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The New World of ICOs and Implications for VC

Updated: Feb 17, 2018

By Nitin Sharma & Pankaj Jain

September 28, 2017. Originally published here


Not only has traditional venture funding to blockchain been eclipsed by ICO funding, the ICO market also seems to be larger than the size of the total early-stage VC market right now



In the first part of this interview, experts Pankaj Jain and Nitin Sharma — both of whom have earlier worked in the venture capital industry for years — touched upon Bitcoin,  blockchain, Ethereum and decentralisation. In this part, the duo dives deep into the crypto world and Initial Coin Offering (ICO) and what it means for the startup investment ecosystem.


Below are the edited excerpts:


What are altcoins or tokens? What does it mean to own a token?


These are two different things but people are using the terms interchangeably. Generally speaking, alternative coins (altcoins) are cryptocurrencies created as alternatives to Bitcoin. Proponents of altcoins believe that having alternatives to Bitcoin is important to create competition, spur more innovation and mitigate risks.


They believe that this will make the crypto ecosystem stronger, akin to how different world currencies (USD, EUR, JPY, etc.) exist in the fiat world. Litecoin, Dash and ZCash are some of the more popular altcoins.


The important thing to understand is that altcoins run on separate blockchains with differences in their protocols. For example, Bitcoin and Litecoin run on different blockchains, and the cryptographic details underneath can vary.


As you’ll recall from the earlier part of the discussion, the world of cryptocurrencies relies on a decentralised network of nodes which are continuously and collectively solving cryptographic problems, reaching consensus, validating transactions and adding them to the blockchain.


Differences such as block lengths can lead to different rewards for solving these cryptographic problems; this translates into different transaction costs that would apply when a particular currency is used. So, for example, Litecoin is supposed to work better for smaller transactions (versus Bitcoin) because its underlying protocol supports faster transactions for smaller fees.


Tokens, on the other hand, are usually defined for use on top of a particular blockchain like Ethereum. Ethereum tokens are what are talk about nowadays in the context of ICOs, and the idea is that the Ethereum platform itself provides the launchpad for all these tokens, without needing them to create their own individual blockchains.


For a rough analogy, think of Apple’s developer tools for the App Store that lead to hundreds of thousands of different applications.


Tokens can provide certain utility, as if they were the “currency” inside that particular platform or economy, and these are called “utility tokens”. In any such use case, tokens are the fuel (the “gas”) or the price to access the protocols or perform an action.


In other cases, they can in some way be equity-linked or even debt-linked. Most tokens today are built on top of the Ethereum blockchain and comply with what’s called the ERC20 standard. Owning a token is equal to holding something which could potentially be very valuable over time in that ecosystem.


The other key reason for their popularity is that they are marketed as a liquid commodity often traded on crypto exchanges, so you’re betting on something disruptive without tying down your money in an illiquid startup.


So, can anyone create these new currencies or tokens?


Theoretically, but not practically. Since decentralisation is the beauty of the crypto world, any group can talk about launching an altcoin.


There are around 800 or so out there. But only a few like Bitcoin matter for now. Any such project has to get interest from nodes to be able to create a large functioning blockchain which can validate and record transactions while guaranteeing speed. Obviously, there has to be market awareness or a new angle for why it’s better than simply using Bitcoin. The currency has to see some large scale adoption and tradeability on exchanges.


Tokens don’t have these challenges because they are defined specifically for use inside a platform or ecosystem. Yet, of course, for the token to be meaningful and necessary, it still has to enhance the value for users of that platform by leveraging the tenets of blockchain.


Give us a couple of examples of interesting new tokens.


The most interesting tokens in our opinion currently have to do with reimagining the basic infrastructure of the Internet through a blockchain lens.


Take a token like FileCoin or Storj, for example, which presents a concept of distributed data storage where, instead of relying on a centralised cloud storage provider (Dropbox or Amazon or Google), data is stored securely across the user network wherever excess capacity is made available. So hypothetically, millions of users can get tokens as a reward for offering space, and arguably the security risks are lower.


Similarly, a token called Basic Attention Token (BAT) — aligned with a new browser called Brave — is very interesting. The idea is that today, users like us are subject to advertising and we provide hundreds of hours of “attention” every month to various sites or apps. We do so largely via platforms controlled by the likes of Google or Facebook. So users like us provide the community or network effect that powers Google or Facebook, but most of the economic value flows to them, and not to content creators.


Brave talks about a blockchain-based browser where user behaviour will be anonymously captured and advertisers will be able to pay viewers for their attention in the form of BAT. So, you fundamentally decentralise the network and make it about direct interactions between users, publishers and advertisers vs. the current centralised framework.



(Note: Filecoin is a new coin or cryptocurrency with its own blockchain, and BAT on the other hand is an ERC20 token issued on top of the existing Ethereum blockchain. Also, none of this should be taken as an investment recommendation).


Another successful ICO was for Civic, which offers the vision of an on-demand identity verification token. Imagine that instead of passing on personal information every time you log in somwhere, or doing so with social authentication (Facebook or Google) in many different places, your sensitive data would never leave your device. Instead, a dynamic Civic ID was passed along to prove your identity.


We’re not saying these new models are ready or proven yet to work at scale, but they are interesting ways to reimagine the status quo.


That being said, the craze has gotten so out of hand that a number of dubious projects and strange coins or tokens are being floated. These have very little to do with blockchain, and in some cases may not even have any business logic. CB Insights pointed out a few funny ones.


Let’s talk about Initial Coin Offerings or ICOs. What is an ICO and how does it work? Can you walk us through an example?


Start by thinking about crowdfunding, like in the Kickstarter or Indiegogo worlds. An ICO is a funding mechanism that is based on issuance of tokens and raising money via a crowdsale (similar to prepaid revenues in the crowdfunding format). In the ICO, a company or foundation typically issues a token which represents a self-enforcing smart contract that has been programmed according to a whitepaper.


The company started by demonstrating the advantages it gets from being decentralised on the blockchain. Let’s take Brave’s ICO for example. In their case, they had also created and launched a product (a browser). They argued in a whitepaper that a new blockchain-based system directly connecting advertisers, publishers and users would be better than today’s status quo.


They talked about better privacy, load times and the ability for consumers to get paid for reading content. They argued that a new token is required to make this happen. They called this BAT and explained what it does, why it is critical and how it would be transacted between parties.


Tokens, as we discussed, represent an internal currency (roughly speaking) within a company’s platform. While this can sound like typical virtual credits or in-app currency, a better way to think about the token is that it’s the price to access the underlying protocols.


Tokens can be either utility tokens that are critical to the functioning of that project, or in some way tied to a claim on equity returns from the company. The idea is that if the platform can truly disrupt the industry via the application of blockchain, the tokens will rise in value and can be a good investment, especially for users who believe in the platform and can participate in the crowdsale. Arguably, the token holders will grow the company’s ecosystem and bring in new users resulting in a network effect down the road.


Coming back to Brave, they defined uses for BAT in terms of acquiring ad slots in the Brave browser, or even inside other browsers or messaging apps, or for micropayments for digital goods bought.


The best projects create technical documentation and Github repositories with some code, and bring together a team and advisors, including some from the crypto world. Many projects also do a pre-ICO sale (often with traditional VC investors) before going to the broader market for a token sale.


In parallel, there is legal and tax structuring work, and for some projects, this can be a significant cost. There is also the writing of an ERC20 smart contract which runs on the Ethereum blockchain, and a security audit of the contract if need be. The project is announced to the community, and marketed via crypto sites and forums, apart from social channels like Reddit, Slack and Telegram to build awareness and provide clarifications.


Finally, there is a token sale platform used for the actual buying of tokens from the company in exchange for BTC or ETH which is transferred to the company’s address. When the sale is concluded, the tokens are issued and delivered to the buyer’s ERC20-compatible wallet address via a smart contract.


In Brave’s case, it sold one billion tokens. They also created a development team pool of 200 million tokens and a user growth pool of 300 million tokens. These pools will allow them to incentivize developers and consumers to spur activity and create the network. In 30 seconds, they were able to collect 156,250 ETH which amounted to about $35 million at the time. (Note that this was an exception rather than the rule).


Do ICOs raise money in dollars or cryptocurrencies? Can the average person participate in ICOs?

For the most part, companies that do ICOs collect payments in Ether (ETH) or Bitcoin (BTC), and in some cases, they allow USD as well. Regarding your second question, while we are not offering any investment recommendations here, it is true that many ICOs can allow average buyers to participate.


Interested parties should do their diligence and check this case by case; in some cases, they are only open to accredited investors or have a minimum amount. Assuming someone wants to participate in an ICO token generation event (also called tokensale or crowdsale), they’ll usually first need to figure out buying Ether and Bitcoin somewhere and in the ICO, they’ll transfer the amount in exchange for tokens from the company.


How is an ICO different from typical VC fundraises?


Obviously, this is extremely different compared to a typical VC fundraise. You are raising the money from users and a large community of believers from the crypto world, rather than institutional venture funds.


The mechanism as we pointed out is very different – it’s far more open, the overall process can be sometimes faster than a VC round (keeping technical prep work aside), and you may not give up equity. You are also taking on the responsibility of delivering value in these tokens, and have to be comfortable with the volatility in Bitcoin or Ether, besides volatility in the price of your own token.


It’s a very interesting new way to overcome the legacy challenges of VC funding, but we should note that it’s still early and no actual new token project has seen validation at scale yet.


How big is this market now, and is the bubble sustainable? How are investors doing diligence around the key risks with these ICOs?


ICOs have grown tremendously in the last couple of months, with over US$2 billion raised thus far in 2017. As per data from CB Insights, not only has traditional venture funding to blockchain been eclipsed by ICO funding, the ICO market also seems to be larger than the size of the total early-stage VC market right now. A large source of capital is the wealth that early investors and miners in the crypto world hold today, since BTC alone is close to US$70 billion in market cap.



We don’t think this is a fad, though there are several indications of a bubble. In the long term, ICOs should be a viable path to funding projects that rely on the blockchain.


At the moment, most of the cryptocurrency price rise and rush of money into ICOs are both speculative in nature. And they feed into each other. ICOs provide a good use case for crypto and an option for large crypto holders to diversify or experiment, and in turn the growth of the ICO market boosts usage and demand for crypto, especially ETH. Basically, this is creating a new ecosystem.


There are a lot of scams, and new investors should be very careful. In our estimate, only about 20 per cent of the recent ICOs are raising any significant sums. There are a number of ICOs where the business premise itself, the team quality or the way the process is run is highly questionable. There are also real security hazards since there is no recourse by design, for BTC/ETH gone to a fraudulent address. Most new investors are following hype without basic diligence, and this is not sustainable.


Those who are closer to the crypto world are asking questions like: Is blockchain critical for this project? Is this platform better with decentralization? Is there even a need for a token? Is the token a real utility token or just a way to raise money? Is the token a security subject to securities laws?


For the diligent, there are certain online review sites that can help. Good projects usually have code or detailed documentation in Github repositories accessible for public review. At the very least, reading the whitepapers in detail can reveal something about the motivations and backgrounds of the team and the soundness of the business plan.


What is the role of regulators?


This is a raging debate right now, and regulators worldwide are figuring this out as we speak. Many ICOs like to clarify that their tokens do not confer any rights or stakes, and hence are not intended to be securities.


The central question is whether tokens – even when they are defined as “utility tokens” – are being invested in with the expectations of returns. If so, should they be regulated under existing securities laws or will they need altogether new guidelines?


In the US, for example, something called the Howey test has traditionally been used to define whether something is a “security”, but it’s not exactly applicable for blockchain-based crowdsales. The US Security and Exchange Commission (SEC) has started to clarify their stance, indicating that in some cases, the token sales will need to be registered with the SEC. They may also restrict which exchanges the tokens can trade on. The next few months will be interesting to watch.


Why did China ban ICOs recently? How does this affect the future outlook?


There may be a few different explanations ranging from wanting to “pause” (vs. outright ban) and take stock of how certain ICOs are clear scams, or what regulations should generally apply to ICOs, to worries about the outflow of capital and money laundering, to long-term implications for monetary policy control.


It looks like almost US$800 million of cryptocurrency was raised via ICOs in just eight weeks in July and August, so clearly the market was overheating too quickly. Earlier this month, the People’s Bank of China effectively put a halt to ICO activity and asked ongoing ICOs to return crypto deposits collected. A few of the largest exchanges also stopped functioning.


It’s hard to imagine China not aiming for a leadership role in the blockchain world, so our guess is that new licensing regulations are coming soon. This should be a good move in the medium to long term, since it will very likely clean the market of substandard projects and scams. It could also spur jurisdictional competition as other countries offer more ICO-friendly policies.


What advice do you have for any startups in the region that might be thinking about ICOs?


Please don’t be swayed by the hype. In a way, ICOs should be one of the harder – not easier – ways to raise money because the bar for decentralisation, blockchain relevance and implementation/prototypes should be very high. The market is correcting rapidly. Only about 20 per cent of the projects raise any substantial sums.


Crypto investors are now well aware of the low quality of many projects, and are becoming far more discriminating. The recent moves by China and the risk of more regulatory scrutiny in other countries further makes them sensitised to the risk. Going forward, we anticipate that serious blockchain projects will raise maybe even larger sums on average and mediocre ones will fall flat.


Doing an ICO properly involves some cost and thorough legal vetting. If you’re trying to raise any significant amounts (let’s say more than a couple of million dollars), it’s very likely that you will want investors from the US, China or the EU, so you need to carefully consider how your tokens would or would not fall under the purview of respective securities laws.


Since many tokens are being offered essentially as investment opportunities, it’s possible that they will need to comply with existing securities laws before new ones are drafted specifically for ICO tokens.


You also need to find the right kind of advisors. Beware of online scams or individuals who sell you a story about completing your ICO, without having the right experience or credentials. You should also be paranoid about the security of the wallets in which you receive the cryptocurrency from the public, and the protection of private keys. The smart contract must also be well programmed and tested so that unintended actions or transactions don’t happen.


What do ICOs mean for the future of VC funding?


For a few years now, the VC funding model has been under pressure from several directions: Kickstarter-like crowdfunding sites, AngelList syndicates and microfunds at the seed-to-Series A stage, and new entrants like PE, hedge funds, strategics and sovereign funds at the later stage.


Decentralised funding via ICOs is one more development in that direction. The important takeaway is that cryptocurrencies and ICOs have the potential to disintermediate VCs to some degree while also allowing a new class of angel investors to emerge.


VCs are no longer the only gatekeepers for early-stage capital. Many more parties can get into companies very early, typically the domain of VCs and angels. With ICOs, it crosses borders and allows ideas to find backers anywhere on the planet, rather than trying to get an introduction to a VC or angel, driving down to Koramangala (Bangalore) or Sand Hill Road, pitching them and going through a process to try close funding.


All this being said, ICOs are still mostly a phenomenon rooted in the crypto community. Taking the esoteric nature of blockchain and the crypto community into account would suggest that ICOs aren’t going to replace traditional VC funding in the foreseeable future.


Also, let’s not forget that good VCs do add tremendous value through their experience and networks which can’t be replaced by ICOs. However, much like seed funding has changed and evolved, we expect early-stage VC will also need to evolve rapidly.


How has the venture ecosystem embraced the rise of cryptocurrencies or ICOs?


This is happening in a number of ways.

  • Several Silicon Valley VC funds have been directly investing in blockchain startups and exchanges like Coinbase for a few years. Many VCs personally hold crypto.

  • 50+ crypto hedge funds that pool and trade various digital currencies and tokens, have appeared on the scene – and VCs have backed some of these like MetaStable, Pantera and Polychain.

  • VCs are beginning to invest in the equity rounds pre-ICO or the pre-ICO sale of tokens (e.g. FileCoin). The idea here is that these are investments with the same high risk – high reward profile, but with the benefit of liquidity.

  • Many have backed separate venture funds created with a blockchain-specific angle (e.g. Blockstack Signature Fund).

  • AngelList has introduced CoinList to enable ICO funding for its community.

  • It’s also interesting to note that some of the ICO funded ventures like Tezos have themselves turned into quasi-VCs after raising a lot of capital.


How do you plan to create more awareness around crypto tech in the region?


We are doing our bit to meet startups and developers and share learnings from our networks in the US and elsewhere. We’ll create more content and continue to follow this space from a fundamental perspective. We are happy to support the growing community on social channels (Telegram, Slack, Twitter, Facebook) in any way we can, or work with the community around hackathons, discussion forums and other networking events.


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