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Even while the speculative crypto niche has cooled down under regulatory pressure, VC investments in blockchain startups still skyrocketed to a total of more than $4 billion during 2018. Instead of flowing through initial coin offerings (ICOs), more venture capital is now reaching blockchain startups in updated forms of investment.
- Blockchain investments are increasing even though the SEC is tightening the rules for ICOs
- Decentralized ledger platforms are disrupting the financial ecosystem, but won’t replace the role of VCs and other traditional early-stage investors
- Decentralized organizations are using crowdfunding to raise money through ICOs in updated ways likelier to gain regulatory approvals
- Traditional companies are creating their own tokens and using the crowd to fund them via ICOs
- VCs directly or indirectly investing in tokens
- New decentralized investment funds focused on blockchain investments and derivatives
Remember when people said ICOs would replace traditional investments?
It’s important to note that research shows over 2,000 significant investors have put money into at least one crypto or blockchain company. Yet, about 75% of ICOs are currently worth less than their initial capitalizations.
Money for blockchain startups hasn’t gone away, it’s just going through more-traditional financing structures. Wary of regulators, US-based venture capitalists are now looking for deals that work without crypto speculation by the crowd of retail “investors,” such as asset-backed coins and security tokens instead of utility tokens.
Taking the crowd out of crowdfunding
Blockchain project funding hasn’t gone away, it’s gone legitimate. Now that the SEC and CFTC have given some opinions, venture capitalists are entering the game with bigger numbers.
Most of the VC industry’s blockchain players are focused exclusively on startups that provide real-world products and services actually based on crypto and blockchain technologies, instead of simply adding “coin” to the name of a dinosaur business.
Not all tokens are created equal
The majority of ICOs have been highly speculative. They’re intended to raise money for development by selling utility tokens through crowdfunding.
Recent guidance from the SEC is now helping VCs decide where to invest – Utility tokens that aren’t backed by assets, or asset-backed security tokens. Although the SEC is now beginning to regulate the crypto marketplace, utility tokens in general still have great value for specific purposes and communities. They’re already a permanent part of the financial ecosystem simply because they can help solve real-world problems.
However, utility tokens fail the Supreme Court’s Howey test for definition of an investment, and therefore aren’t considered securities for regulatory purposes. That’s because they only represent a form of future access to the startup’s products and services, not an asset that could be liquidated.
Another important distinction from security tokens is the fact that utility tokens don’t give holders the right to control corporate decision-making. They usually only enable token holders to interact with an organization’s services.
So if a utility token is planned appropriately, it won’t be regulated as a security. A true utility token doesn’t compete against Bitcoin or Ethereum because it works in an environment of its own. At the same time, even without significant assets behind it, and separate from the underlying value of the token’s functionality, its market price may rise dramatically because of marketplace demand and retail trading activity. That’s what has happened with Bitcoin and Ethereum, etc.
VCs are at the fork in the road
In contrast, security tokens are those which derive their values from external assets that are tradable and convey ownership interest. Security tokens meet the Howey test as true investments because the investor expects to profit from the efforts of third-parties together in a common enterprise.
Security tokens can be used to share profits, pay dividends or interest, account for transactions, voting and managerial control, and other blockchain-enabled functions. Since government regulators are now classifying asset-backed tokens as securities, venture capitalists have begun considering them as entirely different from utility tokens without assets behind them.
Venture capitalists are at the fork in the blockchain road – Whether to invest in utility tokens without underlying assets, or whether to focus on asset-backed coins. On the one hand, VCs that launch blockchain platforms which will be subject to securities regulations can have some measures of protection and oversight by Uncle Sam.
Of course securities are also eligible to be held in government-insured funds and investment accounts. This guarantees liquidity for sales when VCs want to cash out in the future, and it decreases their regulatory burdens in the meantime.
On the other hand, VCs who focus on speculative utility tokens can win the investment game in the same ways that investors have always profited in booming technology markets – by risking their capital on hot startups in hopes of huge gains. In any case, blockchain technology brings speed, security and efficiency to the entire development process for both utility and security token projects.
Trends in blockchain venture capital – Looking back, then forward
The blockchain and crypto investment marketplace is passing through a series of normal stages as it becomes more mature. Let’s recap what has happened so far, and we’ll also look at the current state of VC funding for blockchain projects going into 2019.
There are 4 noticeable trends underway in varying stages of development right now, each with opportunities for agile independent VC investors.
✓ Decentralized organizations use crowdfunding to raise money through ICOs
✓ Traditional companies creating their own tokens and using the crowd to fund them via ICOs
✓ VCs directly or indirectly investing in tokens
✓ New decentralized investment funds focused on blockchain investments and derivatives
Decentralized companies using ICOs in updated ways
The flood of sketchy ICO filings over the past year or two has brought strong regulatory blowback. There’s a clear trend toward more decentralized organizations opting to raise capital directly from the crowd by selling tokens within stricter parameters. Some promoters have chosen to focus their efforts in Europe or Asia instead of in the US.
Unfortunately for venture capitalists, the first generation of blockchain ICOs was like the “dotcom” phase for early tech startups – Most of them didn’t solve real-world problems, so their business models didn’t work. Some old companies simply added the word “coin” to their names and thought they were young again.
It’s understandable that many of the earlier generations of ICOs had no practical business model simply because there was no compelling reason to issue or use a digital token for commercial purposes. Now VCs have learned some new tricks about possible pathways to monetize blockchain models.
Looking to the future, it seems that VCs are more narrowly focused on blockchain technologies which deliver exceptional value for end users, and do so in disruptive ways. Of special interest to investors are those startups which promise to disrupt the traditional financial services escosystem. Likewise, blockchain developers should focus on the financial niche, because that’s where the money is.
Traditional companies issuing tokens
Another clear investment trend in the blockchain ecosystem is the rise in traditional companies issuing their own tokens, whether securitized by assets or as utility tokens. Likewise, some new companies are operating as traditional companies while issuing their own tokens.
For example, Ripple is organized like a traditional inter-bank services company, yet it issued its own token (XRP). It uses a shared ledger consensus system to facilitate cross-border settlements and payments.
XRP was pre-mined then shared out among key stakeholders. The tokens are slowly consumed by a tiny transaction fee, so the amount of XRP in circulation decreases over time.
The value of XRP rises and falls according to the amount of assets represented, as well as the popularity of the platform among users and crytp traders. Ripple has moved beyond inter-bank settlements and is now providing more functionality for e-commerce buyers and sellers, as well as for crypto traders.
Blockchain is the perfect way to provide permanent, secure storage of proofs-of-transaction for a wide range of applications, from financial transactions to real estate title chains. Factom is a decentralized protocol for building record-keeping systems and publishing records into a easily-permanent, verifiable, immutable ledger.
This type of “immutable ledger” offers another model for VCs to participate in the blockchain development boom. Unlike most other blockchains, Factom uses a distributed ledger which allows related entries to be linked together chronologically within the chain, for better storage and retrieval.
Entry data is hashed and written into entry blocks, stored within distributed hash tables, and shared p2p. Each block is also secured through crypto anchor entries into Bitcoin. By anchoring into strong public blockchains, the goal is enhanced security and interoperability.
The Factom blockchain is on a federated p2p network of servers, with membership based on community support and performance. It’s public and open source, so everyone can read entries and make write requests at fixed costs, based on the entry size. Anyone can create a private network for development and run a follower node.
Trust used to be expensive, now it’s cheaper
For venture capitalists in search of targets, there are plenty of startups with blockchain-based trust and verification models. Some models are “trustless,” others such as Factom use an immutable trust model. The goal is to monetize faster, cheaper ways to keep track of huge volumes of transaction data.
Accounting and financial services are expensive, mostly due to the fact that computer records are easy to change, and therefore difficult to verify later. The faster that outsiders can check an organization’s data audit trail, the cheaper its services will be. This is true for all industries that handle data, but especially for financial services.
Title chain on the blockchain
In place of crowdfunding their blockchain projects, ambitious venture capitalists can tokenize service platforms such as commodity exchanges, data validation, verification and publishing systems, and buyer/user rewards programs.
There are new opportunities with blockchain platforms that can protect, synchronize and verify data with minimal user intervention. Their competitive advantage is lower cost.
For example, to record and verify a real estate title chain, the protocol will apply all property sale and ownership conditions in a given jurisdiction. A buyer or seller may have special requirements for loan underwriting, and the property may be located within multiple taxing and permitting jurisdictions. Each step of the protocol has its own rules to reflect the legally-binding validation process, with verification and validation based on smart contracts.
The important advantage of trust technologies is the blockchain’s ability to write a permanent record and assure that all attached conditions have been met before validating the process and transferring ownership. These trust technologies can save users plenty of money because the documentary process doesn’t rely on any cryptographic (or physical) signature for the validation process.
Instead, the record-keeping service simply records and validates the processes that lead to transfer of ownership of the asset. Since the processes themselves can’t be “faked” after being recorded in the block, it’s easier and cheaper to validate transactions.
Anonymous social blockchain
A particularly interesting area for venture capital are platforms that use distributed ledgers and blockchain technologies for anonymized contact-sharing and relationship-tracing. It’s easy to presume the value of apps to track the spread of communicable diseases through social communities, or apps that rent computer hard drive space to nearby mobile devices on-the-fly.
Following the spirit of SEC decisions about ICOs venture capitalists are focused on companies that are launching open-protocol tokens for products and services which are self-supporting. As an example, Brave BasicAttentionToken that rewards users who view ads.
Next round in the crypto VC game
After the ICO boom-and-bust cycle, best practices for VCs include using a significant portion of proceeds from token sales to support open-protocol development. Also, the for-profit corporation maintains its pre-ICO capitalization table and continues with its normal day-to-day operations.
The best scenario is for the VC to be an equity partner in the corporation, and keep a share of the tokens. The deal should also grant to investors the right to buy tokens pre-ICO, as well as the possibility of earning development and operating fees for building and maintaining the protocol.
With these revenue models, VCs are hoping to benefit either indirectly by creating new revenue streams, or directly by appreciation in the token’s marketplace/trading value. There are several possible outcomes for investors, each of which offers its own blend of opportunities and risks.
Knocking off Bitcoin
Regardless of who issues them, in the current regulatory environment, these newly-issued tokens may succeed on their own, apart from financial support from the underlying VC-backed organization. Or, the tokens may fail to be adopted by the target community – even if the company itself thrives.
This could happen if the token ties into a larger crypto like Bitcoin, and the platform’s revenue-producing service gains mass adoption on its own due to blockchain-enhanced functionality. It’s also possible that the service could become widely used, yet without making the company more valuable.
There are also organizations such as OB1 that build open-source protocols for decentralized applications, like OpenBazaar, which use Bitcoin or other existing tokens. This development model is how some people had first envisioned that Bitcoin and Ethereum would grow, but the crypto ICO craze changed everything.
Tokenized equity in blockchain startups
Unlike decentralized organizations that are usually hoping their utility tokens will be considered as software or other form of property for legal purposes, most VC-backed blockchain startups are working under the assumption that their token may eventually be treated as a security for regulatory purposes. But since regulators (at least in the US) generally restrict marketing or transferring private securities, VCs have even less incentive to structure the deal as an ICO. They want straight equity instead.
Venture capitalists can emulate the crowd
The challenges for VCs in the current regulatory environment are to choose the right blockchain startup with a make-sense operating model, then craft the investment deal in a way that won’t worry regulators while still finding a way to administer traditional cash flows, ownership interests, and investor rights. With the right corporate structures and development plans, VCs can emulate crowdfunding and enjoy the best of both worlds.
At the same time, the resulting tokens should be more liquid and easier to trade than the ownership interests in traditional private equity funds. For an idea of what the future may look like for tokenized private equity, Chain and NASDAQ are collaborating.
Traditional VCs are on the block (chain)
The traditional venture capitalists like Sequoia, Andreessen Horowitz, Bain, Union Square Ventures, MetaStable Capital, and others are leading the new wave of blockchain investment. Crypto-funds are the next wave in venture capital. The sense is that the VCs who don’t end up controlling a big chunk of the crypto space will eventually end up being acquired by more-successful players.
Decentralized crypto funds
Venture capital methods are also being disrupted by emerging decentralized blockchain-based crypto funds that issue their own tokens, for the purpose of investing in other tokens. The demise of the DAO project hasn’t stopped VCs from beginning to explore this niche. Two interesting plays are ICONOMI, which provides a crypto fund platform, and the well-promoted “token as service” project, or TaaS.
An ideal scenario for investors is to have central management over a decentralized fund, including management fees, exchange spreads and other revenue streams. These crypto funds will face varying levels of regulation, but the right types of deals can help overcome obstacles while still riding the blockchain-crowdfunding wave. Beyond the platforms highlighted elsewhere in this article, there are plenty of other deals to watch in 2019 and beyond.
- Polychain Capital
- Kyber Network
- Polychain Capital
Digital Currency Group
It always happens the same way every time there’s a new type of tech investment area, like blockchain – Sophisticated investors pour money into the sector, and the early birds make a ton of money. then the small investors start to notice, and they “crowd” into the marketplace… sometimes with their life savings.
At about the same time, unscrupulous promoters flock in and begin marketing crypto investments to people who shouldn’t buy them. By now most of the “real deals” are taken by the early wave of savvy investors, and the peak of excitement is past.
Next the peons lose their money on “crypto” deals of all kinds, and they call their congress members to complain about blockchain investments. Congress complains to the SEC, and the rest is regulatory history.
A year ago, the SEC was just starting to become worried about crypto deals. Now the SEC, CFTC, etc. are all policing the marketplace for quality. VCs have responded by investing in make-sense utility tokens as well as projects that asset-backed tokens that may lead to crypto index funds and other financial products.
There’s a sharper distinction between assets and non-assets. That’s where we’re at right now. This is good for VCs because (in effect) the government is pre-screening out some bad ICOs, or at least there’s the threat of legal action against companies that launch shady ICOs.
Even while there are several overlapping trends in blockchain investment, more-regulated ICOs will continue to thrive, especially when they involve asset-backed tokens. At the same time, the role of venture capital is evolving after the initial learning phase.