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How Cryptocurrencies and Blockchain-based Startups Are Turning The Traditional Venture Capital Model on Its Head
The decentralization effects of blockchain-based cryptocurrencies are hitting the venture capital industry in more ways than one. Whereas the traditional venture capital industry is boring, the crypto-tech industry has become more exciting. Actually, I see the two models as diametrically opposed: one is a closed market, dominated by command-and-control practices, led by a few rich people on Sand Hill Road. The other is a widely open global market where anyone can play, and where the gains and risks are more evenly distributed.
This has led to a re-thinking of how startups who are operating in the blockchain space can raise money, and it has potential implications that will revamp the relationships that venture capital firms can hope to strike with these startups.
As an investor, advisor or board member, I have been closely associated with a variety of early stage companies that are tackling the innovation explosion around cryptocurrency and blockchain-based models, and have had the fortunate insights of seeing where we might be headed.
The upcoming shifts are encapsulated in the following table, covering 9 variables.
So, what is new about this environment?
Return Horizon. Whereas the return horizon for traditional VC funds is squarely in the 7-10 year horizon, we are currently at the beginning of an inflection point in cryptocurrency-led valuations, resulting in much shorter liquidity options for early investors, in the 1-5 year range.
Ownership Model. Traditionally, VCs receive preferred shares by buying private equity. With the new models, they can acquire shares and/or tokens/cryptocurrency that have been issued by the startup.
Entry Phases. Angel, Seed, Early to Late Stages (A-F) are the known trajectories for conventional startup investments. The new continuum has another progression lingo with it: pre-mine, genesis, initial cryptocurrency offering (ICO), listing on an exchange, or private sale of crypto-tokens directly from the company.
Business Model. A traditional startup is typically focused on developing and marketing a tangible product or service. A blockchain-based startup could have a product/service as part of what they are developing, but their stride is best hit when they are also creating a self-sustaining circular economy that is supported by their own currency or tokens, and where there is a transactional loop between earning and spending these tokens within their ecosystem.
Legal Structure. Startups typically incorporate as a Limited Liability Corporation (LLC) or any other traditional way according to the corporate laws in their given jurisdiction. In the new environment, the LLC could be creating a base open source technology/protocol, but they will run a proprietary separate business on top of it or adjacent to it (e.g. IPFS and Filecoin), or they could create a valuable ecosystem around it (e.g. Ethereum). In extreme cases, the organization is non-registered and operates as a distributed autonomous organization on the blockchain (e.g. BitNation).
Limited Partners Mix. The same traditional mix of institutional, high net worth individuals, family offices and funds of funds that typically invest in venture capital funds will be attracted to this emerging segment, only if they are progressive, innovative and forward-thinking, with the ability to allocate discretionary funds under strategic considerations pretexts. In addition, given the more relaxed crowdfunding rules that exist in several jurisdictions around the world, a new venture fund could also get a mix of participation from a publicly crowdsourced segment of investors.
Fund Currency. In addition to fiat currency, a new VC fund could also accept cryptocurrency (especially from the crowdsourced segment), because of the frictionless capabilities that exist for accepting cryptocurrencies online. However, it would be prudent to immediately convert these funds into fiat as the initial reference currency for investment vehicles, in order to avoid being caught in cryptocurrency value downturns, and to remove any perceived intent of currency speculation which is outside the mandate of a venture capital fund.
Market Approach. The best candidates for this new model will be blockchain startups that are purposely creating new business models, and not supporting existing ones. The reason is that these new business models are more fertile grounds for innovative circular economies, new ecosystems, and new value creation, which are important conditions for success.
The nature of blockchain startups is changing, and this change should be accompanied by an evolution on how they are funded.
A new VC fund with the above characteristics has the luxury of having no baggage within an existing Limited Partners Agreement (LPA) where changes may be hard fought. Instead, these elements would be baked as part of the initial LPA, while properly addressing the legal and compliance considerations.
Disclaimer: In no way does this blog post represent an offer to sell securities or an advertisement of raising a new fund. I have yet to announce anything regarding a new fund that I might raise in the future.
Per your disclaimer about the potential of raising a new fund, you keep writing like this and I’d be surprised if anyone other than Fred Wilson and Albert Wenger at USV would invest in it (as I write this the irony is not lost on me that those guys are pretty awesome investors to have on your side :). This post is really disappointing, but rather than to leave it at that, I’ll contribute to the conversation and provide rebuttal perspectives.
First off, “The decentralization effects of blockchain-based cryptocurrencies are hitting the venture capital industry in more ways than one.” is simply not true. We have not seen a company who was able to get venture funding walk away from that and go the ICO, Crowdfunding or Equity Crowdfunding route. To make this claim so boldly is sensationalistic at best, but I bet you get lots of visits to this page 😉 Show us just one executive summary or business plan or cryptocurrency company that could have been funded by well heeled investors. Having seen plenty of these plans myself, your claim here is clearly exaggerated. As with any business, the “thing” being developed has to have utility. Here’s the list of ICOs (on-going and upcoming): https://www.ico-list.com/. Please point us to which of these cryptocurrencies have *any* utility whatsoever? Here’s a list of all the cryptocurrencies, https://www.cryptocoincharts.info/coins/info. Same question, other than Bitcoin, Ether (sort of), and Monero (still early but Alphabay is supporting its use), please share your thoughts on the utility of any of these. How would any professional investor in their right mind even begin to invest in *any* of these? Let’s just say, that in a portfolio strategy, perhaps it would make sense to allocate some small percentage of one’s portfolio to a basket of cryptocurrencies, but I would also recommend to that same investor who thinks this is a good idea, that they allocate some to penny stocks, lottery tickets, and some swamp land in Florida…’cause you never know 😉
The ownership model for the founders is no different than with any other startup, except they also get early currency (especially in pre-mine scenarios). For investors, there’s no “ownership” of the company, only ownership in the coins which means that the founders have off-loaded their risk on to those who would buy their coins. We just saw ICONOMI raise close to $10m on less than a white paper and some fancy blue sky language without having built much of a business or demonstrated technology. Synereo’s AMP coin is supposedly going to provide users of it the ability to extended distribution of their content, except for one problem…the platform has yet to be completed. Heck, MAIDSAFE I believe holds the record for longest time with a coin and no service to speak of. For investors, there is only ownership of vaporware, nothing more. For founders, this is GREAT! Retain all the equity, and completely de-risk themselves to the point that if they fail they were well compensated for their efforts. Not exactly a comforting thought for an investor.
As you describe the Business Model, you’d think that an economy comes first, before the product or service has been developed, completed, and shown to be useful. Are you kidding me?! A self-sustaining circular economy has to drive from the utility of the products or services before the currency. I’m guessing Steemit is your poster child for this model, so likely we will have an example to point to once their experiment is more fully flushed out. I suspect you will need to find another example soon but for now, that’s potentially the only in-market example. Storj and IPFS are still immature and the issues to watch with them are less economic and more behavioral in terms of whether people buy-in to their distributed storage models beyond empathy.
The Legal Structure issue is not so material, other than the fact that you bring DAOs into this. Anyone who invest through a DAO is simply an idiot. While I try not to generally be so judgmental, the notion that one would put their money into a structure that is difficult, if not impossible, to hold liable for losses, is simply insane. Not to mention, that no contractor in their right mind should do work for a DAO lest they held responsible as the only legal entity that can be held liable when things go wrong. Let’s just say that regulators let TheDAO developers escape punishment (at least so far) out of the goodness of their hearts.
Where I really get upset with your post is when you discuss “Exit Method”. IPO, really? In what parallel universe are you living to even begin making such a claim. Let’s crawl before we run, shall we? First, let’s see a company actually make something useful for which a large enough group of people can help make that company profitable and professional investor worthy. Then we can talk IPO. As for ICO, this is indeed an exit which it feels all the existing developers are getting well before they have completed a real product, service, any utility to the coin(s), or as you like to call it, a self-sustaining economy to speak of. ICOs create a perverse incentive for those creating these cryptocurrencies.
Bitcoin did something novel, with Proof of Work requiring participants to invest power before obtaining value. There was no company that profiteered from its release. We’re still working through its utility issues beyond the dark net markets and some instances of remittance. But these are two very large markets on which bitcoin can hang its utility shingle. There are lots of speculators there keeping the price relatively high, but with the utility foundation one can at least feel some comfort in that the floor price is greater than zero. This cannot be said for just about every other cryptocurrency.
> Show us just one executive summary or business plan or cryptocurrency company that could have been funded by well heeled investors.
Ethereum could have raised VC money quite easily.
Didn’t realize Ethereum was a company. Thought they were a non-profit foundation. If I’m wrong in that assumption, then I stand corrected. I’d be really curious to hear what *real* VC was actually prepared to fund them if your assertion is true.
The quality spectrum of startups is very wide, whether cryptocurrencies are part of it or not, so there is nothing new here. Investors need to be diligent anyways.
I agree with what you are implying here- that the waters are treacherous and all is not clear, but there is definitive potential about the possibilities ahead.
https://www.youtube.com/watch?v=ZNpFDLG1Qwc
That video summarise pretty much my thinking. Calling *bullshit* not really, the true is, we don’t stop innovating and we have no respect for the statue quo.
Good to see your evolving perspectives in this latest post: http://startupmanagement.org/2017/01/23/watch-out-the-icos-are-coming/. Probably would have been easier to cut & paste my above comments 🙂
I had forgotten about your comments here.
Let’s connect via email.