In the second part of this series, we shed more light on the new emergent model for fundraising called "Initial Coin Offerings." To read our previous post on Bitcoin's growing status as an asset class, click here.
If we now look at Bitcoin and the blockchain, the key insight is that we now have a general solution to the Byzantine Generals’ problem in distributed computing. Now we can start to look at any service or product you can think of that was previously centralised which can now be decentralized using the blockchain. This applies to anything that has traditionally been centralised including cloud computing, cloud storage, social and community networks such as Reddit or Facebook, or even escrow services, land registry services, insurance, and most if not all financial services. If you look at the size of the markets as currently served and addressed by the centralised incumbents and contrast that with the low network values (market caps) of the emerging set of decentralized, blockchain-based pretenders, one starts to appreciate the sheer scale of the opportunity for blockchain. If the energy, time and attention from investors and developers that we are witnessing flowing into Crypto continue to grow, as we fully expect, then we can expect the value of these decentralized networks to continue to grow rapidly and eventually capture or even exceed the value of existing centralised systems. We are seeing a lot of activity and innovation at all levels of the technology stack, including smart contracts and automation, record-keeping, security issuance and distribution, and digital peer-to-peer lending to name but a few.
Analogously, VC investing is proceeding on track in the same way in which VC exploded with the advent of the internet. This brings us to the phenomenon of the Initial Coin Offering (“ICO”). The ICO has sharply divided opinions with views ranging from bubble to game-changing new technology paradigm that aligns ideation and capital formation in a really elegant and powerful way. Obviously, the data clearly shows that ICO’s are growing rapidly on quarter-on-quarter basis with an increasing number of entrepreneurs, working both on decentralized protocols and applications, choosing to eschew traditional VC financing to raise capital via the ICO path. The quantum of capital entering the ICO space is also growing extremely fast.
Let’s now zoom out to understand what an ICO actually represents. You can think of a blockchain as a database representing a protocol. An ICO is the first offering to the public of a token that provides read-write access to the database, akin to a paid API key. We can now apply the intrinsic value framework we previously discussed. If a particular protocol network performs a certain function or service and does so well, then it has value. Then, the token that provides read-write access to that protocol network has value. Investors, who are working to determine and predict what the future value of the network is, are ascribing a net present value to the protocol (via the traded price of the token). This net present value can increase or decrease over time in relation to the utility function of the underlying network protocol. If the protocol really solves an important problem and provides increasing utility to an ever-increasing universe of users, then its native token will increase in value. If it fails to do that, the token should decline in value. Ethereum and Bitcoin have provided the fuel and energy that initially flows into these token offerings. An entire ecosystem and marketplace is being built.
Looking back on the evolution of the internet, TCP-IP enabled SMTP. TCP-IP and SMTP enabled HTTP. On top of HTTP, we witnessed the emergence of the whole AJAX toolkit, from where we moved on to a whole host of other cloud computing modalities, protocols and frameworks. In the same way, Bitcoin and Ethereum are foundational, enabling technology protocols on top of which other protocols and applications are being built.
What’s interesting about ICO’s is that it essentially refactors and collapses the way we traditionally think of companies into a single, native, bearer token. Let’s take a moment to think about what a company really is. A company is a collection of people, a network of contracts, an entity through which a certain product or service is conceived, developed, marketed and distributed, and which seeks to generate revenue in excess of its total cost on the sale of its services or products. Furthermore, a Company then sells stock in itself or incurs debt which are claims on the cash flows created within that system of developers, operators, distributors and contractors. Blockchain collapses all these functions of a Company into a single protocol, access to which is gated via its native token that provides read-write access to the protocol. The token is the protocol, and the protocol is the token. One can conceive of a token as a digital asset that is cryptographically constrained to be scarce, and which can be transferred permissionlessly between any two peers on the network. An important quality of tokens is that every single token can be tracked and validated in real-time on its underlying ledger i.e it is not possible to clone a token to create a double-spend on the network.
This adds up to a fascinating evolution in technology in that all the functions, operating variables, economic sustainability and utility function of what we traditionally associate with companies has now been integrated into an open, network protocol as expressed by its liquid, tradable native token. This growing realisation is at the core of the explosion in investor capital and developer energy and attention (as measured by github commits) that we have witnessed flowing into the ICO space over the last 6 months.
What’s important to grasp is that these rapid increases in market caps in the Crypto space are not arbitrary or random. They are underpinned by a human phenomenon that is at work, namely that value capture is increasingly happening by blockchain protocols whose distributed governance frameworks coupled with an aligning built-in token (that has a low correlation with other financial assets) are providing a crucial edge in solving valuable, technical problems that are either being unsatisfactorily solved by existing companies built on top of the old technology stack or not being solved at all. This clearly builds the case for crypto tokens to be considered seriously from an alpha generation and portfolio diversification perspectiBetween 2014 and 2016, a key driver of the emergence of the token ecosystem has been significant growth in acceptance of and familiarity with Bitcoin and blockchain in virtually every major country as characterized by national digital currency exchanges that enable conversion of fiat currency to digital currencies like Bitcoin, rapidly growing user adoption, and generation of significant tech developer attention at a local level for all things blockchain. After the emergence of Ethereum in late 2015, there has been an increase in mainstream companies and financial institutions piloting private blockchain projects for internal or consortium use which has contributed to a cautious but constructive regulatory climate in most major nations.
Value Capture Between the Internet and Public Blockchains. Source: USV
To summarise, the fundamentals of Crypto from a financial or asset class perspective, we need to look beyond the perspective of Bitcoin as a technology protocol or even as a currency to understand how the technology behind Bitcoin has created a scalable new architecture/model for open network protocols to be created, funded and deployed. Crypto tokens represent a completely distributed, open, non-dilutive, liquid platform for capital formation and investing in technology networks. They effectively represent a 1000x improvement in time to liquidity as they are liquid by design from the get-go. As these tokens are not equity, they fall outside the realm of securities laws (to the extent that they are designed to be utility tokens), leading to a 100x improvement in the available buyer base as they are available for purchase by a distributed base of small, global buyers rather than just a pre-qualified, finite list of accredited investors in the US.
Access to investing opportunity is democratized as tokens can be sold internationally from the outset (though it is worth pointing out that regulators are slowly starting to draft legislation to encompass the subset of tokens that behave like securities rather than like paid API or “utility” keys) to anyone who wants to invest in the token offering by sending Ether or Bitcoin. A bank account in the US or Europe is not a pre-requisite to invest in an ICO. We can also say that tokens have a liquidity premium. Instead of having to wait for 7 to 10 years to get liquidity on an investment, you can now sell your token after 10 minutes which represents a several orders’ of magnitude increase in the time to the option of liquidity. Quantitative state assessments (time to liquidity enters as an inverse to the exponent of CAGR) shape qualitative state assessments (vastly superior macro framework for investing in technology projects). We can say that token sales represent a way to improve capital inflows and time-to-exit by several orders of magnitude, which are the two most important parameters when optimizing an investment portfolio. Today, the easiest way to create and issue tokens is by building and launching them off the Ethereum public blockchain as so-called ERC-20 tokens.
As tokens are designed to be liquid from the outset, they can be issued and sold at the time of founding of a new network protocol to fund early development akin to the manner in which crowdfunding platforms have been used to raise funding for new projects that would be deemed unfundable under the traditional equity financing paradigm. Token issuances therefore have a very valuable role to play in enabling pathways for foundational, enabling infrastructure to be funded that traditional equity funding would consider unviable due to the problem of the commons.
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