didn’t wait until they were regulated! They would have been too late if they waited. And frankly speaking, with the privacy coins and the decentralized peer-to-peer exchanges, this might be unstoppable!
One could also argue that there are many lemon ICOs out there, but hey! VCs job is to find the good legitimate new tech startups and invest in them on behalf of their LPs. I n addition, innovation in this space continues to introduce enhanced versions of ICOs where you don’t need regulators and trust anymore. For example, Vitalik Buterin, founder of Ethereum has just introduced DAICOs, Decentralized Autonomous ICOs, which could reduce scams in ICO markets by smart contracts. There is also a collaborative Google document started by Anthony Akentiev to list all ICO types in an effort to design the “Fair ICO”.
The Fat Protocol Is Getting Thinner Making Room For VC Investments
At an event I attended last year, Justin Mart, a software engineer at Coinbase, explained how what we now look at as the fat protocol layer, will eventually become thin, and so many applications will be built on top of it making the application layer fatter.
He mentioned the similarities between blockchain and the internet technologies back in the 80s were people couldn’t predict that applications such as Facebook or Uber would exist.
So we now don’t know what the potential possibilities of the blockchain or hashgraph technologies would be in 10 or 20 years from now. This is a great opportunity for VC funds to find and invest in the applications of tomorrow. VCs who adapt faster by adopting new investment strategies will become the Sequoias, Greylocks, Bessemers, and Venrocks of tomorrow.
