Solomon Lederer, Ph.D
In late 2015, when billionaire Mike Novogratz visited Joe Lubin in Bushwick and offered him $10 million for a piece of his company, ConsenSys, Lubin turned him down. He told Novogratz his company isn’t one organization but a spaghetti plate of different entities working on applications for the Ethereum blockchain. Novogratz, undeterred and wanting a piece of the action, decided to buy ether instead, the native currency of Ethereum. The price was then $0.85. A couple months later it passed $5. Today it’s hovering around $300, and it’s rumored that Novogratz is putting together a $500 million fund to invest in the blockchain space.
Blockchains have created a new means for investing. The standard route of purchasing equity or shares in a company is making way to investing in the cryptographic tokens that are issued on a blockchain. As Novogratz learned, and as venture capital firms are now recognizing, these tokens are an easy way to get exposure to the success of a project or company, without the challenges of normal venture investing.
Just a few years ago, Bitcoin and related enterprises were dismissed, if not ridiculed, by VC firms. There were exceptions of course. In 2013, Andreessen Horowitz and Union Square Ventures invested in Coinbase; Boost VC invested in Bitcoin and payments startups exclusively. But they were few and far between. Today however, the massive gains in the crypto space — 1,000% to 10,000% — is making everyone pay attention. A myriad of venture capital and hedge funds are pouring in and looking for ways to quickly get a slice. Conveniently, blockchains and the crowdsales being launched upon them, called ICOs, or Initial Coin Offerings, are a ready apparatus to accept their money.
Startups create their own crypto tokens on a blockchain, usually Ethereum, and offer them for sale to the public. They make the claim that the tokens are needed in some way to power their application, and while that’s true, in most cases the application could have been designed without the need for such a token. However, their function is almost beside the point. It creates a vehicle for investors to gain access to the success of a company, and the demand is strong. This year ICOs raised over 2 billion dollars, with a large portion coming from VC firms.
Filecoin, a distributed file storage startup, has courted Andreessen Horowitz, Union Square Ventures, Sequoia Capital, and Winklevoss Capital to invest in its ICO, which topped $250 million. The messaging platform Kik recently completed its ICO with investments from Pantera, Blockchain Capital, and Polychain Capital. Again, all these firms were just buying a blockchain token with no equity or rights in the underlying company.
Why would venture capitalists give up equity for something that is created out of thin air? The short answer is because they’re making money, a lot of money. They’re happy to find companies that have a good product and will command a strong price for their token. VC firms can make a play without the long commitment and responsibility of a normal investment. Once they get their tokens, they can sell on exchanges as they please.
Billionaire investor Mark Cuban, who has called bitcoin a bubble just four months ago, has come around to crypto. He’s now backing venture capital fund 1confirmation, which plans to invest $20 million into blockchain startups and ICOs. It addition, Cuban is involved with two other ICOs, one for a chat app called Dust, and an eSports betting site Unikrn, whose ICO is ongoing right now. What he once said about stocks is proving true about crypto:
“Cash is earned by convincing someone to buy your shares from you”
At first it’s hard to understand why these tokens are worth anything, if they’re just “made up”. But value is nearly all perception. Just as going off the gold standard did not hurt the validity or value of paper money, a free flowing digital asset can be valuable, even if it’s not legally tied to the issuing company. If the company grows, the demand and value of the tokens go up.
In reality, crypto tokens have a number of advantages over common stock. While supply and issuance of a stock is murky and can be diluted, a crypto token cannot. Every token is clearly visible and accounted for with a locked issuance, so they cannot be inflated in any way. They also move freely, with zero friction. Finally, they can serve a vital function in their associated application on the blockchain.
For VC firms, the lure of ICOs is stronger than for the public. They get to buy them early, during a pre-ICO phase, at a 20–60% discount, so they’re gaining right out the gate. Startups are eager to offer VC firms such discounts, because they need the early cash to help in launching the ICO. They’re also better positioned to raise money from the public with backing from a brand name VC.
The VC firms get their profits quickly, and startups get cash flow without giving up equity. Everyone wins. And while that keeps up, the venture capitalists and their money will keep on coming.